NetApp Inc (NTAP) 2014 Q3 法說會逐字稿

Welcome to the NetApp third quarter FY14 earnings call.

My name is Patrick, and I will be your operator for today's call.

(Operator Instructions)

Please note that this conference is being recorded.

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

Kris Newton, you may begin.

Hello and thank you for joining us on our Q3 FY14 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 www.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 forward-looking statements and projections with respect to our financial outlook and future prospects, all of which involve risks and uncertainties.

Such statements reflect our best judgment based on factors currently known to us and are being made as of today.

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

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

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

Please refer to the documents we file from time to time with the SEC, specifically on our form 10-K for FY13, subsequent Form 10-Q quarterly reports and our current reports on form 8-K, also on file with the SEC and available on our website.

During the call, we will also discuss non-GAAP financial measures.

These non-GAAP measures are not prepared in accordance with Generally Accepted Accounting Principles.

A reconciliation of our GAAP and non-GAAP results is provided in today's press release, prepared remarks and 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 will now turn the call over to Nick.

Thank you Kris.

Good afternoon everyone, and thanks for joining us.

NetApp executed another quarter of solid financial results driven by our strong innovation, competitive position and operational performance.

We delivered revenue within our prior guidance range and non-GAAP gross margins, operating margin and EPS all over the high-end of our Q3 guidance range.

Net revenues of $1.61 billion were up 4% sequentially but down 1% year-over-year.

Branded revenue of $1.5 billion grew 4% sequentially and 2% year-over-year.

Branded revenue was below our expectations for the quarter, driven solely by a shortfall in US federal business.

OEM revenue dollars were flat from Q2 as expected and down 23% year-over-year.

Indirect revenue through the channels and OEMs accounted for 83% of Q3 revenue.

Arrow and Avnet contributed 20% and 15% of net revenue respectively.

From a geographic perspective, total Americas revenue was down 5% year-over-year.

Americas commercial revenue was down 3%, and US public sector revenue was down 13% driven by downward pressure in federal IT spending.

EMEA and Asia-Pacific revenue each grew 3% on a year-over-year basis.

Non-GAAP gross margin of 63.5% was just 10 basis points below Q2 levels but above our prior guidance range due to a combination of strong execution across our organization and lower than anticipated spending.

Non-GAAP product gross margin of 57.1% was 4 points better than Q3 last year and down 20 basis points sequentially.

We recognized expected product gross margin pressure during the quarter from a less favorable mix of business.

However, that pressure was offset by further productivity and efficiency gains driven by our operations teams which we expect will be passed through to pricing over time.

Non-GAAP service gross margin of 60.8% was more than 2 points better than Q3 last year and up almost 2 points sequentially, reflecting lower than anticipated spending across our services infrastructure.

Non-GAAP operating margin in the third quarter was 19.5%, over 2 points better than Q3 last year and above our previous guidance.

As a percentage of revenue, non-GAAP operating expenses declined 2 points from Q2, reflecting continued prudent expense management given the environment we are operating in.

The non-GAAP effective tax rate for Q3 was 17.6%, above our prior guidance.

This reflects a true up for the first half of the year as we now believe our annual rate will increase to just under 17% driven by a slight shift in the geographic mix of profits.

Going forward, we are working through a change in how we report our non-GAAP effective tax rate to be more reflective of our operational results and tax structure and to provide a better comparison with our peers.

We expect to adopt this change in the next couple of quarters, and we will provide more information at that time.

Q3 diluted share count of 346 million shares decreased by approximately 3 million shares from Q2 and was below our prior guidance by approximately 4 million shares due to the partial benefits from Q3 repurchase activity.

Non-GAAP EPS of $0.75 was up 12% from Q3 last year and exceeded the high end of our previous guidance range by $0.02.

Cash flow and balance sheet metrics were strong again in Q3.

We ended the quarter with approximately $5.1 billion in cash and investments, 20% of which is onshore, and generated $332 million in cash from operations.

Free cash flow was 17% of net revenue.

Day sales outstanding at 33 and inventory turns at 20 reflect continued strong operational performance.

Deferred revenue of $3 billion was up $27 million versus Q2 and up $83 million versus Q3 last year.

In Q3, we spent $507 million in share repurchases and $50 million in cash dividends.

We have spent over $1.5 billion and have successfully repurchased over 37 million shares of stock since we announced the program nine months ago.

We remain on track to complete $2 billion of share repurchases by the end of May, consistent with our original guidance.

Today we also announced our next cash dividend of $0.15 per share of the Company stock to be paid on April 22.

Now to our guidance.

We remain confident in our strategy, competitive position and operating level.

However we have to anticipate and build into our expectations that this challenging IT spending environment will continue.

As a result, our target revenue range for Q4 is $1.62 billion to $1.72 billion which at the midpoint implies 4% sequential growth but a 3% decline in revenue versus Q4 last year.

We expect to continue to drive strong operational performance in Q4 and prudently manage expenses to generate consolidated non-GAAP gross margins of approximately 62.5% and non-GAAP operating margins of approximately 19% to 19.5%.

Based on our repurchases in Q3, and in the first 10 days of Q4, we expect our diluted share count for the quarter to decline to approximately 340 million shares.

We expect non-GAAP earnings per share for Q4 to range from approximately $0.77 to $0.82 per share, up from $0.69 last year.

With that, I will turn the call over to Tom for his perspective.

Tom?

Thanks Nick.

Good afternoon everyone.

I am pleased with our execution again this quarter.

Though we saw some pressure from the dynamics in US federal IT spending which we expect to continue, we expect ongoing market share gains driven by our strong competitive positioning and our differentiated product portfolio.

Through solid operational execution and prudently managing expenses, we drove upside in gross margin and delivered operating margin and EPS above the high-end of our previous guidance range.

Our strategy of delivering innovative, best-of-breed solutions that are cloud integrated and flash accelerated is well aligned with our customers' top priorities.

IT organizations are in the midst of a transition as they evaluate the role of new technologies and delivery models in their environments.

Although this transition has resulted in slower decisions and elongated sales cycles, it also presents opportunity.

Customers are adding flash at all layers of their storage hierarchy and are shifting to an integrated mix of on premise and off premise IT infrastructure known as hybrid cloud.

NetApp has established a market-leading position in flash and conversion infrastructure and offers a differentiated approach to cloud and software defined storage.

Customers continue to adopt our latest innovations, confident that our strategy will help them navigate this transition and position themselves well for the future.

It is imperative that CIOs maintain control of their data in a hybrid cloud environment.

As they seek to pull public cloud into the mix of their IT delivery, they have an opportunity to offload the burden of infrastructure and application management but cannot offload the ownership and responsibility of their business data.

The versatility, efficiency and ubiquity of Data ONTAP enables our customers to build solutions optimized for their specific needs.

These solutions we delivered today and our innovative strategies for tomorrow directly address the CIOs' need to seamlessly manage data stewardship across hybrid environments while giving them choice in technologies, applications, and cloud providers.

Our strategy to work closely with a broad set of service provider partners including hyper scalars has proven successful and resulted IDC ranking NetApp as the leading provider of storage capacity for the public cloud infrastructure.

Some service providers and very large enterprises are evaluating the concept of software defined storage as part of the evolution of their virtualization and cloud architectures.

With Data ONTAP, the number one storage operating system, NetApp pioneered the software defined concepts of defining resources and software, managing through policies and delivering storage services across a broad range of hardware.

Data ONTAP paves the way for customers deploying software defined data centers by eliminating the limitations and complexity of traditional hardware silo models.

The flexibility, performance and non-disruptive operations enabled by clustered Data ONTAP are valuable both in on premise data centers and cloud environments.

With a storage architecture that can host multiple disparate workloads and service level requirements, enterprises and service providers can adapt in the face of unpredictable data growth and dynamic business demands with reduced complexity and cost.

The applicability of clustered ONTAP in both on premise and cloud environments is driving an accelerating rate of adoption.

Clustered nodes were up more than 40% sequentially and more than tripled from Q3 of last year.

The attach rate of clustered Data ONTAP increased across every FAS products line with the largest increase occurring in our mid- range systems, demonstrating the breadth of the acceptance of this technology within our customer base and our partner communities.

Adoption of our flash solutions is also increasing.

We believe that customers will deploy flash at every layer in the stack to solve a wide variety of challenges.

This market is clearly not one-size-fits-all.

Our broad portfolio includes both hybrid and all flash storage offerings which enable IT organizations to optimize the level of performance, efficiency and scalability to meet their specific needs.

We have shipped almost 75 petabytes of flash storage since the inception of our flash program, roughly one third of which is in the form of all flash arrays.

We're very pleased with the success of our all flash EF product line.

During the quarter, we introduced EF550 with greater performance and capacity than the previous generation EF540.

Also in Q3 alone, we added more new EF customers than the prior cumulative total.

These customers represent a wide number of verticals with database acceleration as the primary use case.

In addition to the strong traction we are seeing with the EF products, we are also seeing an accelerating number of customers deploying FAS systems and all flash configurations.

These all flash FAS arrays are also being deployed across many verticals, with VDI and shared storage as the primary use cases.

Customers value the maturity of proven storage arrays with the performance of flash, and they're not willing to sacrifice reliability, manageability and data protection in their flash infrastructure.

The momentum of our hybrid solutions in both the EF and all flash FAS products with FlashRay on the way is now a very strong position in the flash market.

We are also seeing continued growth in the total branded E series product line.

E series units inclusive of both E and EF products almost doubled from Q3 a year ago and grew 34% sequentially.

FAS2000 units were flat sequentially while FAS3000 systems grew 8% and FAS6000 systems grew 16% from last quarter.

We will soon be introducing our first generation of cluster optimized FAS platforms, enabling customers to deploy a wider range of performance, availability and capacity options all seamlessly managed for clustered ONTAP.

Our strategy and execution in converged architecture continues to drive positive results with the FlexPod customer base growing more than 75% from Q3 last year.

In Q3, we expanded the cooperative support program with Microsoft joining Cisco, NetApp, VMware and Citrix.

Additionally, we announced enhanced cloud capabilities with new validated designs for FlexPod Data Center with Microsoft private cloud and FlexPod data center with Citrix cloud platform powered by Apache CloudStack.

We continue our readership role in the development of open source cloud management alternatives, working with both CloudStack and OpenStack.

I have spoken before about the challenging setting in which we are operating.

Budgets are compressed, customers are extending the life of their assets, and they are delaying purchases while they evaluate new technologies.

Recently we have seen weakness in US federal IT spending.

We do not see any near-term resolution to the low growth IT spending environment, and our guidance reflects what we believe to be an appropriate level of conservatism.

Nonetheless, we remain well-positioned competitively as demonstrated by our strong gross margins and market share gains.

According to IDC's Q3 calendar year 2013 market share data, we gained over 1 point of share from Q3 a year ago, our fourth consecutive quarter of increasing year-over-year market share gains.

I have also talked about our portfolio being the best ever, and I see that continuing.

We have more products earlier in their lifecycle than ever before and continue to drive platform competitiveness with the solutions in our upcoming announcement.

We expect to extend the lead of our diversified flash portfolio and broaden our partner ecosystem of hyper scale cloud providers in the coming quarters.

We continue to innovate and partner in unique ways to create ongoing opportunity in an evolving IT landscape.

Data growth is not slowing.

And the challenges of managing that data become more complex with the introduction of off premise computing.

The ubiquity of Data ONTAP and our partner strategy uniquely position NetApp to support the long-term demands of IT organizations as they evolve their delivery to a hybrid cloud model all managed with one set of tools for both on premise and off premise data.

Regardless of the IT spending environment, we are confident in the strength of our innovation leadership and the ability to drive continued share gains and shareholder value.

We see opportunity and growth in the emerging hybrid cloud environment.

In wrapping up, I would like to thank the entire NetApp team for their execution intensity.

We are making the right choices and remain focused on innovation and execution which enables us to provide our customers and yield strong operational returns.

Despite the challenging environment, we are generating operating leverage in our business model, supporting continued investment in innovation and yielding strong cash flow.

I also want to congratulate the team for being recognized by Fortune as one of the 100 best companies to work for list for the 12th consecutive year.

NetApp's unique culture is a differentiator that helps us drive innovation and enables our customers to achieve great outcomes.

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

As always, I 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)

Jim Suva, Citi.

We all know that the federal government and government spending has been pressured due to the political reasons and sequester and such like that, but your view -- it has been several quarters now.

Is there a break point where you see that they are going to have to come back and spend regardless, or are they just wringing the towel out as much as possible?

And do you think that this is the new go forward rate of what we are doing right here?

I guess time will certainly tell, but I think from our perspective, it certainly appears to be that the government has -- is going to be in this state for a while.

So I am not in a position to say that I think this is going to bounce back in a week or a month or quarter or longer than that.

I think as we think about where we are going from here, I think we are assuming that this is the situation we are going to see, and it's going to be tight spending across-the-board.

So for us obviously it makes next quarter's compare and Q1's compare and a bit of Q2's compare more challenging.

Assuming that it is no change, then it will start to normalize.

But I think it would be imprudent of us to bake in an expectation that things will suddenly snap back.

I think our assumptions baked into our numbers is this is the environment we are going to see, it's going to be challenging, NetApp will win its disproportionate share, but I am not expecting things will return to normal in the near-term on the federal side.

Sounds like the conservative and good thing to do.

Congratulations again to you and your team at NetApp.

Thank you.

Joe Whitney, Longbow Research.

The sales outlook, Nick, only 4% growth like you said, a little bit under that.

Well below what you have done in the recent past.

I wouldn't think federal is a huge impact there given just how weak the January quarter was.

Given that weak starting point, is there anything else you could point to as far as what is happening in keeping this outlook well below seasonal?

Joe, this is Nick.

We actually missed the front end of your question.

So -- I'm going to ask was your question around growth for Q3 or around the outlook for Q4?

I was asking about the -- just the outlook for the fourth quarter here.

Well below seasonal, and it doesn't seem to me that federal should be a significant impact on a sequential basis, given just how weak the January quarter was for federal.

What else is going on?

Let me first point out that last year, when we look to year-over-year for Q4, federal was down pretty substantially year on year.

We've got to build in that overall federal environment into our thinking for Q4.

And if you were to look at the overall, our expectations for the branded side of the business for the quarter are probably about flattish.

We also have some conservatism and pressure built in on the OEM side of the fence, and we think that is appropriate given if you think one of our big OEM partners there is IBM, and some of the dynamics going on in their business as an example.

Remember, the OEM business, we are going to be dependent upon those parties and our OEM customers in the dynamics impacting them.

We're just a supplier to them.

Those are two areas where we think a level of conservatism is appropriate in terms of building that Q4 revenue guidance for you.

The one thing I would add to that is certainly the federal story is an issue.

But that's not to say that the rest of the global market is everything is fine as well.

You see the guidance of our peers and the commentary of our peers, and we certainly see that as well.

I think all these things are factored in.

Clearly we've got a tough compare with the federal side.

As Tim indicated, as Nick indicated as we go forward into next quarter, we are also heading into the Q1 of both IBM and Teradata, two of our bigger OEM partners, clearly there's a sequential impact associated with that that we will need to absorb.

I think all those things considered, not a lot of bright lights.

Broadly, certainly we've got by virtue of having by far and away number one market share for federal, we have an exposure there that some of the other guys don't have, and likewise we have OEM seasonality that is somewhat different than our own.

And that is something else we need to factor into next quarter.

Thanks.

Bill Shope, Goldman Sachs.

Okay, thank you.

You had another quarter of surprisingly strong gross margins, and that's very encouraging to see that persisting.

With that said, we are still not seeing similar performance on revenues, and I understand all the factors you mentioned, particularly the federal weakness.

But is there any component here where you're giving us some elasticity that you have to walk away from more aggressive deals in the quarter at a -- more often than normal?

How should we think about the pricing dynamic and whether or not you may be leaving some revenue on the table for strong gross margin?

I think overall, certainly we want -- we would not want to sacrifice any hard-won sales discipline here.

But nonetheless, I think that we need to separate specific very competitive large deals and big accounts from the broader motion of the business.

So I think in the broader motion of the business, I think we have been disciplined about our pricing.

I think we have come a long way over the last year in training our field and our partners about the value proposition of clustered ONTAP.

As that becomes more mainstream and we see repeat purchases there, I think the value proposition is exceptionally strong.

We too are certainly heartened by the strength of the gross margin two quarters in a row.

I don't think the rest of the industry has seen that.

And I don't think it's a coincidence that that also coincides with much broader acceptance of clustered ONTAP.

That said, I think our big transactions which are either new accounts or complicated for any number of reasons, I don't think in this market we are walking away from those easily.

I think that we are willing to pursue business, we are willing to be aggressive to go after big deals, we are aggressively going after accounts, and in terms of these large opportunities, we are not walking away from too many them on price, certainly no more than we have in the past.

But I think broader discipline, better execution of the value proposition and better training of both our people and our channel partners have been a bigger contributor than that.

Let me expand on a couple of pieces, Bill, because when we look at really the progression of Q2 to Q3 to Q4, there are a couple of components to overall gross margin to take a look at.

I'm going to start on the services side of the fence for a second.

On the services side of the fence, gross margins went up from Q2 to Q3.

Our expectations will be that they are down a bit between Q3 and Q4, but in the services side, and we have had a little bit of this conversation before, here what we are doing is spending to build our infrastructure in a lot of cases.

So sometimes there is, and in this quarter, there were certainly a timing of spend that was a little different than our original expectations that impacted the gross margins in the quarter and helped us drive that 2 point increase sequentially from Q2 to Q3.

So we expect some of that to -- that timing of spend to come back into the system in Q4.

So those margins will come down.

And then on the product side, I think that is where you would see the impact of Big Deals, the impact of the elasticity that you asked Tom about, and we had expected a decline sequentially from Q2 to Q3 on the product gross margin side of the fence in the 1.5 to 2 point range.

Some of that is always due to mix, product mix, customer mix; we saw all of the things we expected.

We offset that with really great execution in the business and realization of a lot of value there.

So we really made up the difference on the product gross margin side, but just looking at overall gross margins, you really have to get under the covers to the two pieces because they are different drivers for the two, and that point on pricing is really more of a product situation than it is a service gross margin.

Okay, that is very helpful, thank you.

Steven Fox, Cross Research.

Thanks, good afternoon.

Just going back to a couple comments you made in the prepared remarks.

You talked about some spending delays or decision processes extending out-of-round evaluating new technology and delivery models.

Can you expand on that, how much of that was new impact relative to what you thought and whether this is something that can abate in the next couple quarters, or how do you think that plays out before that becomes a non issue?

I think we see things that other people are seeing.

We certainly see IT budgets particularly in the very large accounts under a fair amount of pressure, and the consequence of that is clearly that people are going to try and reduce their CapEx by using resources longer and higher rates of utilization.

Perhaps use some of the storage efficiency features they hadn't used in the past and generally elongating product life.

The other side of it though is I also believe that customers are looking at more technology choices like flash, and they are also looking at delivery model options as well like cloud.

And if you are in an investment cycle where you are looking at do I build another data center that I'm going to be wedded to for years, and am I going to regret that three years from now and wish I had gone to the cloud or likewise do I make a big investment the next version of software, something like that.

I think in the advent of cloud and SaaS and new technologies, there's elongated decision cycles because people don't want to make bets on technologies that are long-term in nature that they will regret in a few years.

I certainly see that.

People trying to figure out how to integrate these new technologies, how do we integrate them into the workflows with all the benefits they may perceive and the risk they may perceive and factor that all in.

No doubt that particularly in the cloud I think is slowing down decision cycles as people really saw how that can be realistically deployed in their environment.

Any different than in prior quarters?

Certainly a relatively new development, I wouldn't say dramatically different this quarter than prior quarters.

You definitely see it, that customers are somewhat reluctant to make very long-term commitments in a rapidly changing technological environment.

Great, that is very helpful, thank you.

Lou Miscioscia, CLSA.

My question is really on the same line as that.

When you look at service side flash with flash competitors, cloud storage with companies like AWS that are growing at 1 petabyte to 1.5 petabytes a day, cloud storage with the software as a service company and object storage, hasn't the environment changed so we all should just be thinking about very low modest, 2% to 3% organic growth for your branded business just going forward?

Because these things are on the horizon and doesn't look like they're going to change, and wondering if we should just really rethink or reset things here, Tom.

Clearly we are in the low growth environment.

I don't think it is -- we are going to subject ourselves to that type of questioning.

Because clearly the question whenever we go through one of these is, is it different this time or will it bounce back?

And I think all of those things are factors.

The things that I talked about, about elongating product lives, driving efficiencies, running at high utilization, slowdown in decision processes, those are all real.

There's no doubt about that.

But I think it's also fair to say that we also see some of them moving to the cloud.

Server-side flash is much less of a factor, but the cloud is clearly the big disruptor in peoples minds.

And there is no doubt that there are workloads that make sense in the cloud, and clearly there is the flipside of that of course which is -- (technical difficulties) Can you still hear me?

I can, and I don't think it was me, just to let you know.

I am not really sure either.

The long and short of it is I do believe there's some workloads that go into cloud.

A lot of them tend to be temporary workloads, a lot of them tend to be proof of concept type workloads, and some of them are low utilization workloads.

But that said, when we talk to end-users, I think the big question that people are facing is how they broaden the appeal of those workloads and broaden the use of the cloud, which is a very complex data management issue.

It isn't as simple as running in the cloud; it's how do I integrate that into my workflow, how do I protect it.

The data stewardship problems don't go away even if the data moves.

Now from our point of view is that we are not going to deny that data has gone through the cloud.

Do I believe that will depress somewhat the long-term growth rate of the industry or somewhat different than historical norms?

I do.

Do I think it's 2% to 3%?

I don't.

I think data growth will overpower that.

I still think that the long-term growth rate of this industry is higher than that, but our challenge is recognize that data is going to go to the cloud, and the opportunity or the need for customers to manage that data well and protect that data, it only gets more acute.

So from our point of view is we have clustered ONTAP and Data ONTAP that manages dats on our hardware and other people's hardware, our goal is to embrace the hyper scalars.

You see things like that at a private stores; you will see more things from us along that line.

Now our challenge that we want to put ourselves is how do we make it possible for customers for the use cases that make sense to effectively and seamlessly integrate the cloud into their environment?

I think the person who does that ultimately wins the data management battle, and that is the strength of our portfolio.

If we don't have five or six different products we're trying to integrate, we have the opportunity to create one data management framework across all storage whether it's on premise or off premise, whether it's on our hardware or not.

Is the cloud a factor?

Sure.

Is the cloud mainstream?

No, it's not.

The Company then enables customers to make it mainstream is going to be the winner in this space.

Good luck guys.

Katy Huberty, Morgan Stanley.

Thanks.

The software entitlements in maintenance line went ex growth for the first time ever despite decent branded product growth over the last four or five quarters.

Can you just talk about what drove that deceleration?

Hi Katy, it is Nick.

If I look at the last 12 quarters, there is always going to be movement in those lines, especially on that SEM line.

That does come off the balance sheet which means it is going to be dependent upon the length of contract, on the balance sheet, whether there is any large or lumpy contracts that are coming off over time, and then what is going on.

It's a combination of the two.

So when I look back again over 12 quarters, sometimes it is flat, sometimes it is up dramatically; this is all timing.

I would not get too much into that, but when you've got an overall business like we have at this type of revenue rate, I appreciate the fact that you are going to look at some of those lines and say that is down, but I think you've got to look a lot of that is timing.

Did you see any change in the length of contract or renewal behavior in the January quarter?

In terms of the overall contract life and the life of what is in the balance sheet, there is no dramatic change there.

These are tens of thousands of contracts, and you can think of it as a massive Excel spreadsheet in terms of what the amortization of that looks like over time.

And then during the quarter, we will always have our fair share of renewal transactions or our fair share of very large multi element transactions, all of that is in the mix.

Got it, thank you.

Bill Choi, Janney.

Thank you.

Tom, I want to continue the prior discussion you were having here on revenue versus margins; it was obviously a question about elasticity.

I want to take a different kind of angle and want to talk about reach here.

You have completely refreshed your entire product line, so you might be benefiting from some upgrade opportunities with existing partners, but yet when we look back the last few years, you have had a lot more competition for the channel.

Clearly EMC has been a lot more aggressive, and you still have all these new players like Pure, like Nimble, getting some of your former partners or existing partners.

So if you could talk about it from that angle, reach channel partner programs, has anything changed materially in the last year or two that prevents you from really benefiting as the cycle comes back?

No, if anything the broader channel reach into the general territory has actually been a much higher growth part of our business than the major accounts.

So I feel good about how we are going down that path.

And as far as the smaller companies, certainly we see them, but at the end of the day, the overwhelming competitive engagement is with the traditional companies that we -- and larger companies we hear about everyday.

From our perspective, I don't think the competitive landscape has changed.

Certainly some of them are carrying some of the smaller players into some of the midsized accounts, but for the most part, I don't think that has disrupted our momentum.

In fact, you see our numbers on the indirect channel as being as high this quarter as they have ever been despite the -- some of the OEM rolloff.

So I think I feel really good about our channel program.

I think one of the things that happened this past quarter, particularly with the clustered ONTAP adoption was that we saw a big jump in the 3000s.

And what that would signal to me is a lot more breadth, and breadth really comes from our channel partners.

But other data point is in terms of new customer acquisition which is also primarily driven by our channel partners, our new customer acquisition year to date is almost double what it was last year.

Actually I feel good about the general territory.

I feel good about the channels.

As reported by a lot of other people, the larger accounts which are probably more proxy for the macro is clearly where we see more slowdown, but our channel momentum is the bright part of the story both in terms of the commercial channels.

And state local and higher ed had a very quarter for us again, and that is 100% channel.

Are you still growing the number of your channel partners at this point?

Probably not.

Our number of channel partners in terms of people that are part of the program is measured in the thousands.

What is more important for us is the ones that are producing and make sure that those guys are well compensated, they are interested and they understand the value proposition.

We are not looking to add another thousand to a long list.

We're looking to make the ones that are productive a lot more successful.

And one of ours reported last quarter a very strong quarter, one of our public channel partners.

I think fewer better partners is probably a thing that we are really looking for, particularly with the clustered ONTAP transition, the expansion of our portfolio, there are a lot of big opportunities for them to differentiate from our other partners and take us forward because those are our top priorities.

Fewer better partners, where are we on the transition?

How long before you stabilize the number to what you think is ideal?

I think that in the end, our channel program has to be measured against the opportunity and Return on Investment, and that is the thing we have valuate everyday and I think it varies country by country.

The cut off -- overall remains robust, remain strong, and frankly if our major accounts are growing as fast as our channel program we would be having a different conversation right now.

Okay, thanks.

Mark Moskowitz, JPMorgan.

Thanks, good afternoon.

Just want to come back to the topic around the new norm here in terms of this more muted revenue growth profile.

Is this a function of maybe you guys are a victim of your own success in terms of all these different software sets just allowing or enabling customers to buy less.

Less is more today, and therefore your revenue content per department for both new and legacy customers is decreasing.

And could this be a continuing trend?

I will be firm in my disagreement with that.

I think -- I can roll the clock back to the aftermath of the financial crisis, and we had just introduced deduplication, we had conversations on this call about is deduplication slowing your growth rate because clearly the growth rate has come down.

And the simple fact of the matter is if we have 99% market share either in the market or the customers themselves, we might have a different point of view, but we don't.

If we can give the customer a better solution, ultimately declare and pay more of their footprint, that helps us.

The aftermath of that downturn, NetApp had a 30% organic growth year with the exact same technology, and I think the goodwill that we built, new customer acquisition we built along the way, the market share gains even in the tough environment that we accrued paid off huge for us.

Where we are today, I do believe that there is a limit.

In other words, people can extend the life of the equipment for so long, and eventually that may become -- eventually they need to go back to the normal growth rate on top of that.

So as a one-time expansion which could depress the market, and we certainly see that over the last couple of years.

But at its core, I still contend that just about every activity undertaken by mankind has generated data.

The generation of data is not changing.

People are modulating the copies of the data which is the growth rate of the industry, but that has consequences, and people are trying to use assets longer.

I think elongation of asset life will slow down the growth of the market in the near-term, but eventually that needs to normalize.

I'm not sold on the idea that this is the new normal, that storage is going to grow at the rate of IT; that hasn't been the case historically.

Certainly there are other delivery models, but in the long run, I still believe that storage is inherently only going to increase, and I think that this market will bounce back.

Thank you.

Kulbinder Garcha, Credit Suisse.

Thanks, and Tom, I want to go back to that last comment with respect to storage outperforming IT as well as maybe utilization rising.

I guess you guys have a lot of systems out there, do you guys measure storage utilization?

Can you give us any sense on where it is in your system on your system's history?

I'm trying to understand how high some of your customers may be pushing that because the one thing that is clear is storage -- you're right -- historically has outperformed IT, hasn't probably in the last year, year-and-a-half, and that's were some of the structural concerns -- it's not normally gone this long.

I'm wondering if you've got any tangible evidence as opposed to anecdotal when customers tell you where utilization might be.

And for Nick, just with respect to cost savings, if we are in this -- (technical difficulties).

That is not me, by the way.

We actually -- maybe it was perfectly timed that I didn't hear your question.

I was just going to stay with respect to OpEx savings and cost savings, if we are in the subdued revenue environment, can we -- suppose we are like this for the next year for argument's sake, will NetApp become more aggressive on the cost basis?

Could we have another restructuring do you think?

I will answer the first question.

In terms of the protracted nature, if you look at IT, it has been protracted against all categories.

I do believe that there are categories that are getting funded in this environment, certainly security is a top of my concern for every CIO I speak to.

I think within a constrained environment, there may be some competing platforms that we might not have had in the past.

Doesn't change the fact that storage is growing, it's a consumable, and I expect that storage to outgrow IT, I expect that trend to come back.

In terms of metrics in the field, I would hate to quote a metric that I will get held to every time.

Certainly equipment life is extending.

I think that there is no debate about that.

In terms of utilization rates, we do have some data on that, but obviously that depends on a whole bunch of categories in terms of use cases, product platform and that nature.

But there's no doubt that equipment life is extending, and you see it in the form of -- as Nick talked about earlier -- length of first-time service contracts and the number of renewals as opposed to tech refreshes after the fact.

Let me come to your question on the spending side of the fence, so first of all, we are going to be and we have continued to note that we are very conscious on the spending side.

I think we are also really quite proud of the work that the broad organization has done whether it be in supply chain or many different pieces of the operation in ensuring we are getting the biggest return for the dollars spent whether that is in the channel or in the manufacturing side across the board.

I think we are really quite pleased with that.

And we are going to keep up that focus, and I think that is going to be part of and continue to be part of the reality.

Our job is to find the areas of investment that will yield the biggest return and make those investments there.

Our job is also to look at those areas that aren't yielding return or where we think that the investment is outside of the return and direct accordingly.

I can't answer a question specifically on what actions we will take at any one point in time because we take actions and make decisions every day.

But being conscious of our costs and being conscious of where our investments are directed, that is part of our day to day, and you should continue to expect that.

The one thing I would add on that subject is one thing that -- clearly a tough environment that we are particularly pleased with is we did a restructuring last year.

And it was painful, and it should be.

And it's not something that we were happy about doing.

But in parallel with that, we took a very serious effort about the rest of the cost structure on the COG side and things of that nature.

And I think that the improvement in gross margin is the culmination of some very important activities that we did there.

So in a very tough environment, we see NetApp gross margins go up, and I don't think that has been the trend of either our competitors or more broadly in the IT industry.

And as the Company also generated expansion of our operating margin in a very difficult environment as well.

So I think our execution intensity is way up, and we are committed to make the decisions that will be necessary to generate shareholder return and long-term health for the Company, but I should also add that a do expect this industry to come back.

We are not going to sacrifice investment that we believe will create competitive advantage for us that will sacrifice our position going forward.

And the market share numbers are really strong.

While the topline numbers aren't great, four consecutive quarters of increasing market share gain in the IDC numbers, that's a sign of winning, and so confidence is high.

And we don't want to let that go just because we are going through a tough period that we think will ultimately lapse.

I think we have made some hard decisions, made some painful decisions, the execution intensity is high, but we're not going to sacrifice the investments we think are going to enhance our competitive position going forward and jeopardize our ability to capture the return of this market.

Thank you.

Ananda Baruah, Brean Capital.

Hi, good afternoon, thanks for taking the question.

More of a clarification on your gross margin comments in the prepared remarks.

I think you guys mentioned, Nick, that you would eventually pass the efficiency gains through product margins through pricing overtime.

And just wanted some context on that.

Should we expect gross margins to begin to decrease now as we move forward?

Some of that is implied in your April guidance.

Just wanted to get the full context.

Thanks.

Sure.

First of all, when we -- when I gave guidance 90 days ago, we talked about the product gross margin in Q2 and some of the savings in our expectation that those would pass through in Q3, and in fact, they did.

So that is something we're going to be doing.

There is always a bit of timing lapse that we have to work through, but we recognized savings in Q2, we passed some of those savings through in Q3.

We recognized even more savings in Q3, and we are going to pass through some of those in Q4.

It is just timing, and I think it goes back to the really strong efforts around execution and operational excellence that are going on here.

So yes, the guidance that we gave on gross margin would imply a lower product gross margin in Q4 than in Q3.

That is as a result of some of the pass-through.

That is also -- if I go look over time between Q3 and Q4 over some years, there is a reasonable downtick in product gross margin.

So none of that should be expected.

Overall, I think using some gross margin to generate some growth and strategic accounts, that is a trade-off we'd make frankly.

I think more broadly if I look at our channel business and general territory business and the broad transactions, I think we are doing quite well there from both a growth and a gross margin perspective.

I wouldn't basically give that up, but nonetheless, no shortage of ugly deals to pursue particularly breaking into new accounts and those of keen interest to us.

And we have been doing that all along despite the gross margin rise, but if we saw opportunities around competitive takeout opportunities or opening new accounts that had high growth potential for us, we're certainly willing to use gross margin to make that happen.

Got it, is there a normalized gross margin that you think or a range that you think is reasonable in the spending environment?

I think we gave our long-term model in terms of gross margin, and we are certainly at the high end of that, but I think we need to move onto the next question.

Thanks a lot.

Nehal Chokshi, Technology Insights.

Yes thanks.

On the US commercial, that was down 3% year-over-year.

And I understand of federal came in below expectation.

And that OEM has also been a pressure, but compared to prior two quarters, commercial was up 8% and 11% year-over-year.

I am trying to figure out why is there an 1100 basis point reversal in the year-over-year growth -- can you help out with that?

Yes, I agree, I said that earlier.

I think as we look at -- if I look at this quarter and the Delta from the midpoint of guidance, I think its easy to put that in the context of the federal business both in terms of they only grew as fast as the flow of the other territories or if they were nominal 10% of our total revenue instead of 9% like they were this year, 10% last year, both of those explain all of the difference.

But going forward I think that the more general IT trend that you see reported from other people, we are not immune to that either, and we're seeing that in all the geographies.

I don't want to say that the difference between normal seasonality and where we are guiding is all about federal.

Certainly federal isn't helping, and we don't expect it to come back.

The OEM is a factor.

And I think that is on the trajectory.

But I think that the rest of the major markets are still challenging.

And I don't see them improving.

We had some bright spots in some of our emerging markets.

China was especially strong for us, but it's not enough to offset the major markets.

So I think if I look at the numbers, US commercial down 3%, that is clearly a downtick from where we were last quarter, and that's factored into where we are going forward.

I don't believe that -- and certainly nobody at NetApp believes that that's a competitive dynamic.

I think we're seeing what other people see and that impacts our numbers and will affect our guidance.

That's a conservatism that we built in.

Federal clearly a factor, but I think we have been seeing some downtick and weakness broadly in the major markets as well.

What is the reason for that downtick in the major markets?

I think it's all the other dynamics.

You watch the IT spending numbers estimates come down and down and down, and I think we see that.

One of the things about storage is we can talk about the snapback in storage, storage and consumable and generating a lot of storage, but storage spending is still up, the umbrella of IT spending.

We don't sit around the table and say I wish we could spend money on R&D because we can't because we have to buy more storage.

Those conversations don't happen.

IT budget that is set, storage over time will get a disproportionate amount of it, and it doesn't change the fact that storage is still very highly correlated with overall IT spend.

As IT spend comes down, storage comes down with that.

I believe that in the long run it will outgrow IT, but it will never separate itself from it.

All right, thank you.

Eric Martinuzzi, Lake Street.

Thanks, on the OEM side, I've been trying to guess at where this long tail flattens out and have been off; we will leave it at that.

Given that we did $787 million last fiscal year and I am tracking to a little under $600 million this year, are we in that zone where we can say it does start to flatten out or given the decline still too soon to tell?

I think that the IBM story -- roughly flat last two quarters.

And I think that we have been guiding towards flattening out.

Probably the big mover in that story certainly over the last two years has been the IBM component.

I think we have been very upfront with that.

And I would say that IBM is gliding into the range that we expected of them.

Although we don't have any direct knowledge, certainly there are a lot of decisions going on at IBM that could help us or hurt us.

There's some uncertainty around that that we might not have had six months ago.

But I think that the trajectory that they are on is very much in line with what we guided to, and I do see that settling in.

And the other partners in that community has all been good.

And that said though, if I look at branded E series like the all flash EF and branded E series, non-EFE series on the branded side is growing even faster.

And I said on the prior call, we are looking for aggregate E series, branded plus OEM to be a growth business for us next year.

We're excited about that combination.

Okay, but I'm in this minus 20% to minus 25%, and that seems like it ties out to the Q4 guidance, is that roughly accurate.

If you are talking about the OEM for Q4, what we mentioned earlier is that our Q4 is the Q1 for the OEM.

That will put pressure on that business.

If you look at last year between Q3 and Q4 the sequential down was 18%.

So the type of math you are doing could absolutely be the types of numbers we've got in IBM, as Tom said, upside or downside.

But we've got to be aware of that dynamic.

So certainly we are being conservative in what we expect from OEM.

One or two less questions.

Thanks.

Rajesh Ghai, Macquarie.

Given that the move to the hybrid cloud is inevitable for enterprise IT and you seem to be finding some success selling into the hybrid cloud, the public cloud or -- or vertical with your ONTAP appliances, I was just wondering does your model change over time and how long would that be?

Do you see a potential for gross margin to increase given that size of the customers, you are not going to see any benefit out of that?

And also related to that, wondering if you could begin sharing some specific revenue metrics so that we can gauge progress and see where it goes.

Thank you.

I think over time, clearly we have had a service provider vertical for a while, and over the past year, it has been that segment at least the US commercial market has been our best performer, so I think we continue to do that.

More broadly within the hyper scalars, the likelihood of hyper scalars buying our standard product and deploying it I think is pretty remote.

We certainly pursue IP discussions with them, that may or may not yield anything, but in the end, where we are right now, IDC has us ranked number one in capacity of storage in the public clouds, I think our service provider program is working well for us.

I think in the endgame, to move that and make that more mainstream and make it integrated into the key flow of key business applications for customers, there needs to be a seamless integration of off premise and on premise computing.

If you think about it, in order to use the service providers, also the hyper scalars, if data can be managed and protected and backed up and organized and archived all with one data management tool, that would be really compelling.

Really that is the push we are on at the next level, and rather than fighting the cloud and debating the relevance of the cloud, I think similar to our deduplication conversation of five years ago, if we embrace the cloud and make it possible for customers to use it, the likelihood of a greater standardization deployment of our data management across the enterprise goes up.

And if we are riding more data, controlling more data with our data management, then the opportunity to add more value through software also goes up.

From our perspective, I do believe that hybrid cloud is very much in its early days, but if there was ever a technology in this world that could span on premise computer and off premise computing and likewise multiple hardware, it would be ONTAP.

We already have ONTAP that runs on V-Series, runs on other people's software, ONTAP that runs on other people hardware, ONTAP on a virtual machine that runs on generic hardware, the ability to basically go off premise and bring that into Data ONTAP and management tools is a compelling value proposition.

I think one that really nobody else can realistically claim.

And for my perspective, that is the epitome of software defined storage when enterprise data management that could manage any storage, whether it is on hardware or not or on premise or not.

That's the thing we are going after in the long-term.

In the meantime, where we are now, if you look at the market share numbers I think the team feels like we are winning.

I think we are gaining share, it is a tough environment, and the senses if we are continuing to gain share when this thing does bounce back and I believe it will, we will be positioned better than ever.

I really feel good about long-term strategy around hybrid cloud.

I think that is something we are uniquely capable of delivering, and at the current state, I think we are winning in the public cloud with the service providers, and I think if you look at market share we are winning on premise as well.

E-Series in its early days, flash array on the way, so it's a jungle out there, and I wish we had more topline growth to show for it, but I think we are doing the right things, I think where winning against any competitor, and I think we feel confident about our ability to continue to innovate in the future.

I think we need to move on.

Thank you very much.

Thank you all for joining us today.

And look forward to talking to all again in another 90 days.

Thank you ladies and judgment.

This concludes today's conference.

Thanks for participating.

You may now disconnect.