NetApp Inc (NTAP) 2014 Q4 法說會逐字稿

Welcome to the NetApp fourth quarter and FY14 earnings call.

My name is Jamie, 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, Vice President, Investor Relations.

Kris Newton, you may begin.

Hello, and thank you for joining us on our Q4 FY14 earnings call.

With me today are our 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 forward-looking statements and projections with respect to our financial outlook and future prospects, such as our guidance for the first quarter and full FY15, all of which involve risk and uncertainty.

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 filed from time to time with the SEC, specifically 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 give you his perspective on the business this quarter.

I'll now turn the call over to Nick.

Thank you, Kris.

Good afternoon, everyone, and thank you for joining us.

NetApp delivered another quarter of solid financial performance, driven by our innovative portfolio of solutions, competitive positioning, and strong operational execution.

We achieved Q4 revenue inside our prior guidance range, and non-GAAP gross margin, operating margin, and EPS, all above Q4 guidance ranges.

Before discussing our FY14 results and future expectations, I'd like to first provide more detail on our performance in the fourth quarter.

Net revenues of $1.65 billion were up 2% sequentially, but down 4% year-over-year.

Branded revenue grew 6% sequentially, and as expected, was relatively flat on a year-over-year basis.

OEM revenue declined further than expected, and was down 30% from Q3 and 34% from Q4 last year.

Indirect revenue through the channels and OEMs accounted for 83% of Q4 revenue consistent with the last two quarters.

Arrow and Avnet contributed 24% and 17% of net revenue respectively.

Non-GAAP gross margin of 64.4% was almost a point better than Q3, and above our previous guidance.

Non-GAAP product gross margin of 58% was up almost 1 point sequentially, and 2 points year-over-year, due to a combination of continued operational productivity, favorable product mix and lower hardware warranty costs.

Non-GAAP service gross margin of 62.7% was up almost 2 points sequentially, and more than 6 points year-over-year, due to higher support revenue and lower spending, partially related to delayed projects, as well as lower headcount related to realignment actions.

Non-GAAP operating margin of 20.9% was above our previous guidance range, driven by a combination of higher gross margins and lower operating expenses, resulting from the realignment action we took mid-quarter.

We made the realignment decision to accelerate key strategic initiatives, while at the same time, streamlining certain elements of the business, such as OEM.

Overall, this action resulted in a headcount reduction of approximately 4%, and a GAAP restructuring charge of approximately $39 million in the quarter.

Non-GAAP EPS of $0.84 was up 22% year over year, and was $0.02 over the high end of our prior guidance range.

This reflects solid operational performance, as well as an approximate $0.01 net benefit from the combination of realignment activities and lower share count, partially offset by a higher Q4 effective tax rate, versus prior guidance.

Q4 weighted average diluted share count of 336 million shares decreased by almost 10 million shares from Q3, due to repurchase activity throughout the quarter.

Cash and balance sheet metrics for Q4 remain strong.

Free cash flow of $313 million was 19% of net revenue.

Inventory turns were at 19, and days sales outstanding increased to 47, reflecting typical seasonality.

Deferred revenue was up $141 million versus Q3, and up $91 million from Q4 last year.

Finally, we repurchased approximately $374 million of stock and paid $49 million in cash dividends during the quarter.

Now turning to FY14, I would characterize the year in much the same way as I characterized Q4: solid financial performance based on innovation leadership, robust operational execution, and strong competitive positioning.

Throughout the year, we introduced new solutions that enabled customers to solve their challenges today, while providing them with an innovative architecture for tomorrow.

For the fiscal year, net revenues of $6.33 billion were flat from FY13.

Branded revenue was up 4%, but was offset by lower OEM revenue, which was down 26%.

Including the impact of lower OEM revenue, geographic revenues in EMEA and Asia Pacific were up slightly, offset by lower revenue in the Americas, which was due to challenges in US federal spending.

Full year non-GAAP gross margin was 63.2%, up 2.5 points from FY13, and non-GAAP operating margin was 18.3%, up 3 points from FY13.

Our non-GAAP effective tax rate for the year was 17.2%, slightly above our prior guidance and FY13, reflecting the impact of our geographical sales mix and year-end true-ups.

Non-GAAP EPS for FY14 was $2.78, up 22% from FY13.

We ended the year with a strong balance sheet, and a continued high degree of financial flexibility to invest in the business, and enhance value to shareholders.

We closed FY14 with approximately $5 billion in cash and short-term investments, approximately 14% of which is onshore.

Over the course of the year, we generated $1.1 billion of free cash flow, and fully executed our capital allocation strategy, which included retiring just under $1.3 billion in convertible notes, and returning $2.1 billion to shareholders through a combination of share repurchases and dividends.

As expected, we ended this fiscal year with approximately $1.1 billion remaining in our share repurchase program.

Today, we are pleased to announce an increase in our next dividend to $0.165 per share, to be paid on July 22.

This represents a 10% increase compared to Q4, and reflects our confidence in the business, our consistent ability to generate healthy domestic cash flow, and our ongoing commitment to generating shareholder value.

Now, to guidance.

We expect our Q1 target revenues to range between $1.42 billion and $1.52 billion which at the mid point implies a sequential decline of approximately 11%, and a 3% decrease year-over-year.

The sequential decline reflects our typical Q4 to Q1 seasonal revenue dynamics, as well as conservatism around OEM business, in light of our Q4 results, and our future expectations, given the business conditions impacting certain OEM customers.

That said, we expect to continue to drive strong operational performance and prudently manage expenses.

In Q1, we expect to generate consolidated non-GAAP gross margins of approximately 63.5% to 64%, and non-GAAP operating margins of approximately 15%.

Based on our stock repurchases in Q4, and in the first 10 days of Q1, we expect our diluted share count for the quarter to decline to approximately 332 million shares, and non-GAAP earnings per share for Q1 to range from approximately $0.53 to $0.58 per share.

Overall, as we look to FY15, NetApp remains well-positioned to help customers navigate through their hybrid cloud strategies, with market leading scale-out and converge solutions.

We remain confident in our strategy, and committed to enhancing shareholder value over the long term.

For the year, we anticipate mid-single digit branded revenue growth, ramping over the course of the year, and partially offset by declines in OEM revenue of up to 40%.

Though ultimately dependent on revenue mix and growth, we expect 2015 gross margin of approximately 63% to 64%, and operating margin of approximately 18%.

As I mentioned last quarter, we are implementing 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.

For the year, we currently expect our non-GAAP effective tax rate, under this new methodology, to be approximately 16.5%.

Finally, we intend to accelerate our current share repurchase program, and to complete it over the course of the next 12 months, a year earlier than originally announced.

Bottom line, our plans for FY15 translate to just under 10% growth in earnings per share, and continued strong cash flow generation.

With that, I will turn the call over to Tom for more detail on the business momentum.

Tom?

Thanks, Nick, and good afternoon everyone.

I am pleased with our operational execution again this quarter.

We delivered revenue within our guidance range, while expanding gross and operating profit margins to levels among the highest in the history of the Company, all despite unanticipated headwinds in our OEM business.

In calendar 2013, we outgrew the market, gained share, and increased gross margins, demonstrating our competitive advantage, and the value we deliver.

With the steep ramp of clustered ONTAP, the acceleration of our broad flash portfolio, and our differentiated approach to the cloud, we are participating in a greater range of customer engagements than at any time in our history.

As we have discussed before, customers have new choice in technology and IT delivery options that enable them to modernize and create compelling business outcomes that were not previously possible.

Of particular impact is the cloud, which offers a degree of flexibility, and for certain work loads, economic benefits, that can not be achieved with traditional on premises computing.

For our bundled work loads where the economics are not advantageous, or where regulatory security or performance concerns exist, owned infrastructure is a preferred choice.

These factors will result in most enterprises having a combination of internal and external infrastructure, commonly known as the hybrid cloud.

Ideally, customers would like the cloud to be a seamless extension of their internal environment, truly integrating public and private clouds.

One of the biggest challenges to this vision is data management.

While other parts of the infrastructure are largely fungible, and carry no history, once data is created, it needs to be protected and managed for its lifetime.

As data grows, data and application mobility become increasingly bandwidth and time-consuming.

The net result is that data management, NetApp's core competency, is absolutely essential in the realization of the promise of the hybrid cloud.

Data ONTAP, the number-one storage operating system in the world, already delivers the industry's richest data management portfolio; and clustered ONTAP is unmatched in meeting IT transformation requirements of both the enterprise and Service Providers.

It is the only enterprise scale-out SAN platform, it is more reliable and easier to manage than other scale-out NAS solutions; and is able to consistently support multiple work loads, with multi-tenant management and performance scaling across disc, flash and hybrid storage.

On our Q4 call last year, we talked about the complex development transition to clustered data ONTAP being behind us.

Over the course of FY14, we saw increasing momentum, as customers and partners learned about the value of clustered ONTAP, and began deploying it broadly.

For the full year FY14, clustered nodes grew 242% from FY13.

The attach rate of clustered ONTAP increased across all of our product lines, with high-end platforms approaching 50% in Q4.

Most notably, the attach rate of our new FAS8000 product line was over 60%.

To date, we have shipped over one exabyte of storage managed by clustered ONTAP systems.

With hybrid cloud as a dominant paradigm, on premise IT is not going away; however, due to budget constraints, the customer's ability to evaluate, integrate and ultimately deploy solutions is being impacted.

This trend is driving the demand for converged solutions that reduce the time to deployment and lower integration risk.

By working with other best of breed hardware and software providers, we can offer a compelling business value with reduced risk in ways that can not be matched by the proprietary stacks of the server vendors.

Our strategic partnership with Cisco around FlexPod solutions delivers on this promise, and we saw FlexPod unit shipments grow 71% from Q4 of last year.

With over 18 petabytes of flash sold last quarter, NetApp is the leader in the flash market, with the best positioned portfolio, both in terms of what is available today, and what is coming.

We are seeing multiple use cases emerging with different requirements, balancing price, performance and features.

One of the clearest examples is database acceleration.

We are seeing rapid adoption in database environment using the EF all-flash-array, where data management is done by the application.

Given the high end nature of these work loads, exceptional performance and availability are necessary.

The latter requirement frequently disqualifies the less mature new entrants to the market.

We frequently see EF systems in front of frame arrays, sometimes actually replacing them.

We are very confident in the competitive position in the EF, both now and in the future.

A second, less clear, set of use cases are those that have to be served by more fully featured flash arrays, as customers balance the performance and power saving advantages with the higher cost of flash media.

We are seeing some traction in highly compressible less mission-critical work loads like VDI.

As mentioned in our last call, we are seeing increased deployment of all-flash FAS arrays with clustered ONTAP, a customer can create an all-flash node within a cluster, and use transparent volume migration to less active data to lower-cost media as the data ages.

Or a customer can distribute the flash throughout the cluster, to effectively produce a scale-out multi-protocol hybrid or all-flash solution.

These are capabilities that no other vendor offers, and we expect adoption to accelerate, with the introduction of newly refreshed high performance controller platforms.

Units shipped of the EF family grew more than 300% and all-flash FAS units increased 80% from Q4 a year ago.

Beyond the strong growth of the EF family, the branded E series products also grew nicely.

E series units shipped, exclusive of the EF products, grew more than 170% from Q4 of last year.

Our high-end FAS shipments grew 8% grew 8% year-on-year.

Mid-range FAS systems shipped were roughly flat, and entry systems were down 18%.

In Q4, we introduced the FAS 8000 product line, our first generation of cluster optimized systems.

We are very pleased with the performance of the new products, and have the fastest initial quarter ramp of any systems in our history.

Soon, you can expect us to refresh the remainder of the FAS product line.

In past calls, I have discussed the difficult environment in which we are operating.

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

In a constrained environment, we must hone our competitive edge, and capture more than our fair share of the opportunities.

With the rearchitected clustered ONTAP, the introduction of the EF, the ramp of the E series and promise of FlashRay, we are participating in opportunities that would not have previously been available to us.

We also need to be sure we are investing in the technologies that will be industry leading, as the market transitions and new architectures emerge.

Our recent realignment was specifically intended to direct our resources towards our biggest opportunities.

Our investments in the integration of cloud services and open source solutions into our software defined data management framework will uniquely position us to enable our customers to operationalize the cloud, and other new emerging technologies.

We expect our branded revenue growth to once again outpace that of the total industry in FY15, with solid gross margins and strong cash flow.

Before opening the call for Q&A, I'd like to thank the entire NetApp team for their hard work and dedication.

We are focused on innovation and execution, which enables us to meet the evolving needs of our customers, and yield strong operational returns.

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

At this point, we 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 Instructions)

The first question comes from Alex Kurtz from Sterne, Agee.

Tom, could you just talk about how you see the next fiscal year playing off that's around [cals] in your pipeline, whether it's refreshes of new products, new verticals that you're attacking?

I think people are looking at the branded product guide for the year, and trying to understand how you get to that number, and where you're seeing that play out from a seasonality perspective, and new products that you expect to have come to the market in the next 6 to 12 months?

Yes, I think as we look at the market overall, clearly it's a challenging environment, as we talked about.

We see people extending the life of their assets, and if you take assets from a three or four year life to a four or five year life; that's a pretty big hole in the growth rate of the market.

I think we're clearly seeing that.

There's a couple things, I think, that are specific to us as well.

We have a very, very strong federal business.

We're number one market share there, and clearly with the shutdown at the end of the fiscal year, we didn't have that at the beginning of last year.

So I think we got tougher Q1 and Q2 compares on the federal side of the business that ultimately will age off.

So I think, overall, we'll take a tail wind if we get it, but I don't think anybody is predicting that.

At this point in time, we'll try to compete in the market where we're at.

But if I look at the business overall, certainly the OEM, we're disappointed in that this quarter, and looking forward.

With the uncertainty and lack of visibility we have deep into those businesses, I think it's just time to take that down; so we don't have any more surprises and focus on the branded business.

The branded business was up 4% year-to-year last year, and if I look at our portfolio, whether it be ramp of clustered ONTAP, it would still be relatively early days a year ago.

If I look at how far we've come from EF, from effectively a standing start to a compelling position in the market, I think the field is embracing E series in a meaningful way, that they weren't doing a year ago; and FlashRay on the way.

And the other thing is, you'll hear more about our software defined and cloud story at Analyst day, but in sharing that with customers, I think people view that very, very positively and see that as a reduction of risk by NetApp.

So I think that we've got a set of things, even independent of the macro around us, that we did not have in our toolkit a year ago.

And while we have some tough compares on the federal side, and I don't think anybody is expecting a miraculous turnaround in overall spending.

I just think our competitiveness is that much better; and I think that we could leverage those into growth.

And like I said, in the aggregate, we did 4% branded growth this year.

So I'll leave OEM aside, that's really going to be a challenging one to take that down, so we can stop talking about it for the time being.

The real focus is on those OEM businesses that are still growing, and likewise, primarily around the branded.

That's why we broke out the OEM comparison all along, because we knew we would be on this downward trend, and we wanted to focus on the go-forward businesses.

Alex, this is Nick.

Just to follow-up, you asked a little bit on seasonality.

On that branded side of business, we expect that seasonality, even Q4 to Q1, to be pretty consistent with what we've talked about in the past, and then as I indicated, this ramps over the course of the year.

We'll go through, Tom talked about federal in Q2, go through year-end in Q3, and a ramp up in Q4; but pretty normal in terms of, certainly the Q4 branded side and then ramping through the year.

Thanks guys.

The next question comes from Joe Wittine with Longbow Research.

The question is on the service provider business.

EMC recently came out and framed up the size of the infrastructure they're selling to the cloud SPs, and it had the effect of the lifting the curtain and easing investor concerns on the overall cloud risk.

So I know you've referenced the third party data in the past, saying you're number one.

But are you willing to frame up the relative size of that business for you, and really the relative opportunity for you going forward as well?

Well, I think there's plenty of cloud business definitions out there.

We've had a vertical market around the service provider community, which includes the telcos and traditional service providers, and in fact, that's been the fastest growing segment for us.

Product calls, we talked about 200 service provider customers and a number of applications we run there.

So the service provider, you've seen the data, net number one in storage in the public cloud, but our view is to go beyond that into the hyper scale; and it doesn't necessarily mean that we're going to sell the hyper scaler systems but the hyper- scalers offer a capability that's attractive to our customer set.

And what you should expect to see from NetApp, as we rollout and talk about our strategy, is how do we enable customers to realize the benefits of that?

How do we enable them to create a seamless extension of their on premise computing?

So for us, the data management component app and software component app is key, and I think in some ways it's effectively the ultimate in unified storage, is the ability to create an opportunity to seamlessly extend our data management, whether it's on our systems or other people's systems; whether it's a NetApp private storage, in conjunction with Amazon, or whether it's actually in the cloud.

So from our point of view is that all of those are components, that it's the traditional sell-through of the service providers that providing enterprise services and therefore are big consumers of commercial equipment, and I think our position there speaks for itself, and like I said, even last year, in a tough market, that was our fastest-growing segment.

And then beyond that, we're also looking to embrace the hyper scalers into our data management framework, so all of those components of the cloud, both the traditional service providers and hyper scalers are integral to our overall strategy.

The next question comes from Brent Brace from Pacific Crest Securities.

Tom, wanted to follow-up on the strategy side.

Specifically, what's your appetite, risk appetite to diversify the portfolio, accelerate growth through M&A?

And the reason why I ask, you've generated over $1 billion in cash flow over the last four years, in each of the last four years you have over $4 billion in cash net of debt.

But if I look at the OEM partnering strategy, that business has been cut in half now at a $440 million kind of run rate.

Your branded business has grown 3% or 4% over the last couple years, but again has benefited from a tailwind around a new product cycle.

So question here.

What's the strategy, do you plan to stay the course with what you're doing?

Or are you thinking about different ways to accelerate growth, diversify the portfolio through M&A, given the strong cash flows, given the cash that you have on your balance sheet?

I think, first thing on the OEM side, one thing to bear in mind on the OEM side is probably two facts.

One is that we talk about the OEM business, and the OEM business declined, there's multiple components of that.

Part of that is E series, but there's also N series, which is the old ONTAP base products, so the IBM relationship, which is on a similar trajectory.

So the OEM business discussion isn't specifically an E series discussion.

On the other hand, the branded side of E series brought with us the capability to be in a position we're in, with all-flash arrays, and the aggregate, you see our flash numbers.

So we're very, very happy with that and likewise the momentum of the E series.

And the thing I'd point out on the EF and the E series is the nature of the business that we are competing for and winning there.

In the overall majority of the cases, we would not have been competing for, had we not had those products in our portfolio.

So we remain as excited about the E series portfolio from a technology perspective as we ever have.

Clearly.

the OEM business is on a trajectory that it's on, and clearly, we've been breaking that out separately, anticipating the trajectory that it would be moving; albeit, this latest step down was a bit of a surprise.

To be more complete on the M&A side, I think we're open to opportunities that will drive the growth of the Company.

I think that we're looking for deals that are executable, that obviously are affordable, that fit within our core competency, that we can bring value to, that by virtue of having it in our portfolio, we can add value to our business; and ultimately, we're going to drive growth.

So I think in a transitioning market, where there's a lot of new technologies, and a lot of new alternatives for customers, there's a lot of properties out there to look at.

So to answer your question, I'm not going to signal any intention, or any time frame, or any targets.

But suffice to say, we understand the dynamics, we understand what customers are thinking, and for the right transactions, we would be very much inclined to do M&A.

That's helpful, thank you.

The next question comes from Katy Huberty from Morgan Stanley.

Yes, thanks.

The DSOs would suggest that it was a back-end loaded quarter, and others have talked about a stronger April relative to the calendar first quarter.

Just curious, whether you saw that April strength, and if that could possibly deliver some surprise in the July quarter relative to your seasonal guidance?

Katy, sure.

DSOs at 47 days were a little higher than they were in Q4 of last year.

It does talk to certain elements of the business happening towards the end of April.

It's all current, so we have no concerns on those, and no concerns on collectability.

In terms of the guidance, again that guidance is based on bottom-up so we do across the business, across the geographies, across the OEMs, the bottom up for Q1.

So I'd point out that what we talked about before, that sequential view of Q4 to Q1 is pretty consistent with what we've done in the past.

We've remained conservative on the OEM side on top of it, which we think is appropriate, given how Q4 went, and given the position of some of the OEM partners.

So I think the guidance stands, and I don't think there's anything to suggest that it should be higher than what we put out there to you at this point.

And the DSOs again are just an element of the business, and there's strong execution happening already in Q1, with respect to bringing in all of that cash.

The other thing I'd point out is, this tends to be the highest DSO quarter of the year, so while it's up substantially from the prior quarter, it's up from the prior year; but not as much, just a few days, so four or five days.

So that tends to be the cyclicality of the business but I wouldn't try and read anything into the DSO and second guess our guidance.

Okay, thank you.

The next question comes from Brian White from Cantor Fitzgerald.

A couple things.

One, could you talk a little bit about the relationship with Cisco and ACI, and also Intercloud; it was a big deal at Cisco Live this week.

I know you're part of it, and there were announcements around it so maybe how do you think that will play out?

And just for Nick around operating margins, it seems like there's a much steeper drop in this Q1 in operating margins than we saw last year, you had a similar revenue fall off, so maybe you could address that?

Thank you.

Yes, I think general on many fronts, we continue to collaborate with Cisco, so certainly the ACI, the Intercloud obviously continues with FlexPod, some other things around some other initiatives, OpenStack.

So we continue to do that, and it continues to be a very multi-facetted relationship, so in our interaction with them, it's all systems to go.

We're finding more and more ways to engage.

As far as Intercloud and ACI, clearly those are top initiatives for them.

So I think being connected to them and being part of the messaging, and part of the product offering, and part of the customer discussion, is really important to us.

So I think all-in all, Cisco is pushing pretty hard, and that collaboration with NetApp is working really well.

We continue to have momentum, and we talked about FlexPod shipments being up 71% year-over-year.

So still very, very much alive and well and in fact not only ACI, but Intercloud; we just had an appearance with them this week at the Cisco live event.

I think the other point I'd make in terms of the sequential here, I talked about the sequential revenue decline; and when I go back a couple years, and there were sequential revenue declines from Q4 to Q1 of into the teens, last year, it was 12%, which is Q4 of 2013 to Q1 2014.

Those will carry with them a decline in operating margin in the Company.

All of them will.

We'll also have gotten some benefits in the fourth quarter from our repositioning activity we did, mid-quarter we talked in terms of the earnings.

We start reinvesting those, and that's a reallocation activity.

So that's all baked into the change and the difference in operating margins from Q4 of 2014 into Q1 of 2015, so I don't think there's anything outside of that.

We're balancing investment, we're balancing returns from the business, and we're balancing sequential revenue declines that we typically expect from Q4 to Q1.

In fact, if you go to the guidance, we're actually guiding above where we were a year ago, and not promising the same trajectory this year, we're at almost 21 points at this point right now.

So clearly the seasonality, with the gross margin of the business, obviously the revenue fall through to the bottom line is actually quite large, so as the revenue is volatile, so is the bottom line.

So, it's a transition from Q4 to Q1, I get that.

But if you do the year-over-year compare, I think it leaves us in a position to deliver on Nick's full year commitment.

Great, thank you.

The question comes from Kaushik Roy from Wunderlich.

Can you help us understand why the traditional storage system vendors, IBM, EMC and others, are seeing negative revenue growth, whereas the new hybrid vendors such as Nimble or converged guys say the mechanics are growing so rapidly.

Is it because they have a new architecture that's superior?

Alternatively, does NetApp need to build something from the ground up?

Well I think that, obviously, you've got much different scale, you've got installed base, there's a whole bunch of dynamics that separate the smaller players from the bigger players.

And when I look at this, those cover a fair amount of ground in terms of use cases.

I think there's some of those technologies there that are outside of our current space, if we were to participate organically, we would have to start from scratch.

But in the storage systems market, if anything, I'd use flash as an example.

We certainly heard a lot of this start from scratch, new technology, everything we knew about the past is no longer relevant.

And here we are, with EF in a very, very strong position in a very, very well defined segment of the flash.

And then likewise, I think the ability to deploy flash, not necessarily as a standalone point product, but as a node in a cluster, with all of the data management, and the volume migration, and all that goes with it, is a pretty compelling offering.

So we've heard this, do I need to start from scratch?

And certainly if it's not in the business we're currently in, the answer to that is yes.

In the businesses that we're in, if I actually look at where the momentum lies in this business, and who's actually driving a leadership position here, it's actually NetApp.

And flash is probably the classic example here, and I'll just state it flat out, is I would not trade the flash portfolio of NetApp for the flash portfolio of any other Company, whether starting from scratch or otherwise.

Okay, thank you.

The next question comes from Srini Nandury from Summit Research.

As you look at last quarter, you gave information about the number of new customers you're adding.

Can you provide the statistic, if you can this quarter?

And as you look at average deal sizes over the years, how has it changed, most recently?

I don't remember a new customer component.

We may have talked about it specifically in terms of maybe an EF or an E series, but suffice to say, those numbers are up huge.

In fact, the E series book has roughly doubled in two quarters, with EF included.

That continues at a big number, so I don't know that number off the top of my head, but suffice to say, it's robust.

In terms of aggregate deal size, in terms of overall transactions if you look at our mix, we're seeing 3000s and 6000s, or I should say the mid-range and the high end platforms doing a bit better than the lower end platforms.

So on the aggregate, the ASP just on that basis would be going up, but that's an individual box ASP.

I think more broadly, if there's probably one trend that we saw over the course of, certainly of Q4, is we actually saw more bigger deals available to us; and if I'd say there was one thing we saw in that quarter that was different than perhaps some other quarters, it is just very, very significant deals.

And they come in various varieties, some of them are tech refreshes, some of them are new projects.

And the other thing is enterprise service and enterprise license agreements, very, very large transactions on that dimension.

While they don't help us in the near term in terms of revenue realization, you see it on the deferred balance is up $100 million from last year.

So if I just go to deals overall, I'd say more bigger deals available to us, maybe that's a positive development, but too early to tell.

But the other thing we saw a lot of last quarter, more so than any other quarter, is enterprise license agreements and enterprise service agreements.

And the value to that, of course, is while it doesn't have the near term revenue because of the ratability of it, it's a commitment to NetApp over the long term.

Obviously a lot to see in some ways, because the software is pre-sold, and it's also a commitment to on premise computing.

Thank you, Tom.

The next question comes from Keith Bachman from Bank of Montreal.

Tom, I'd like to ask a strategy question as well.

Particularly related to the OEM business.

The OEM business was down 34% this quarter.

You're guiding it to decline by another 40%.

The margins are lower than the branded business.

Why be in the business?

It sounds like you're letting customers continue to take their business back.

Why not be more proactive in taking the business to its natural state, rather than watching it decline?

Well, I think that being in the business means a few things, so I want to be clear on a couple of points.

We could cease to serve product to our OEMs, I guess that's a way to exit the business.

If the idea is why don't we just get rid of that business on the technology, is that the technology underneath that business is the E series technology, and EF that goes with it, which is very strategic for us and has a lot of momentum.

And likewise the N series, which is also on the same downward trajectory with IBM, has ONTAP underneath it.

So at the end of the day, the technology investments behind these technologies that are driving our branded business are alive as well, and we're excited about those as ever.

However to take those through the OEM channel is clearly what we're talking about here.

Yes.

So two things, one of which is the investment in terms of the restructuring that we just did.

Clearly, the OEM go-to-market activity around those vendors, and again, not committed to us long-term, that's clearly an area that we've taken down.

And we get that size in proportion to where we think this business needs to be.

The other question of why don't we just stop selling it to them, I think what that does is it just takes the number down fast, but doesn't change the ultimate outcome.

In the meantime, there's no doubt that some of those products that are being sold are being sold to customers we weren't going to get to on our own.

Now the broader question for partners that have made choices other than NetApp, we aren't sitting idly by.

We are competing to preserve that business and bring it into the NetApp domain.

So the idea that this is a passive, where we just sit and watch, I wouldn't say that.

We've clearly scaled the business appropriately.

We're clearly investing in the technology, although targeted primarily for our branded customers, and at the same time, where the relationship is not good or where they are making choices about other products in their portfolio; we are aggressively pursuing that and competing with that, with our branded product and our existing channels.

So is the inference, Tom, just that this business ends up being a $50 million to $60 million run rate business, or does it ultimately go to a position where it's zero?

And I understand the technology is important, that's not what I'm suggesting, but just the OEM slice in particular?

I don't think it will go to zero, because there are relationships in the OEM business that are actually quite positive that are entirely incremental to us, and with the right investment very profitable for us as well.

So we aren't going to get rid of those, but what should be clear, Keith, is that the reason why we broke this business out in the first place two years ago, or three years ago, from the very beginning, was the understanding that it was going to be on a trajectory different than the branded.

The rationale of the transaction was not about the branded business.

That was nice, but it was really about the technology and -- I'm sorry, not about the OEM business it was about the technology and the opportunity we can connect, we could go after on the branded side.

So if we thought that this business had the same economics and the same run rate, we would have never broke in it out into two different categories, with an understanding we would be moving in this direction, is why we wanted to be able to carve this off, and just view whatever we get out of that as incremental; and focus on the momentum on the branded side, which on the E series has actually been quite strong.

So, at the end of the day, I think this latest step down was a surprise.

We'll be up front about that.

It's not what we forecasted.

On the other hand the overall trajectory of down from the first day when we acquired it, that is not a surprise, and that's why we broke the businesses out and report the way we do.

Okay, thanks.

The next question comes from Lou Miscioscia from CLSA.

Thank you.

Tom, can you dig in a little bit deeper to the service providers?

It sounded like you're breaking them into two different categories, the hyper scale companies.

It sounds like you are considering selling your software only to them.

And if you are, could you possibly size the opportunity for that market?

And then secondarily, we talked to a lot of service providers and hyper scale web hosters, and not all of them are actually designed their own software, so making it difficult for you to sell any product to them.

Where does that break exist?

Could you shed some light on that?

Is it just three or four that do it all themselves, five, 10, 15?

Where do you think it might exist?

Thank you.

Okay, so clearly a few questions in there.

So let's actually start from the hyper scalers and work back.

And so the likelihood of us selling, or companies like us, selling full systems to the hyper scalers to deploy in their environment is pretty low.

Because they've engineered their environment, they've written their own tools and in a lot of cases written their own apps.

So in that particular case, would we consider unbundling our software and selling elements of intellectual property to them?

Absolutely we would, because the data management problems that they face don't go away.

They are still challenging problems.

I don't want to signal that's what we're doing or there's an incremental revenue stream associated with that.

Just say that that's something we would be open to into the right circumstances.

But the difference between the hyper scalers and some of the other service providers, even the large ones, is in order to do these roll your own, develop your own solutions and infrastructures, takes an enormous amount of R&D.

And the ability of all of the players in that particular space to deliver that level of R&D investment is limited, so not everybody can emulate what a Microsoft or an Amazon are doing.

And in so doing, they will pick other particular dimensions, they will go after integrating traditional commercial products, and that's what I was talking about the service providers earlier; and that is, people are trying to provide enter prize services at a very, very high level for very, very sophisticated customers, integrate with their on premise environment, and that's what we're trying to drive with the service providers.

And that's a big market opportunity for our standard product, and we're going after that as aggressively as we can.

And I think the numbers support the success, and certainly it's been a growth market for us.

However, they ultimately will need to compete with Amazon, and it isn't clear, or it's certainly not clear that they've got the R&D to basically engineer all of these things themselves; which is driving a level of collaboration with them, and that drives the desire for such things as OpenStack technologies or open source technologies like OpenStack.

So from our point of view, in helping the service providers create services that can compete with those guys, we're also collaborating with a lot of the open source community to help them create solutions that they can customize for their environment, but leverage the open source community.

So it's a whole hierarchy of things, so if we're going to sell to the hyper scalers, it will primarily be an intellectual property type transaction.

And if we sell to the service providers, in some cases, depending on the scope and scale and complexity of the services they're offering, that buy standard products.

And in addition, they will also try and do some element of customized do-it-yourself open source, and that's what's really driving our investment in OpenStack.

But the other thing about the hyper scalers is, we're viewing this as hyper scaler only as a customer.

I think what you'll hear more from us on Analyst day, too much to go into here, is the hyper scalers offer a set of capabilities that are very attractive to the customer, and being able to operationalize that and deliver those values to the enterprise customer is still a very difficult problem.

And the question is how do you create a seamless extension of on-premise computing into the cloud that can leverage the hyper scalers?

And the key component of doing that is data management, and we'll talk about our software defined strategy and how ONTAP enables us to solve all of that.

So the long winded answer here is that all of the service providers are also partners.

Sometimes we'll sell them full systems, sometimes we'll collaborate with them around their open source, sometimes we'll sell intellectual property.

But at the end of the day, the end goal is how do we create a set of services that can be consumed by the enterprise.

And therefore, the seamless extension of on premise computing and the data management that goes with it is very, very important to realizing the hybrid cloud vision.

Thanks, Tom.

The next question comes from Rajesh Ghai from Macquarie.

A lot of commentary on the call regarding the momentum of the E series and the EF series.

Was hoping you could quantify the size of the branded E series business?

And related to that, wanted to understand the factors behind the decline in the OEM business, how much of that is being caused by the OEMs moving to other solutions, or their own solutions?

And how much is related to the macro secular challenges you may be facing in the server businesses?

Thank you.

Well, I think the nature of the OEM business is, first and foremost, their ability to compete and the other factor is what is the product mix within that account and I think they all vary.

IBM is probably the most visible and the most common one.

They report their storage business separately, down significantly the last few quarters, over 20%.

Likewise, IBM also has a portfolio of products that they can sell that are alternatives to NetApp.

So at IBM, we have both of those dynamics at play, and that is their ability to sell-through has been challenged, and likewise, our positioning within their portfolio has been challenged.

Now the other OEMs vary OEM by OEM, and one of the things about the OEM business, so we need to be careful about what we disclose about them.

But I'd say that amongst our other OEMs, I think we are firmly positioned in terms of the products that we offer.

So the dynamic of mix shift within the OEM I don't think is in play, and most of the OEM dynamic is related to their own sell-through.

The size of the E series?

Maybe, why don't I make a point there, Rajesh.

We actually don't go into the specific details on the sizing of each piece of business.

What I would say to you, and Tom made mention before around why we did this transaction three years ago, and the value of the E series to that transaction.

So when we go look at how are we doing on the transaction side of the fence and we look at the ramp up and run rate we are driving for on the E series branded side, we are actually well within, if not trending above, our original expectations of that business.

So we're very satisfied with the how the E series branded business is going, and how that technology is working in this portfolio.

Probably the other thing I'd add on E series, is if you look at where EF is moving aggressively, which is effectively SAN database acceleration, that's probably not a market.

That's been a dominant motion for us in the past, and it's probably safe to say the overwhelming majority of the opportunities we're pursuing there, are opportunities that would not have been available to NetApp had we not had that product in our portfolio.

And I think likewise, if we look more broadly at the E series and where that's being deployed, and the type of use cases around price, and performance, and capacity optimization; those two are workloads that probably would not have been pursued by our sales force, had we not had those elements in the portfolio.

So if I look at E series, there's no doubt that E series is not substantially overlapping what we currently have, that E series is truly bringing incremental opportunities to NetApp, both within our existing accounts and as a tool to open new accounts.

That's helpful, thank you.

The next question comes from Sherri Scribner from Deutsche Bank.

I wanted to get your thoughts on overall enterprise spending, as we move into the back half of the year.

Obviously, enterprise has been confused about what they want to invest in, in terms of their infrastructure, and we've seen a pause in spending.

Your guidance suggests there's some acceleration in growth in the back half of the year, I think IDC just updated their expectations, expecting an acceleration in the back half.

Wanted to get your thoughts about linearity through the year?

Thanks.

Well, I think one of the things that's a factor that will be unique in NetApp in this is really federal.

We saw federal slowdown with the shutdown, and the budget activities, and that hit us hard in Q3 and Q4.

So we'll have tougher compares on the federal side for sure, in Q1 and Q2, so it's clearly a factor that's specific to us.

I also think that we've got our own dynamics, we have our own product refresh.

But the product family, the hardware platforms have never been newer than they are today, so as we get the last of those announced and into the market we could see uptick there.

I think the broader sense of overall IT spending, certainly we see equipment aging.

We clearly see that.

We see some bigger deals, as I talked about earlier last quarter.

But I think at this point, it would be probably a little bit too early to both, predict a return and also factor that into our guidance.

Our guidance is pretty much based on the NetApp-specific factors and no fundamental material change to the market overall.

If we get a tail wind, we'll take it, but right now we're assuming no change in the market as we think about our go-forward plans.

That's helpful, thank you.

The next question comes from Scott Craig from Bank of America.

Thanks, good afternoon.

Nick I was wondering if you could discuss the gross margin outlook for FY15?

There's obviously going to be a number of moving parts and that could be mix or whatever.

So I was wondering if you could give us your assumptions, as you look at the product and services, and then some of the underlying assumptions even within those?

Thanks.

Sure.

I think when you look at the year and you look to the overall guidance of 63% to 64%, there's always going to be puts and takes quarter to quarter.

Over the past year, on the product gross margin side, we've had a pretty substantial ramp up here, over the course of the year.

We've talked about the productivity we've driven in the system.

We've also talked about continued price competitiveness, in spite of driving that additional productivity in the system.

And in addition, there's going to be OEM mix, and that certainly was part of Q4 and I talked about warranty and those types of things as well.

So those are all factors that we will work through in FY15.

So on the product side of the fence, I'm not specifically pointing out your guidance range for product or service or SEM should be X. I'll potentially talk more about that at the end of June at our Analyst day.

But these types of rates, certainly, I expect the product gross margin will be down a bit in Q1.

So I wouldn't want anybody to take away that 58%, which is the exit from Q4 is the floor for next year, and this will be what it is.

It's going to be a little bit more dynamic than that.

But continuing to work the productivity side, looking at the mix, all of those pieces will play a part.

On the services side of the fence, we ended the year pretty substantially up.

The services side is a little fundamentally different from the product side, and why is that?

Because on the services side of the business, we invest in front of the revenue that is to come, because in many respects, a big chunk of this business is us, servicing contracts that we've entered into for periods of time.

So we will, from time to time, make significant investments in that infrastructure, and then take advantage of those investments, as we go.

So certainly, when we look from a Q4 to a Q1, I'm expecting that services gross margin to come down.

I expect the services gross margin to move around a bit over the course of the year.

But again, be within those types of guide posts of the overall margin guidance I gave of 63% to 64%.

Last point on that services is 62.6%, which is a Q4 exit, is a high water mark, and I'm looking at four years of history here.

So I don't think you should take away that's the type of rate we would expect on services gross margin.

Certainly in Q1, and likely for a good part of the year in 2015.

Yes, I'd like to add a little bit additional commentary on the gross margin side.

The gross margin side, in terms of where we've been, it's actually up 3 points year over year in each of the last two quarters.

And I think it's a function of several things.

Nick went through a number of the elements, but on the product side, clearly, we spent a lot of time this year working through the COGS side of the equation, and driving efficiencies in the business; and I'm really pleased with the work of the team on that front.

But at the end of the day, the competitiveness and gross margins goes for the competitiveness of the product, and there's a lot to be said in that number, in terms of the competitiveness of product of where we were a year ago.

So one of the questions we get a lot in forums like this, or the call backs later is, are you basically letting growth go in favor of gross margins?

And it's just simply not the case.

I mean, one of the things that you want to be really clear about is, that in this environment there aren't a lot of big deals running around, and we have a lot of capacity chasing too few deals, and nobody can afford to walk from deals.

So we are competitive, we are aggressive, particularly in trying to break into new accounts, and NetApp is not walking away from business based on price.

On the other hand, within a reasonable set of bounds, at the end of the day, price is not the primary driver.

Ultimately it's functionality, not without limit, but within bounds.

Functionality ultimately determines who wins and who loses here.

And I think what NetApp has proven over the course of this year, is that with the training of our partners, the training of our people, and the understanding of our customers as the value proposition, that we can win on function; and we don't have to be the price leader to be successful here.

And that's why you're seeing 3 points of gross margin increase for NetApp, and you're also seeing decline in gross margin of our competitors.

I don't think that's a coincidence.

That's directly tied to the competitive products in the face of the customer.

Thank you.

Our final question comes from Maynard Um from Wells Fargo.

Free cash flow as a percentage of net income over the past four years in the fourth quarter has been really in the mid high 20% to 30%.

In this quarter it was at 19%.

I think some are obvious, but can you just talk about the puts and takes, and then how we should think about free cash flow in Q1 and FY15, can this drive back up to the 19% to 21% type levels?

Thanks.

Yes, I'll go into cash flow certainly at our Analyst day.

When we look at cash flow, we certainly think about the high teens types of numbers, and that's what we model out.

And we're thinking through what we need in the business, and what runs through on the net income side, but we're going to have to think about DSOs.

Obviously, we talked about that earlier on this call.

CapEx and a number of factors.

So, when you think about free cash flow as a percentage of revenue, those types of high teens is where we aim for, that certainly doesn't happen quarter to quarter, and Q1 are usually lower in terms of cash flow performance as a percentage of revenue.

And then we look at capital allocation and I'd just reiterate, we're going to expect again, a year where we generate over $1 billion.

We had very strong performance each year over the last several, and this is a cash flow generating Company, and at a high teens, as a percentage of revenue is very, very healthy.

And then we go and talk about capital allocation, and what we've done there over the past year, and what we plan to do for this coming year is also very strong.

Great, thank you.

I would now like to turn the call back over to Tom Georgens for final comments.

Thank you, and thank all of you for your interest in NetApp.

I think as we finish Q4, and we finish the fiscal year, if I had a high level theme, it's that NetApp was very, very strong on the execution front, on the operational perspective.

Driven very, very high gross margins, very, very high operating margins.

So in a tough environment, I think the ability of the Company to execute, drive value to our customers, and ultimately deliver compelling return to our shareholders with EPS up 22%, I think that came through.

In calendar year 2013, where we had market share gains above the average of our last 10 years.

And we continue to look forward to the upcoming year where we have things we did not have a year ago.

We have got clustered ONTAP, now with true momentum, we've got E series, we have the momentum of our flash, we've got new platforms, we've got FlashRay on the way.

And we also look forward in Analyst day recognizing this is also an industry in transition, that now we can compete for on premise computing and the elements today; but also talk about where we're going as a Company, our vision for software defined, our vision for the cloud and how NetApp continues to be relevant and continues to be successful.

So thanks all of you for your time today and I look forward to seeing all of you at Analyst day.

Thank you.

Thank you, ladies and gentlemen.

This concludes today's conference.

Thank you for participating.

You may now disconnect.