NetApp Inc (NTAP) 2015 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the NetApp first-quarter FY15 financial earnings call.

(Operator Instructions)

I would now like to turn the call over to your host, Kris Newton, Vice President of Investor Relations.

Please go ahead.

Hello and thank you for joining us on our Q1 FY15 earnings call.

With me today are CEO Tom Georgens and 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 such as our guidance for the second 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 file from time to time with the SEC, specifically our Form 10-K for FY14, 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 principals.

A reconciliation of our GAAP and non-GAAP results is provided in today's press release and on our website.

In a moment, Nick will walk you through some additional color on our financial results, and then Tom will give 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 well in fiscal Q1.

We achieved net revenues above the midpoint of our previous guidance range, evidence that our strong portfolio of solutions is well aligned with the evolving priorities of our customers.

And we delivered another quarter of strong operating results, with non-GAAP gross margin, operating margin and EPS all above Q1 guidance ranges.

Net revenues of $1.49 billion were down 10% sequentially, reflective of typical Q4 to Q1 seasonality, but less than the sequential declines we had experienced over each of the last two years.

Branded revenue of $1.36 billion was 91% of net revenues and was up 1% from Q1 FY14.

OEM revenue continued to decline on a year-over-year basis, consistent with our expectations.

OEM revenue of $129 million was down 23% versus Q1 last year.

Indirect revenue through the channels and OEMs accounted for 79% of Q1 net revenues due to typical seasonality and an increase in large transactions fulfilled directly in Q1.

Consistent with historical trends, Arrow and Avnet contributed 22% and 16% of net revenue, respectively.

Geographic performance came in as expected.

Non-GAAP gross margin of 64.3% was just 10 basis points below Q4 and above our Q1 guidance range.

Non-GAAP product gross margin of 57.1% was down almost a point sequentially on less favorable product mix but up almost 4 points year over year due to a combination of supply chain savings, favorable product mix and lower warranty costs.

Service gross margin of 62.7% was consistent with Q4 and up more than 3 points year over year due to higher service revenues.

Non-GAAP operating margin was 15.9%, almost 1 point above our previous guidance.

We continue to invest in the business to deliver innovative data management solutions for the hybrid cloud while at the same time maintaining prudence around overall spending.

Consistent with my comments on the last two earnings calls, effective this quarter we implemented a change in how we report our non-GAAP effective tax rate to be more reflective of our operational results and tax structure.

As a result we have excluded for Q1, and will exclude for future periods from our non-GAAP tax provision, the impact of items such as income tax audit settlements and the temporary lapse of tax laws such as the federal R&D credit.

Our non-GAAP effective tax rate for the first quarter was 16.5%, in line with our expectations.

Q1 weighted average diluted share count of 329 million shares was below our prior guidance and decreased by approximately 7 million shares sequentially due to share repurchase activity in the quarter and the benefit from Q4 repurchases.

Non-GAAP EPS of $0.60 exceeded the high end of our prior guidance range by $0.02, reflecting an approximate $0.01 benefit from lower share count resulting from Q1 repurchases and the combination of higher than projected revenue and strong gross margins.

Now turning to the balance sheet.

We ended the quarter with approximately $5.6 billion in cash and investments, 19% of which is onshore.

The sequential increase in onshore cash was due predominantly to our $500 million seven-year senior notes issued in June.

Inventory turns were at 20, and Days Sales Outstanding decreased sequentially to 36 on normal seasonality.

Deferred revenue of $3.1 billion was seasonally down versus Q4, though less so than in each of the last two years.

That said, deferred revenue was up $135 million from Q1 last year.

Q1 cash from operations was approximately $216 million versus $286 million in Q1 FY14.

Free cash flow was 11% of revenue in Q1 and was impacted by higher payments of annual incentive compensation and an audit settlement.

The audit settlement had no impact to cash and cash equivalents as we utilized excess stock option benefits to offset taxes payable related to the audit.

In Q1, we returned over $172 million to shareholders, which included $119 million in share repurchases and $53 million in cash dividends.

We remain on track to complete the last billion dollars of our share buyback program by the end of May 2015 consistent with the guidance we provided last quarter.

Today we also announced our next cash dividend of $0.165 per share of the company stock to be paid on October 22, 2014.

Now turning to guidance.

We are pleased with the momentum we see building in the business but remain conscious of market dynamics.

Our target revenue range for fiscal Q2 is $1.49 billion to $1.59 billion, which at the midpoint implies about 3% sequential growth and roughly flat revenue year over year.

We expect continued branded revenue growth, including a seasonal uptick related to the US government fiscal year end in September, to be partially offset by continued declines in OEM revenue.

We expect non-GAAP gross margins of approximately 64% to 64.5% and non-GAAP operating margins of approximately 17.5% 18%.

Based on our repurchases Q1 and in the first 10 days of Q2, we expect our diluted share count for the quarter to be approximately 330 million shares.

We expect non-GAAP earnings per share for Q2 to range from approximately $0.66 to $0.71 per share.

Our expectations for FY15 remain unchanged at this time.

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% for the full year.

Though ultimately dependent on revenue mix and growth, we continue to expect non-GAAP gross margin of approximately 63% to 64% and non-GAAP operating margin of approximately 18% for FY15.

We continue to expect our non-GAAP effective tax rate for the year to be about 16.5% and full-year non-GAAP EPS growth of just under 10%.

Finally, we expect to continue to generate strong cash flow, and as I indicated earlier, remain on track to complete our existing share repurchase plan by the end of May 2015.

In closing, we are confident in our strategy of helping customers navigate the transformation of their IT deployment as they take advantage of new technologies like flash and new consumption models such as cloud.

Our best in class portfolio is driving momentum in our branded business, enabling us to invest in continued innovation while delivering shareholder value.

Now I would like to turn the call over to Tom for some additional color on the quarter.

Tom?

Thank you, Nick, and good afternoon everyone.

I am pleased with the results the NetApp team delivered this quarter.

The strength of our portfolio, combined with the continued operational discipline, enabled us to achieve revenue over the midpoint of our prior guidance with gross margin, operating margin and EPS above the top of our previous guidance ranges.

IT is in the midst of a significant transition.

Enterprises are facing the profound challenge of adopting new technologies and delivery options while managing the reality of their current infrastructure and meeting the increasing demands of the business.

Customers see the business value of these new options but also recognize that they cannot abandon or even freeze in place the mature, proven and compliant solutions that run the business today.

CIOs need solutions that continue to enhance and optimize their current environment while simultaneously enabling the full potential of newer architectures and delivery models.

NetApp's portfolio of data management solutions improves the economic flexibility and business impact of customers' existing infrastructure while our cloud and technology vision gives them confidence in our ability to help them navigate the future.

This message is resonating, and more large enterprises are placing big bets on NetApp.

Consistent with the increase in enterprise buying activity we saw in Q4 of FY14, we also saw a significant increase in deals over $1 million in Q1 from the same quarter last year.

Cloud is the biggest disruptor to the industry.

They can enable enterprises to optimize elements of their IT portfolio in ways that were never available before and provide flexibility and cost benefits for certain workloads.

However, the economic benefits are not advantageous for all workloads.

Likewise there are non economic considerations like security, regulation and performance that also impact cloud decisions.

Our customers are telling us they want a hybrid cloud, the deployment of internal and external resources combined in a way that is optimized to meet today's needs with the ability to evolve over time.

Seamless data management is integral to the realization of this vision.

Once data is created, it needs to be managed forever and therefore accumulates, which makes subsequent movement both time-consuming and bandwidth intensive.

This makes the requirements for storage different than that for servers and networking, which are more fungible in nature.

Only Data ONTAP, the industry's number one storage operating system, addresses these requirements through its rich software functionality that provides a seamless data management experience across internal and external cloud resources.

Clustered ONTAP is unmatched in meeting the IT transformation requirements of both the enterprise and cloud service providers.

The rapid adoption of clustered ONTAP continued in Q1 with shipments of clustered nodes growing 177% from last year.

The attach rate of clustered ONTAP increased across all product lines.

Both midrange and high-end platforms are approaching a 50% attach rate, and the recently introduced cluster optimized FAS 8000 family is above 60%.

The success of clustered ONTAP is due to its ability to provide support for a broad range of workloads and improve operational capabilities while reducing the overall complexity of the storage infrastructure.

Clustered ONTAP enables customers to grow incrementally and nondisruptively with the flexibility of a wide range of deployment options from converged and integrated systems to third party arrays as well as software only solutions.

Customers also need a range of performance levels from their storage infrastructure.

All data has a life cycle over which its performance and economic value varies, which drives customer requirements for all flash, all disk and hybrid arrays.

However, regardless of the attributes of a specific data at any point in time, almost all data is ultimately hybrid over its lifecycle, necessitating automated data management as a critical component to realize the full potential of flash technology.

In fact the majority of our midrange and high-end systems ship in a hybrid configuration with a mix of flash and hard drives.

On our Q4 call I talked about customer demand for all flash configurations of our FAS arrays.

The ability to create all flash nodes in a larger cluster with unified data management and transparent volume migration is a compelling capability not offered by alternative architectures.

In Q1, we built on this momentum and expanded on our flash portfolio by introducing all flash FAS products to further address the need for ultimate performance while leveraging existing tools and processes.

Shipments of all flash arrays, our EF family and all flash FAS products grew 48%, and flash capacity shipped more than doubled from Q1 a year ago.

With the broadest portfolio of array-based flash solutions, NetApp is well positioned to help IT organizations optimize for a wide variety of performance, efficiency, and scalability requirements.

I am proud to say that just last week, our flash solutions were honored with two awards at the Flash Memory Summit, the most innovative customer implementation and for the best all flash NAS array.

In Q1, we refreshed our entry in high-end FAS product lines with the introduction of the FAS2500 family and the FAS8080 EX.

Year on year, our high end and midrange FAS shipments grew 14% and 10%, respectively.

Entry FAS systems are down 19%, consistent with our expectations of the transition to the new FAS2500.

Branded E-series systems, exclusive of the EF products, more than doubled from Q1 a year ago.

FlexPod, our converged architecture solution, continues to perform well with shipments up 25% from last year.

Now let's come back to the big industry disruptor, the cloud.

It is generally viewed as a threat to enterprise IT players, but with our differentiated approach, we see it as an opportunity.

Enterprises value our seamless data management as do cloud service providers who rely on our proven efficiency, seamless scalability, and nondisruptive operations to support a responsive and profitable public cloud operation.

Of our top customers in Q1, roughly half are companies that offer cloud-based services and purchase NetApp for use in both their internal enterprise IT and external cloud offerings.

Whether customers are providers or consumers of cloud solutions, NetApp is uniquely positioned to add value.

In Q1, we announced the extension of NetApp private storage solutions to include Microsoft Azure and demonstrate our ability to interoperate between Azure and Amazon Web services.

Additionally, we deepened our hybrid cloud partnership with Equinix.

The Equinix Cloud Exchange can dynamically connect NetApp private storage customers to multiple public clouds.

By maintaining full ownership and control of their data with NetApp private storage, yet being able to access multiple cloud compute resources through high-bandwidth links, customers can realize a full flexibility and economic benefits of multicloud solutions without the risk and regulatory concerns associated with relinquishing data stewardship.

We serve a broad range of workloads with the ability to bridge the enterprise on premises architectures of today with the cloud architectures of future.

Clustered data ONTAP is a data management framework to seamlessly enable enterprise hybrid cloud.

E-Series provides access to new workloads and customers and complements ONTAP as a dedicated high-performance SAN solution.

Spanning both ONTAP and E-Series environments are our FlexPod converged architecture and hybrid all flash solutions.

FlexPod helps customers by removing the risk and burden of integration to speed the deployment of new technology.

Our flash solutions fill customer requirements for high-performance storage including the displacement of legacy frame arrays.

The set of workloads and architectures that we address today is unparalleled in the Company's 20 year history.

With our portfolio of solutions, we're helping the world's largest enterprises transform their IT departments with a better way to manage their environments, deliver new capabilities to the business, and achieve their vision for the hybrid cloud.

We're seeing momentum in our key investment areas: clustered ONTAP, flash, cloud, branded E-series, and expect that momentum to accelerate over the course of FY15.

We're confident in our continued ability to win with our best in class portfolio that addresses the most predominant customer needs, our track record of innovation, and our enterprise relationships.

We're also confident that our strategy and financial performance will translate into shareholder returns.

We will continue to drive operating leverage in our business model to support continued investment in innovation and future growth.

I would like to thank the entire NetApp team for the continued dedication and helping our customers realize their goals while maintaining a high level of operational discipline.

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

As always I ask you to 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?

(Operator Instructions)

Brian Marshall, ISI.

Thanks guys.

Nice quarter.

A question with respect to FlashRay, could we get a quick update there on what we are expecting for the back half of the year launch?

And then it's been over a year since you made any material acquisitions.

I was wondering if that was reflective of your thoughts about being devoid any innovation on the private company landscape in storage?

You want to tackle more FlashRay and build from the ground up going forward?

Thanks.

First two questions.

As far as FlashRay is concerned, we've been saying for quite some time that that is a this-year product, and we will see customer shipments of that product next month.

Really no change from we've been saying all along and continued progress there.

In addition to FlashRay obviously the EF momentum continues to be strong, and we also did our all flash FAS announcement last quarter.

So in terms of the flushing out of the total portfolio for the different use cases we see, I think we feel really good about the flash portfolio.

We think flash as we said all along will live in many incarnations and hybrid storage, as standalone devices.

The compelling component of all flash FAS is not even an all flash FAS.

It's an all flash node in a broader cluster leveraging all of the data management in the transparent volume migration that comes with it.

I think overall the answer to your flash question, is FlashRay is on the way, has a set of use cases that it's targeted at.

I think we are still very excited about that excited about that, we're excited to get that in the market.

Certainly we've had a lot of dialogue with customers.

We've had early machines in customers' hands.

The total flash portfolio I think certainly has been a key component of our momentum.

As far as the acquisition side, I wouldn't read anything into the situation.

I think we're always looking for acquisitions that are going to be meaningful to fill gaps or opportunities in our product line, and you should expect to see us continue to do that.

As far as larger transactions are concerned, those are going to be entirely asynchronous.

They're going to be functions of timing, ability, cost, execute ability.

But I wouldn't signal any fundamental transition or thought or planning around large transactions, but smaller transactions should be somewhat on a regular cadence.

And you should expect to see us do that.

Certainly no change in our posture on either of those fronts.

Thanks, Tom.

Lou Miscioscia, CLSA.

Maybe if I could tie two questions together.

I would rather you didn't.

Okay.

When I look at the OEM revenue, I thought that came in a little bit higher than expected and the branded came in a little bit lower.

I realize you were reiterated your guidance for the full year for the branded hitting double digits -- hitting midpoint with a 5% type of growth.

If it doesn't hit that, would you consider trying to reduce some of your OpEx which is higher than some of your competitors?

Lou, it is Nick.

Let me start on that one, and Tom may have some comments as well.

The indication on OEM was it was going to be up to 40%, and the discussion on OEM was for the year.

As the business declines, it's going to be dynamic.

We have seen some and you all have seen some announcements with respect to end series which is going to be effective this quarter.

As we decline through pieces, calling a specific by quarter is going to be complicated.

We're not going to do it.

We talked about an up to 40% for the year decline, and I think we are still consistent with that and that is reflected in my comments.

The branded revenue growth discussion was mid-single digit.

You saw branded revenue growth, and I think that accelerates over the course of the year.

Really consistent with our view at financial analyst day, consistent with we said in the fourth quarter.

I don't think there's any net change here.

And we move from a negative position last quarter to positive growth position this quarter.

I think that is the start of the march as we expected to build as the year progresses.

As I think about the year as it plays out in terms of where we're going to get continued growth, certainly the comparison, the federal side of the house gets a little bit easier in the second half of the year.

And if I think about where we are today and things are coming to market from where we are a year ago whether it be clustered ONTAP in production.

We had a very strong E Series quarter, OnCommand Insight, our software portfolio, flash.

We just refreshed all of the platforms, we laid out our cloud strategy.

So I see a number of stimulants to our business that were not available to us let alone a year ago or even six months ago.

As far as the broader question about operating expense, we're sized to our plan for the year and off to a good start.

Certainly if there is a major reversal to that, we will have to change our plan just like always.

But I think we're on track and that is not top of mind right now.

Right now it's making the investments necessary to continue to fuel the growth.

In no way defensive about our OpEx spending at this point in time.

We have a plan and we're executing to it, and we haven't made any changes to it.

Thank you.

Brian White, Cantor Fitzgerald.

I'm wondering if you could walk us around the world in terms of trends you are seeing by geography.

Looks like EMEA outperformed APAC and Americas.

Maybe some color there, just what are you seeing on emerging markets?

Some companies are seeing weakening again, some are curious about the markets.

Thanks.

I think in the GL breakdown, there's a couple of elements.

Obviously includes some of our OEM business which distorts the number to some degree.

And also timing of revenue relative to bookings.

I would say if you think about the bookings perspective which is a little bit more current, EMEA kind of carried us and actually did a really good job last year.

But I would say that the biggest thing that we saw last quarter that was different is we saw strength back in the enterprise.

We saw larger big deals, particularly US enterprise, and for a variety of factors.

But it's felt like it's been improving for the last six months whether it's maturity of clustered ONTAP or adoption of technology or macro in nature.

And I would say from where we stand today from six months ago, clearly the return to enterprise spending is probably the biggest notable change, and we see that across the board.

In terms of activity levels, US both commercial and public sector were probably the stronger areas this quarter which is probably unlike last year.

Around the world, EMEA is still after a pretty good year, I think they continued along at that pace but not quite as good as the US and the public sector.

The question on emerging markets, for one thing is that we are not as penetrated equally invested all the emerging markets.

But the two where we made significant investments are clearly India where we have a big infrastructure.

That is actually soaked in momentum in the last six months, so we're actually pleased about the progress there.

And China was also in the plus category for us.

There are other segments, Brazil and Russia that have other complexity to them, but those are not major contributors to NetApp at this point in time.

So I don't have any real relevant macro commentary there given our market share.

China and India still contributors to us, and we are positive about that.

And probably the biggest difference we saw last quarter and the end of the prior quarter was probably a rebound in enterprise spending in the US.

Great, thank you.

Andrew Nowinski, Piper Jaffray.

Good afternoon, thanks for the taking the questions.

I wanted to ask a question on clustered ONTAP, it's ramping nicely and you're seeing a big attach rate across all the platforms.

Could you give us any insight on what improvements are coming with 8.3, and then based on the new features customers asking for, how much of an impact do you think it will have on your win rates against the competition?

I will talk about 8.3 in a second, but overall the ramp of clustered ONTAP has been pretty gratifying.

I think in the early days of the ramp, it was primarily brand-new to NetApp accounts moving into new workloads in existing accounts, and now it's become fairly a lot more mainstream in our larger accounts and predominant selling motion by our sales force.

I think the ramp has been quite good.

A year ago we were talking about feature parity and why you get 7-mode and the clustered ONTAP without having nearly that much of the conversation at this point time.

On top of that, the transition tools that were in the 8.2 release are being widely deployed and helping customers make the transition to 7-mode to clustered ONTAP as well.

8.3 has things like Metro cluster, a whole bunch of other performance enhancements.

Metro cluster is a product that we use for high-availability of disaster recovery, allows us to compete with recovery times that are basically superior to all of our competitors including the frame arrays and something that we use to sell to enterprise accounts.

It's a clear differentiator for us, and this will not necessarily be the Metro cluster of clustered ONTA.

It will be a brand-new set of functionality that will deliver that capability and a lot more.

That's probably the big payload component of 8.3.

We probably do have some customers waiting for it, but we are certainly not in the category we were a year ago where we had a substantial amount of our customer base waiting for feature parity before they moved forward.

I think the vast majority of our customer base certainly on a unit basis, those days are past and the migration has begun.

Great, thanks a lot guys.

Ben Reitzes, Barclays.

Could you talk about a little bit about your comments about the pickup in enterprise spending?

What in particular did you see?

Did you see some more excitement with regard to your new products, or what were you really getting at there in the sustainability of what you're seeing in the US?

I think first and foremost, I think the message is size of deals.

We saw a pickup in million dollar plus deals in Q1, which is generally not the quarter we do that.

We saw it in our enterprise accounts.

We saw in a fair number of service providers, big investments in the service providers.

As we indicated in the earnings calls script, many customers that are both enterprise consumers of technology and also service providers themselves.

So we see that really in those two categories.

I wouldn't align it to any individual industry.

I would say most industries -- there are some clear aggressive buyers.

Even financial services has had some good aggressive buyers, and a lot of people there pulling back at the same time.

I wouldn't say it's universal, but I would say probably the biggest indicator of confidence in the future is large transactions and also enterprise license agreements which is once again a long-term committed to NetApp that we're willing to make up front.

I think that momentum is heartening.

Obviously it's early to tell and not ready to call a trend, but we certainly have seen more of that in the last four months than we've seen in quite a while.

Enterprise and the cloud service providers -- Enterprise is where the money is Cloud service provider is where the growth is, and it's good to see momentum in both of those and certainly interested in the technology.

That said independent of just deal size and what appears to be more availability of budget, we're certainly seeing a broad range of our products being sold into these accounts.

E Series brand had another very strong quarter.

In fact it almost overpowered Q4 to Q1 seasonality.

That's up substantially year over year.

OnCommand Insight which is a portfolio of products that we acquired and integrated over the years had some very, very large transactions, a $9 million transaction at a major energy company to see momentum of that as well.

Big push the we've been telling our team is that in these enterprise accounts, we need to be selling the entire portfolio because we have compelling solutions there.

That's been a big push over the last six months, so we're certainly seeing that.

To your second point, I certainly think that the strength of the portfolio and the breadth of the portfolio is giving us more selling opportunities into those accounts, but that said, the broader trend of larger transactions longer-term commitment is also gratifying as well.

I think that is independent of the portfolio

Thank you.

Amit Daryanani, RBC Capital Markets.

I was hoping you could talk a little bit, when it comes to your October quarter guide specifically how you're thinking about the public-sector tracking in the October quarter.

I think historically the business in the segment has been up 40% of 45% on a sequential basis.

Do you expect a comparable level of growth going forward in this October quarter or do you have a different set of expectations there?

It's Nick.

We're going to expect a sequential increase in the business for sure.

As you know over the last couple of years here, we've moved through sequestration, we've moved through shutdown, we've moved through a variety of things that have obviously impacted the end result of the US public-sector.

We have just like every quarter really started with a bottom up forecast of the business including in the US public-sector.

We expect a sequential increase.

We're not calling a specific percentage for that.

I wouldn't want to do that on this call.

It is built into the guidance we've given you, and we look at that just like we look at the Americas commercial, just like we look at the things Tom talked about in terms of enterprise buyers and large transactions.

All of that is built in.

Again we expect a sequential increase for sure.

We've got a little bit more budget clarity for sure.

We at least hope we don't see shutdown.

There's nothing like that on the horizon right now.

But that's all built-in.

I would just echo Nick's comments about more budget clarity.

Last year we were finishing a fiscal year which the sequester was in effect and then transitioning to a period where the government could conceivably get and ultimately did get shutdown both of which happened within our quarter.

I'd say where we are now it isn't that we've seen a massive reflexive bounce back in spending, but there's a lot more budget certainty.

I think we have a little bit better understanding that the end of the fiscal year dynamics of the government will be more reminiscent of prior year's than last year and is baked into the guidance that we gave going forward.

That's helpful.

Thanks a lot.

Congrats in the quarter, guys.

Mark Heller, DA Davidson.

Thank for taking the questions.

Most of mine have been answered.

I was wondering if you might give us an update on the Amazon partnership.

I know you talked a little bit about cloud, but I don't know if you could talk a little bit more about that one specifically.

I think we're looking to do a number of things both in terms of partnering and as a leverager of their infrastructure.

One thing we're clearly doing with NetApp private storage and the concept of NetApp private storage is that the data will reside on the customer's network likely at a colo facility but connected to the customer's network and have access through a set of technologies that gives them high-bandwidth access to the compute farms.

The long and short of it is for an Amazon Web services type of analogy, what the customer can do is maintain control and data stewardship of their data yet have access to the elastic compute and the ability to have instant access to a very, very large server farm and likewise downsize at the same time and basically have all of the benefits and the flexibility of the elastic computing of Amazon without having any of the concerns about security and data ownership.

They maintain control of their data and have access to the flexible compute and get a substantial value of the flexibility microsales can provide at a fraction of the risk.

We've done this past quarter is we've actually added Azure to that mix, and as a result they can do the same thing with Azure and our analyst day that we did this year with our industry analysts.

We demonstrated the ability to interoperate between the two.

Basically run an application in one, fail it over and operate in the other.

The value of that and the extension of the NPS vision which initially was really about data stewardship and access to flexible compute is now really about MultiCloud.

As I can effectively have a legitimate MultiCloud strategy that I can have resources available to me from Amazon, I can have resources available to me from Microsoft.

If I hold the data, then I can truly broker the multi-cloud environment for our customers.

That's really where we're heading with the NetApp private storage is the idea of multicloud.

Our customers are not giving control of the data and therefore being locked into a specific cloud provider.

They have access to the flexible computing network and multiple players, yet they still own their data and they still have all of the data stewardship, all the data responsibility and all the security protection that they would have as if it was on their own infrastructure.

That's really the vision of NetApp private storage.

Access to the flexible compute and the flexibility and the economics of the server networking that provides yet maintaining control of the storage without subjecting themselves to any of the intellectual property and security risks.

That's really where we're going with that.

I think it has really significant value to enterprises that a lot of customers for whom the appeal of maintaining control of the data whether it be for flexibility or cloud mobility has tremendous value to them.

But they also want the elasticity of the compute model that Microsoft and Amazon and an ever-increasing set of other cloud providers can ultimately provision for them.

That's really the play there.

How do we bring the cloud as a resource to bear with its economics and its flexibility, and how do we make that consumable by the enterprise in a seamless and secure fashion that they can make an integral part of their overall operating environment?

Thanks.

Katy Huberty, Morgan Stanley.

Tom, can you help us reconcile the commentary on more large deals and just an overall better enterprise and service provider spending environment with still low single-digit growth in the branded business?

And does enterprise and service provider strength come at the expense of deals through the channel given that indirect mix decreased for the first time since the late this quarter?

I think a couple points there.

One of the other outlets for the renewed activity that we see as I said, the bookings and revenue have a certain time like to them is -- one of the areas where a lot of that will go is into deferred balance.

We actually saw deferred revenue increase $135 million year-over-year.

Some of the things we do I talked about the large transactions we did in OnCommand.

That's entirely a ratable deal for us.

That's entirely in the deferred balance and not recognized in this particular quarter.

A lot of the longer-term transactions we're doing with our partners, whether it be enterprise license agreements or enterprise service agreements, those are also ratable over time.

Some of the manifestations of the increased momentum would be in revenue growth and the branded improved from last quarter but admittedly still 1%.

On the other hand, we will see a big increase in the deferred balance which is another place where some of that business activity will ultimately lie.

That will come back through the revenue line overtime of course.

And the other question was --

Should we expect indirect decline through service providers?

I think two things on the Internet one of which is in the indirect numbers is the OEM business.

If you back the OEM business out, the percentage of our business through the channel in Q1 this quarter was actually higher than it was each of the last three years.

But that said, with the enterprise business, some of the enterprise business does look through our more sophisticated and larger channel partners and some of it does not.

I think that as we do more enterprise business, the likelihood that some of that will flow through some of our purely direct channels is higher and as a result that will also take the number down.

It's not a consequence of any strategy that we've made or any change of investment, at least not in the near-term.

It's more of just we see more of the enterprises, the enterprises are more likely to be direct in the midsize business.

As a result we see some variability.

But overall no changes in strategy.

And even on the Q1 to Q1 compare over the last three years, we still saw channel as a greater percentage of the mix than any of the prior years.

Aaron Rakers, Stifel.

Thanks for taking the question.

I would like to go back to the opportunity with Data ONTAP and cluster mode capabilities.

With now having a full refresh product family in your portfolio, is there any quantitative context you can provide with regard to how much of your install base is running cluster mode today?

What the age of that install base looks like and what I'm really trying to get at is what the upgrade cycle, how you're thinking about that opportunity over the next several quarters.

I think it safe to assume that the installed base which has been assembled over a very long period of time is still primarily 7-mode, and some of that will stay.

Some of our customers will stay in 7-mode and just put new applications in clustered ONTAP.

I think it varies across the board.

I think we see in general is that most of the upgrade activity to clustered ONTAP also comes in conjunction with the hardware upgrade.

So we don't to transition twice.

And when there's a significant gap in time between when they believe they will be able to go live with clustered ONTAP, they are more likely to basically do a hardware upgrade now and then basically wait in time.

But the closer they get together, they would love to do the hardware upgrade and the software upgrade at the same time.

I think that some of what we've been seeing over the last six months is that customers have evaluated the product, they tested it, it has the feature set that they need, they've proven it in the lab.

And now particularly with the hardware refresh, they can go ahead and do a hardware refresh in their environment and do the upgrade at the same time.

If they were not confident in clustered ONTAP, then I suspect they would be differing hardware purchases.

I don't think we're completely through the cycle and is not a concern anymore.

But I certainly believe that waiting for the release of clustered ONTAP that they could actually run in production delaying hardware purchases, while I still think there's some of that, I think that's been diminished over the last six months.

Jayson Noland, Robert Baird.

Tom, I wanted to ask about FlexPod.

Strong again, and we hear good things in the channel.

We're seeing more converged solutions and hearing more about hyper converged.

FlexPod's likely immaterial percentage of revenue now.

Is there still innovation that could be done there, and is the growth rate sustainable?

The answer to both of those questions is yes.

We've got a long line of things around innovation, particularly around some of the value propositions of clustered ONTAP and translate that to the entire FlexPod, whether it be nondisruptive operations or scalability.

All those types of things I think are all really big important plays for us to take FlexPod actually even further upmarket into more mission-critical applications.

I think we clearly see a lot of strength there.

We also see integration of FlexPod with E Series now to basically target a different set of workloads.

And obviously some joint development activity around newer technologies like OpenStack that was strategic to both of us particularly in the service provider space.

I think there is no near-term end of innovation that we could be doing together to basically drive this business forward.

And now there is only on the product side.

There's also go to market side in terms of position, the products, better alignment of our partners, more global deployment of this technology.

In my interaction with Cisco and my interaction with John Chambers, there is no congratulation here.

The question is how do we take the business to the next level and continue to generate growth for both of us.

This is a meaningful business for us.

Even at their scale it's a meaningful business to them.

They made that abundantly clear to us.

As a result, doubling the business from here over some time frame is meaningful for both of us.

And those of types of things we're trying to talk about and those are the types of things we're trying to get into the budget plan and moving forward.

I don't think there's any letup on FlexPod.

We don't think that we reached terminal velocity of that product by any means.

Appreciate the color, Tom.

Maynard Um, Wells Fargo.

Hi thank you.

Looking at your free cash flow as a percentage of sales, it's about 10.5%.

Q1 is usually seasonally low so presumably you're on track for that 17% to 19% target.

When you look at what's happening now in the ELA cycle helping the deferred revenues, are you just being conservative on that ratio for the year?

Or do think you could get the low 20s like you have in the past?

Can you just walk us through some of the dynamics to those numbers?

Hi Maynard, it is Nick.

I took the guidance for the year and the discussion in that high teens type of level stands it's the first quarter.

We have a lot of pieces of the business.

We talk about the dynamics of the business for the rest of the year.

How we've maintained guidance at this point in time.

I'm sure there's a difference in terms of Q1 versus Q1 last year in terms of free cash flow as a percentage of revenue.

There's a couple of points I made in those points in the script on those.

This is a strong cash generating company.

We continue to do quite well there.

That is built into the guidance, and I think our expectations remain consistent at this point in time.

No net change.

Obviously as things or if things do change we will give you that point of view when it's necessary.

I guess the real question was if the deferred revenues are increasing because of the ELAs, what are the offsetting items that are not allowing that deferred revenue to drive that cash flow?

So just in Q1 as an example on a year-over-year basis, the cash and deferred revenue is up $135 million.

That is better than we've done in the past.

The sequential declines left -- we will look at all those pieces.

ELA's are not an occurrence that is happening every day right in every form.

There are elements of this business model as it grows and as we look at different business models and sell those, all of those will be built into our guidance over time, but they are emerging.

So these are pieces of business, that deferred revenues for the company over $3 billion.

So in terms of moving the needle on free cash flow as a percentage of revenue and that type of number, that's going to be -- is not an immediate light switch.

One way of 20% or another way of 20% is way I would look at it.

And as things change over time, we will certainly give you that guidance over time.

The net is strong cash flow generating company is going to continue that way.

The ELA and how we sell business are going to be thinking about the cash generating side as well along the way.

And specifically for Q1, I think I wouldn't put Q1 as a trend.

We had bonuses are paid in Q1 and I think thanks to our employees the numbers were higher than last year, so that was a compare.

We had a tax settlement, a few other things that were out there.

I think the long-term cash generation of the business particularly when you added the high gross margin and the higher operating margin I think still remains very robust.

Jim Suva, Citi.

Thank you and congratulations to you and your team there.

My question is concerning gross margins.

It looks like you had much better-than-expected gross margins.

Congratulations on that.

If I recall right back at your investor day in June, you were implying that gross margins for the year should be 63% to 64%.

Could you help me understand the cost behind the beat in the solid guide and how I bridge that with your full-year guidance of 63% to 64%.

It looks like we're actually tracking quite a bit above that gross margin goal for this year.

Thank you.

Sure Jim, it's Nick.

Certainly we gave that 63% to 64% guide for the year.

The two pieces here and we talked about a little bit in a scripted comment are on the product gross margin and the services gross margin.

Each of them has a couple of different pieces to it.

Let me walk you through.

On the product gross margin, I talked about product mix.

Talked about supply chain savings, I talked about warranty.

Those things can move around and in fact in past quarters what I had indicated on the supply chain savings is that we generally realize it or recognize it right and then we pass some of it through or a lot of it through depending upon what it is.

If it's on commodities we pass it straight through to customers.

There will be a tiny difference between the time we update the pricelist versus sometimes when we recognize the city.

That's something that will move.

If you were to say -- Nick, at this point in time product gross margin should just continue to go up.

I would not necessarily agree with that.

Because we have to look at the timing of the passthrough of items, the type business we're doing and blend that all together on product gross margin.

On service gross margins a little bit of a different set of statistics going on.

Number one is we have to look at service revenue and what type of service revenues those are.

If those are hardware maintenance contracts revenues or if those are professional services revenues.

Those have different margin profiles assisted with them.

And the other thing on services that we have to look at and we talked about from time to time is investments in the services infrastructure.

Because in Q1 versus Q4, I would look at the performance here as a bit of leveraging the expense base of structure that is there.

As we look at install base and install base growth, remember we invest ahead of it to make sure that we are fully capable of servicing that install base as it comes to fruition.

Yes benefit on gross margin here on the first quarter of the year, we feel very good about that.

We're going to continue pushing on all of those levers.

But we're not changing the full-year view because on the product side of the fence, the passthroughs sometimes the competitiveness we want to put into transactions or the services side on the investments and the infrastructure.

Those things can change and we will run those levers over the course of the year.

Congratulations again.

The one thing I want to add on the gross margin side is Nick talked about the savings.

I think we talk about products go to market, but I think the team has done a remarkable job operationally to really drive efficiencies into our supply chain.

We realized that benefit last year and looking to drive it this year.

I think I wouldn't underestimate is I don't think it's any consistent -- any coincidence that the gross margins have improved as the value proposition of clustered ONTAP became better understood by our sales force and our customers.

The industry is littered with companies that are talking about declining gross margins, and NetApp has had the highest gross margin of our history, up 3 points year-over-year.

I've think we feel really good about that.

On the other hand, we also reserve the right to use that gross margin advantage to create opportunities for ourselves where we see them, whether it be new markets or new accounts or new opportunities.

That's also factored into this is that we believe there's opportunity not to broadly lose discipline on discounting because we certainly don't want to do that, but for strategic markets or strategic accounts, we're certainly willing to be very aggressive with the product line.

I'm really pleased operationally.

I think we've done really strong things there.

But if the validation of value proposition in particular that margins are increasing while others are decreasing.

We also reserve the right to use that for competitive advantage in the right circumstances.

Great, congratulations again.

Steve Milunovich, UBS.

Thanks, I wonder if you would know what percentage of your capacity shipped today is flash and what impact that has on margins as it increases?

I don't have that off the top of head.

I did our capacity increased 23% year-over-year in the aggregate.

And flash is a greater percentage than it's been in the past not surprisingly.

Although we ship flash in many incarnations, that's disk capacity.

We also ship flash as plug-in cars as a cash in product.

In terms of overall gross margin, I can't imagine it has a material impact at this point in time, and we ship it in various points.

I would not make the claim that flash overall is either driving the gross margins up or taking it down.

But at the end of the day, flash as a capacity driver is not the biggest one.

Clearly if customers are looking for capacity, they're going to go to hard drives.

Flash is primarily a performance driver.

The likelihood that's going to be a very large percentage of our revenue at any point in time I think is pretty low.

I don't think that's what that data set looks like.

Flash is going to accelerate low latency high-performance workloads and as a result it will be optimized for that.

But the economics of it are such that it would be cheaper to store less critical less active data on solid-state drives.

I think the challenge and the ultimate value and people to the enterprise is the company that actually manage that migration over the data lifecycle.

To put the most important data on flash and everything else on hard drives recognizes that over time the active data becomes idle and there is new active data that needs to be stored.

That's a key part of our value.

So long answer to your question I don't expect flash to be a very large percentage of our overall capacity even though it's going very quickly.

And not all of our flash is going to be in the form of hard drives.

Some of it will also be in the form of plug-in boards because I think that flash in all of its substantiations are going to map to the enterprise, and we intend to do all of them.

Thanks.

This ends our Q&A session today.

I will turn it back to management for closing remarks.

First off, thank you for your interest in NetApp.

I think we're pleased with the outcome of the quarter coming in above where thought we would on the guidance and obviously very strong on the EPS and the profitability side.

Gross margins at an all-time high and very strong operating margin.

In roughly flat environment are still generating a point of operating margin leverage.

I think we see clearly momentum around clustered ONTAP, around branded E series, around OnCommand.

This past quarter we spent a fair amount of time with industry analysts and financial analysts and customers in fact myself particularly talking about our cloud strategy and where we go from here.

I think our ability to win and gain share in the market as it exists today I think is very strong.

I think we have reinvigorated our core offerings, and think the core offerings of a lot of our competitors are languishing.

But more than that we talked about where we're going in the future how we're going to help customers get from where they are today to where they want to go particularly in integrating the cloud and how NetApp is going to continue to be relevant and a leader and an attractive opportunity going forward.

Thanks again for your time.

See you again in 90 days.

Ladies and gentlemen, thank you for participating in today's program.

This concludes the program.

You may all disconnect.