NetApp Inc (NTAP) 2017 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the NetApp third-quarter FY17 financial results conference call.

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

Later, we will conduct a question-and-answer session and instructions will follow at that time.

(Operator Instructions)

As a reminder, this call may be recorded.

I would now like to introduce your host for today's conference, Kris Newton, Vice President, Corporate Communications and Investor Relations.

You may begin.

Hello.

Thank you for joining us on our Q3 FY17 earnings call.

With me today are our CEO, George Kurian, and our CFO, Ron Pasek.

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 and guidance, 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 fourth quarter and our expectations regarding future revenue growth, improved profitability, cash flow, and shareholder returns, all of which involve risk and uncertainty.

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 including macroeconomic and IT spending environments, and our ability to successfully innovate in the growth areas of the market, gain market share, expand our operating margin, reduce our cost structure, and continue our capital allocation strategy.

Please also refer to the documents we file from time to time with the SEC, specifically our most recent Forms 10-Q, our Form 10-K for FY16 and our current reports on Form 8-K, all of which can be found on our website.

During the call, all financial measures presented will be non-GAAP unless otherwise indicated.

I'll now turn the call over to George.

Thanks, Kris.

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

We executed well in the third-quarter of FY17, again delivering solid results with revenue at the midpoint of our guidance range and both operating margin and earnings per share above our guidance.

Our innovation in emerging areas of the market is expanding and creating new growth opportunities for us.

In the quarter, we strengthened our industry leading portfolio with the introduction of new All-Flash Arrays and hybrid cloud solutions, positioning us to address a growing set of customer use cases.

With focus and disciplined execution, we are successfully innovating to meet the evolving needs of our growing customer base, while at the same time streamlining our business.

As we deliver on our commitment to return the Company to revenue growth with improved profitability, cash flow, and shareholder return, we remain focused on three priorities.

First, our Data Fabric platform and the strategic solutions that are built for the opportunities of a data centric world.

Second, lowering our cost structure and streamlining operations while maintaining our ability to innovate.

And, third, a robust capital allocation program which includes the mix of share buybacks, dividends, and investment for the long-term growth of the business.

I'll begin with an update on our first priority, Ron will update you on the other two.

Our strategic solutions position us to lead in the new era of IT.

These flash enabled cloud integrated offerings provide customers with the future-proof solutions required for success in a data centric world.

In Q3, strategic solutions constituted 65% of net product revenue, up 22% year over year.

Net product revenue from our mature solutions declined 18% year over year.

As we've said in the past, the headwinds from mature solutions will lessen, allowing the growth of the strategic solutions to return the Company to moderated revenue growth in FY18.

Consistent with the plan we've laid out, and as you saw in our Q3 results and Q4 guidance included in our press release, the momentum of our strategic solutions is already delivering top line growth.

Customers are maximizing the value of their data, prioritizing investments to modernize their data centers, increase agility and integrate cloud resources with on-premises environments.

Clustered ONTAP allows customers to modernize their infrastructure by replacing standalone silos of storage and monolithic frame arrays with a scale-out software defined shared storage platform.

Uniquely in the storage industry, clustered ONTAP enables seamless enterprise data management across flash, disc, and public and private cloud footprints for enterprise applications with the ability to consolidate multiple workloads into a single repository for improved efficiency.

Clustered ONTAP continues to perform very well.

We are gaining new customers, expanding our footprint with existing customers, and successfully migrating our installed base.

In Q3, clustered ONTAP was deployed in over 90% of FAS systems shipped.

Unit shipments of Clustered ONTAP systems grew 24% year over year, and the installed base of FAS systems continues to grow and Clustered ONTAP is now running on approximately 40% of systems in that large and growing installed base.

Additionally, we reached an exciting milestone this quarter which underscores the momentum we've had with Clustered ONTAP.

Clustered ONTAP now manages over 50% of the FAS system capacity in our installed base.

Flash is the mainstream choice for new on-premises deployments as customers seek to lower total cost of ownership, while gaining greater speed of responsiveness from key business applications.

NetApp leads the industry in the transition to flash with cloud integrated solutions that provide unrivaled efficiency, speed, scale, and data management.

For IDC's calendar Q4, All-Flash Array market data, we strengthened our number two position and our growth in flash continues to outpace both the market and our competition, large and small.

Although NAND supply is tight, we are confident in our ability to meet demand and we expect our share gains to continue.

In our third quarter, our All-Flash Array business grew 160% year over year to an annualized net revenue run rate of almost $1.4 billion, inclusive of All Flash FAS, ES and SolidFire products and services.

The majority of our All-Flash Array business is driven by Clustered ONTAP, deployed as both FAS engineered systems and FlexPod converged infrastructure solutions.

This year we have refreshed our entire All Flash FAS portfolio with the A-Series, designed specifically for flash and are experiencing strong adoption of these new products.

The A-Series All Flash systems deliver industry leading performance, capacity, scalability, security, and network connectivity in dense form factors.

In Q3, we introduced a new entry level system which extends enterprise grade flash to mid-size businesses.

At the start of Q4, we announced a new high end system which continues NetApp's track record for innovation with an NVMe-fabric ready clustered architecture.

We also enhanced our storage efficiency capabilities and introduced an industry leading workload specific guarantee that scales to a 5 to 1 data reduction ratio.

The beginning of February marked the one-year anniversary of our acquisition of SolidFire.

SolidFire creates an avenue of growth for us to address customers' data requirements as they build out next generation data centers.

We are growing the SolidFire business through the expanded reach of NetApp, acquiring new customers, introducing SolidFire into existing NetApp accounts and bringing NetApp solutions to SolidFire customers.

We are further leveraging our SolidFire investment and expanding our growth potential by developing the next generation of hyperconverged infrastructure built on SoldFire innovation.

We will do what has not yet been done by immature first generation of hyperconverged solutions, bringing hyperconverged infrastructure to the enterprise by allowing customers the flexibility to run multiple workloads without compromising performance, scale, or efficiency.

As part of the Data Fabric platform, it will also be the first fully cloud integrated ACI solution, giving customers the ability to leverage their data across on-premises, public cloud, and hybrid cloud environments.

With this innovation, we further broaden our industry leading portfolio with cloud integrated solutions available in standalone, converged, hyperconverged, and software defined offerings.

We will have more information on the development of this exciting new solution for you in the first quarter of FY18.

The NetApp Data Fabric enables data management that seamlessly connects disparate systems, software stacks, clouds, and data centers.

This allows customers to architect the IT environment that best meets their needs, utilizing a mix of flash, disc, and public and private cloud resources.

IT organizations can be more responsive to the needs of the business by leveraging the scale of on-demand cloud capabilities, while maintaining data visibility with a single consistent view of data and infrastructure across clouds and on-premises resources.

We continue innovating in this space, and at the start of the third quarter announced new Data Fabric services.

These as a service and consumption-based offerings allow customers to control, manage, secure, and move data across on-premises and public cloud resources.

By providing data portability and cloud integration, we are increasing our strategic relevance and expanding our opportunity.

Customers and cloud service providers are choosing NetApp because we enable their hybrid cloud strategies.

A large US-based insurance company chose NetApp Private Storage for cloud to leverage the elasticity of the cloud to spin up and down computed network as needed for quantitative research and analysis while keeping full control of their data.

A large North American-based retailer selected NetApp All Flash FAS to replace its legacy EMC SAN infrastructure because we solved their current application integration, replication, and management challenges with a compelling path to hybrid cloud.

At a cloud-based talent management solution provider, we displaced over 1 petabyte of legacy EMC and HP storage for the Company's production and disaster recovery environments.

Our cloud integration and the ability to scale with their business were key factors in the customer's decision for NetApp.

Ron will go into depth about cost savings and capital allocation, and I want to re-emphasize our commitment to both priorities.

We are helping customers transform their businesses for success in the data powered digital era by enabling their efforts to modernize the infrastructure, build next generation data centers, and harness the power of the hybrid cloud.

With our powerful portfolio of innovative solutions and data fabric strategy, we have enormous opportunity to lead in this next era of IT.

I remain extremely confident in our ability to successfully execute against this opportunity.

The transformation of NetApp is yielding results and has changed the trajectory of our business.

We have a sharp focusing on delivering innovation to address an expanding range of customer requirements in the fastest growing parts of the market, while lowering our cost structure and streamlining the business.

We've improved our agility and are delivering innovation at an accelerated pace.

With continued execution, we're on track to increase shareholder value and return the Company to long-term growth and to our target operating margin range.

We will hold an Investor Day in New York on April 5, where we will share more detail on the evolution of NetApp to lead in the data powered digital era, as well as our multi-year business outlook.

We hope that you'll be able to join us.

I'll now turn the call over to Ron to walk through our Q3 financial performance and expectations for Q4.

Ron?

Thanks, George, and good afternoon, everyone.

As a reminder, I will be referring to non-GAAP numbers today unless otherwise noted.

Q3 marked another strong quarter with net revenues hitting the midpoint of guidance.

Net revenues were $1.4 billion, an increase of 5% sequentially and 1% year over year.

Product revenue of $784 million increased over 10% sequentially and 5% year over year.

As George highlighted, the strength of our strategic solutions drove overall product revenue growth.

The combination of software maintenance and hardware maintenance and other services revenue was $620 million, relatively flat sequentially and down slightly on a year-over-year basis.

Gross margin was at the low end of our guidance range at 61.5%, reflecting higher excess and obsolete reserves due to faster than anticipated adoption of our latest platforms, and to a lesser extent foreign exchange headwind.

Product gross margin of 45.7% decreased about 2.5 points sequentially and 5.5 points year over year.

Software maintenance gross margin was roughly flat on a sequential and year-over-year basis.

Hardware maintenance and other services gross margin increased about 4 points sequentially and 5.5 points year over year, directly attributable to our ongoing transformation efforts.

Operating expenses of $579 million decreased 9% sequentially and 8% year over year, and were below our Q3 guidance due in part to variable compensation and to a lesser extent foreign exchange benefit.

As a result, operating margin of 20.2% was above our guidance range.

Our effective tax rate for the third quarter was 18.6%, an increase of over 1 point sequentially, reflecting a higher mix of US profits as transformation benefits were slightly disproportionate to the US.

Weighted average diluted shares outstanding were 281 million.

Earnings per share of $0.82 was $0.05 over the high end of our guidance range, a result of higher operating profit and lower diluted share count.

Our cash and balance sheet metrics remain healthy.

We closed Q3 with $4.6 billion in cash and short-term investments with 11% held by our domestic entities.

In Q3, we repurchased $284 million of our stock and paid $52 million in cash dividends.

We remain committed to completing the share repurchase programs that we outlined in February 2015.

Today we also announced our next cash dividend of $0.19 per share which will be paid on April 26, 2017 to shareholders of record as of the close of business on April 7, 2017.

Deferred and financed unearned services revenue was up 1% sequentially and 3% year over year.

Q3 cash flow from operations was $235 million, an increase of 49% sequentially.

However, on a year-over-year basis, cash flow from operations was down $120 million.

Although GAAP net income was comparable in Q3 FY16 and Q3 FY17, we had higher levels of inventory in accounts receivable this quarter.

Accounts receivable grew in the quarter due to higher revenue and linearity in the quarter.

Inventory grew due to timing associated with specific deals, as well as an increase in evaluation units for All Flash FAS and SolidFire.

We generated free cash flow of $190 million, a decrease of 39% year over year.

Our cash conversion cycle was 17 days, which was an improvement of 9 days on a year-over-year basis but 8 days longer sequentially.

Again, these metrics reflect higher accounts receivable and inventory, partially offset by higher accounts payable.

As George said, we are confident in our ability to meet demand in flash as we have secured enough NAND to meet the anticipated demand for the remainder of the fiscal year.

Now to guidance.

Our transformation efforts are yielding results.

NetApp is stronger, more focused, and more agile.

We remain committed to executing against the plans we've outlined for you.

For Q4, we expect a revenue range of $1.365 billion to $1.515 billion.

We expect consolidated gross margins of approximately 60% to 62%.

The gross margin range incorporates some conservatism due to NAND cost increases.

We expect operating margins of approximately 18.5% to 19.5%.

As we announced in Q3 a year ago, we are reducing our cost structure across both cost of sales and OpEx by $400 million gross annualized by the end of FY17.

We are reinvesting some of the savings into strategic opportunities, and based on our Q4 guidance, we are over-achieving our committed net run rate savings of $130 million exiting this year.

Finally, we expect earnings per share for the fourth quarter to range from approximately $0.79 to $0.84 per share.

With that, I'll hand it back to Kris to open the call for Q&A.

Kris?

We'll now open the call for Q&A.

Please be respectful of your peers and limit yourself to one question so we can get to as many people as possible.

Thank you for your cooperation.

(Operator Instructions)

Our first question comes from Andrew Nowinski of Piper Jaffray.

Your line is now open.

Great.

Thanks.

Thanks for taking the questions.

Your All Flash revenue growth accelerated this quarter.

One of the reasons we're hearing that you're getting wins within your installed base is because customers prefer not to retrain their staff on a new operating system when they move to all flash.

Have you seen any changes in your win rates within your installed base?

And then can you provide any color around the percentage of existing customers that are still not yet running an All-Flash Array?

Our success in All-Flash Arrays is broad and wide.

We have net new customers.

We have new workloads within our existing customers and upgrades within our installed base.

I would tell you that the net new customers and new workloads are materially bigger as a percentage of our All Flash business, reflected, for example, in the market share gains we're seeing in the SAN business, rather than our traditional installed base.

As a percentage of our installed base, All Flash FAS is a very small percentage.

It's less than 10% of the deployed installed base.

So we've got lots of head room to go.

Thanks, Andy.

Next question.

And our next question comes from Mark Moskowitz of Barclays.

Your line is now open.

Yes, thank you.

Good afternoon.

Just want to get a little sense here in terms of how much of some of the momentum in your revenue base is being driven by some of the disruption at some of your other competitors versus just you guys having a much better product set than a year ago?

And then, Ron, I know you did talk about the gross margin profile, but just want to get a sense here if there's any more detail you can share with us in terms of why the product revenue margin is a little lighter relative to our expectations but the services margin much better?

Thank you.

Let me take the first question.

We are seeing momentum both because we have a compellingly differentiated product set.

As we have noted, the all flash market is now going from early adopter to the mainstream market where customers are moving at higher disk-based states over to solid state and, therefore, require the full range of features in their All-Flash Arrays from a business process, from a data management protection and availability perspective.

Both All Flash FAS, as well as SolidFire, give customers a compellingly differentiated platform.

And the EF-Series is the fastest performing box in the industry.

I think in addition, we are clearly seeing disarray at our competitors.

Our leading competitors neither have the flagship flash product, as well as are going through substantial challenges from an integration perspective and customers are looking to NetApp to give them a path forward for their all flash [estates], as well as to the hybrid cloud.

Ron?

So, Mark, I think what we tried to intimate is on the services side that represents quite a bit of our transformation efforts.

It's not just OpEx.

We've done a lot of work to increase the margins on the services business.

On the product side, what I mentioned quarter-to-quarter, the only unexpected variance was E&O due to faster than anticipated product transition.

As we move to Q4 in the guide there's a little bit of headwind for flash COGS increase.

Thanks, Mark.

And just a reminder to everyone, please limit yourself to one question.

Thank you.

Our next question comes from Steven Fox of Cross Research.

Your line is now open.

Thanks for the question.

Just following up on that, can you just expand a little bit more on your product gross margin outlook, maybe beyond this quarter?

You mentioned some NAND costs, and like you addressed the reserves.

As those reserves sort of grandfather along and your mix sort of continues to improve towards flash, how do we think about longer-term product gross margin potential?

I'm going to save that answer for our April 5 investor meeting.

I'll give you quite a better view of next year and probably a little longer term.

It's not something I feel comfortable guiding with right now.

Okay.

Since we're passing on that, can I ask a quick one then.

You mentioned on the competitive environment.

Can you give us a little more color then on the competitive environment within All-Flash Arrays, how rational do you think it is versus your expectations, or any other color would be helpful?

Thanks.

I think first of all in the competitive landscape things have not changed substantially.

As we've said, the major competitor that we go up for the majority of the deals are the large system manufacturers, most notably EMV and the other high end SAN arrays that we are displacing with All Flash FAS.

HP has always been the low price leader and they lack the feature set in terms of data management services, so they compete aggressively on price.

And the start-ups are increasingly challenged to differentiate themselves.

So you see evidence of desperation from various different smaller start-up players.

I'll just leave it there.

Great.

Thank you very much.

Thank you, Steve.

Next question.

Thank you.

And our next question comes from Tim Long of BMO Capital Markets.

Your line is now open.

Thank you.

If we could just dig into some of the other strategic areas.

Obviously, the All Flash piece grew pretty aggressively in the quarter.

It looks like some of the other pieces, of which you break out in the strategic line, are down fairly meaningfully year-over-year.

Could you just talk a little about what's going on there, is it cannibalization, what's driving the down side to the other part of strategic?

Thanks.

Overall, strategic products were up 22% year-on-year.

So we saw really strong growth.

In terms of the strategic numbers, it's only product revenue that comprises the strategic number.

Our All-Flash Array number includes products and services, right.

I think when you think about All Flash versus hybrid flash arrays, they're essentially solutions we offer customers.

Some customers for their workloads choose All Flash solutions and some customers choose hybrid solutions.

We have a unique advantage in the market that we are able to offer customers choice with the same set of data management capabilities.

So if the price of NAND rises unexpectedly we can always offer them a hybrid solution, which no one else in the market can offer.

Thank you.

Thanks, Tim.

Next question.

Thank you.

And our next question comes from Jayson Noland of Robert Baird.

Your line is now open.

Okay.

Great.

I wanted to ask on NVMe, George.

It sounds like a big deal, but love to get your perspective from a timing and NetApp positioning perspective?

We have NVMe support in the flash arrays that we introduced to market.

So the FAS 9000, the 8600, the 8200, 2600 series all have NVMe integrated on-board for a low latency cache.

We also have in the A700S a NVMe-over-fabric ready architecture.

NVMe will become just like fiber channel.

It will take time to get adopted and become deployable widely at customers as a true storage solution.

We're working with the industry to make that available and it will become part of every platform.

I don't think there's meaningful differentiation from NVMe.

I think, as I've said continuously, proven data management capabilities, integration in the application domain and delivering business value will be the conversation with customers.

NVMe will become a check box that all of us will have, us included.

Thank you.

Thanks, Jayson.

Next question.

Thank you.

And our next question comes from Katy Huberty of Morgan Stanley.

Your line is now open.

Yes, thank you.

George, I want to ask you just a high level question around the cost savings, because the OpEx level that you're running at now you haven't been there since 2011 when the revenue run rate was about 7% lower.

So can you talk about some of the areas where the Company is able to be more efficient than it was at different revenue levels, especially given that the product portfolio has expanded and the competitive landscape is arguably more intense than five years or so?

And then just as you look going forward, how do you think about balancing opportunities for additional cost savings versus starting to reinvest more of that to ensure that you can maintain the growth that you put up this quarter?

Thank you.

First of all, in terms of the cost savings that we have taken on, it's a transformation across all aspects of the business.

I would say in the product portfolio, it is to leverage the capabilities that the supply chain has, to not only meaningfully reduce the cost of introducing new hardware platforms, but actually accelerate the pace at which we are introducing new hardware platforms.

The recent lineup of FAS hardware platforms were introduced at three times lower cost of introduction and three times faster.

So they're substantially better in terms of the way we build systems and hardware.

The second is in terms of our shared services environments, we've consolidated the operations of many of our back end functions into a shared services platform.

There's continuing work to be done to complete that transition.

But that offers promise of not only savings for this year but in years to come by being much more efficient.

Things like reporting payroll administration, various elements of human resources and so on will be delivered from a centralized shared services facility rather than close to the employees, giving us both consistency and operating leverage.

And in the go-to-market area, as you can see, the work that we have done, particularly in the services business, have materially improved the profitability of that line.

We have integrated, for example, self service support, online chat as opposed to human support, and you'll see us integrated advances in machine learning so that customers can both get better satisfaction, but at a lower cost.

So we remain committed to doing that.

As we think about the saving what that we generate, we'll continue to look at all of the options that are in front of us, right, returning some of that through improved profitability to shareholders, as well as investing in the long-term growth of the business.

One of the meaningful areas that we've invested in is SolidFire.

As you can see, we're not only leveraging that investment in the All-Flash Array segment, but to deliver a compellingly differentiated hyperconverged offering to the market.

Katy, you should think of the transformation as not an event, it's something we're going to do ongoing.

We'll talk about that more on the April 5 meeting.

Thank you.

Thanks, Katy.

Next question.

Thank you.

And our next question comes from Simona Jankowski of Goldman Sachs.

Your line is now open.

Hi.

Thank you.

First just a quick clarification.

I wasn't clear if OpEx is now at a bottom and will build up from here as you stabilize, or do you expect it to go down?

And then the question I had was on hardware maintenance which came in a bit short of our consensus expectations.

If you could give us some insight into what drove that and how you see it going forward?

Let me take the second question first.

So first of all, our installed base and our FAS installed base continues to grow.

When you exclude PS and training, maintenance is only down 1% year-over-year and 1% quarter-over-quarter.

We are starting to see some ASP declines that we're passing on, basically better pricing as a result of our transformation savings.

Coupled with that, we're seeing asset lives extends to five years and beyond, which explains the growth in deferred revenue and more specifically long-term deferred revenue.

And as product revenue continues to grow, this will lead to service revenues growing again.

With respect to OpEx, if you impute the guide I gave for Q4 there is some seasonality upward.

And, again, I'm not going to guide next year, but we still have work to do on our cost structure.

So we'll just leave it at that.

Thank you.

Thank you.

And our next question comes from Joe Wittine of Longbow Research.

Your line is now open.

Thanks for the question.

On your OpEx out performance in the first three quarters of the fiscal year, you've developed a pretty consistent pattern where gross profit dollars are very close to the midpoint of the ranges, which is great.

But then your OpEx is substantially lower, roughly $20 million a quarter below the implied guide.

So what is that dynamic driving that consistent beat?

I know you quickly referenced lower variable comp this quarter.

Is there anything kind of --

There were a lot of different pieces.

The combination of variable comp and FX is only half of the variance.

There's a ton of other little things that added up.

I would just say that you're right, year-to-date we're consistently under spending.

I think that points to the culture we're changing around OpEx management and transformation.

Thanks.

The rest of my question was does your same methodology kind of apply to the April quarter guide?

Thank you.

I do the best job I can on the guide.

There's no (inaudible) play here.

Thanks, Joe.

Thank you.

Our next question comes from Steve Milunovich of UBS.

Your line is now open.

Thank you.

I was just curious, when you talk about installed base numbers are you talking about number of systems, number of customers, and how does the rate of change today compare to, say, two years ago?

It's the number of systems under contract.

Two years ago, I still think we have more systems under contract than even two years.

It's probably at an all-time high right now, in fact it is.

Was the installed base growing at a similar rate or faster two years ago?

I think the installed base of units is growing at a faster rate now.

I think in terms of the systems, life cycle continues to expand, right.

So I think the continued extension of life cycle is what causes the installed base to have legs and growth, right, in addition to the product revenue growth that we're seeing now.

Thank you.

Thanks, Steve.

Next question.

Thank you.

And our next question comes from Maynard Um of Wells Fargo.

Your line is now open.

Hi.

Thanks.

In the past, you've typically passed along the cost of media price increases or price declines to customers, but based on your product gross margin conservatism commentary, has something changed in your ability to pass along those costs?

And any color on when NAND pricing should start to decline and be a tailwind for you?

Thanks.

Let me take the first one and Ron will take the second.

I think in terms of our approach to media prices, we've generally taken the position that we will pass on whatever cost structure being offered to us, benefit or disadvantage, from the media manufacturers to our customers.

I think the caution is really reflecting the dynamic nature of SSD availability and pricing.

As we noted, we've put in place the capability to meet a short supply.

We're wanting to guarantee a short supply to our end of customers and that has been a priority ahead of specific pricing agreements.

From what we can tell, obviously, this is somewhat an estimate, demand will be tight for -- supply will be tight for the rest of the summer, probably should ease later in the calendar year is what we're thinking.

And prices should come back a little bit better later in the calendar year, as well.

Great, thank you.

Thanks, Maynard.

Thank you.

And our next question comes from Simon Leopold of Raymond James.

Your line is now open.

Great.

Thank you very much.

I was hoping you'd be able to help us quantify the headwind from the NAND in terms of how much pressure it's putting on the gross margin?

And then help me understand why your product gross margins traditionally have been lower versus some of your peers?

I imagine it's a little bit of apples-to-apples, but help me fit the baseline with that?

Thank you.

Yes.

So in the guide for Q4 I'd say there's probably a headwind of about 0.5 point in total gross margin erosion.

About seven ticks is SSD COGS increase to some extent.

I think if you look at our history of gross margin it has vacillated over the years.

I think it's something we do need to focus on, and the good news is we've offset that with a lot of the increase in the service margins.

All right.

Thanks, Simon.

Next question.

Thank you.

And our next question comes from Rod Hall of JPMorgan.

Your line is now open.

Yes, hi, guys, thanks for taking the question.

I just had two.

I want to clarify one thing and then I have a question, I guess.

The clarification is can you guys just say -- you're saying that you've got NAND supply into, I guess, the April quarter.

Do you have it on through July or have you only guaranteed it for one quarter forward?

Because it sounds like October and January quarter's probably the supply you think is going to be back to decent again.

And then my question is the Dell EMC channel deal that was announced a couple of weeks ago, I guess, it started the beginning of February, can you just comment on whether you're seeing impact from that in the channel?

Do you have to make any changes in your own channel program and how lucrative is this relative to your existing channel program?

Thanks.

So with respect to NAND, we've secured supply for the remainder of this calendar year, at which point I don't think this is going to be an issue anymore from a supply standpoint.

From a channel program perspective, we've started to see the beginnings of an integrated channel program from EMC.

I'll just tell you that incentives are just a small part of the total value proposition that a channel partner looks for from their supplier.

I think the competitiveness of the product portfolio, the fact that we enable our channel partners to have a rich base of margin rich services associated with the business that they're doing with NetApp continues to make us a compelling value proposition to our partners.

So we're going to continue to attack with the full breadth of our channel, and we are making progress as our results note.

Thank you.

Thanks, Rod.

Thank you.

Our next question comes from Sherri Scribner of Deutsche Bank.

Your line is now open.

Hi, thank you.

I just had two accounting clarifications.

It seemed like the strategic solutions revenue changed slightly historically and versus last quarter.

So can you just explain what moved into the different buckets?

And then looked like amortization ticked up.

Can you explain why amortization went up?

Thanks.

So we did make one adjustment to historical strategic for one product that we had accounted for incorrectly.

We're experimenting with what's called express packs.

That didn't get counted in strategic in the past few quarters.

There are solutions that are fixed configurations of our Clustered ONTAP and All Flash FAS products that make it easy for the channel to procure, and we did include that in a couple of the past quarters.

There's a slight adjustment for that.

The second question was on amortization?

There's a slight increase in SolidFire amortization for new developed technologies.

It's pretty small.

Thanks.

Thanks, Sherri.

Thank you.

And our next question comes from Eric Martinuzzi of Lake Street Capital.

Your line is now open.

I've just been comparing the international, the mix versus a year ago.

Looks pretty consistent there.

Do you see that sustaining, and could you comment specifically on EMEA and APAC?

We have a broad book of business around the world.

I would just tell you our book of business is affected by GDP outlook, as well as the competitiveness of our portfolio and execution against those opportunities.

I don't have any specific -- we didn't notice any specific change in pattern through the course of the quarter across the broad base of geographies that we serve.

Thanks, Eric.

Do you expect -- okay.

Yes, we expect the trend to continue the same.

Thanks.

Thank you.

And our next question comes from Amit Daryanani of RBC Capital Markets.

Your line is now open.

Hi, guys.

This is Irvin Liu calling in for Amit.

So on your flash business, given that flash is currently running at a $1.4 billion annual run rate, are you guys seeing the margin profile for flash improve versus your mature business, and if so, how should we think about flash array margins versus disk versus or versus hybrid?

You shouldn't think of a different margin profile between strategic and mature.

They're relatively the same.

I think that's also true with flash hybrid and traditional spinning disk.

Thanks.

Next question.

Thank you.

And our next question comes from John Lucia of JMP Securities.

Your line is now open.

Hey, guys.

Thanks for taking my question.

I just want to see if you guys could give us an update on the spending environment in storage in general.

Seems like things have improved over the last couple quarters in terms of the way you're discussing the market.

Have you seen sales cycles shorten or are customers more decisive in their spending?

Any kind of color would be great.

I think through the course of the quarter we saw a strong year-end budget flush.

We saw January return to fairly normal patterns of uncertainty across the geographies that we serve, and saw linearity similar to normal sort of back end loaded quarters.

I think in terms of the segments of the market that we serve, I think our pivot is targeting the faster growing parts of the market.

So there's a lot more interest as a share of wallet for the technologies that we're offering today, like solid state next generation data centers, object storage, as well as what we're thinking about delivering to market in the hyperconverged space.

I think in terms of traditional environments, you continue to see people sweat assets, try to get longer life cycles out of that.

We're benefiting from the fact that we've got a differentiated portfolio.

We're benefiting from the fact that the portfolio is targeting the places where customers are spending.

And, frankly, we're benefiting from the fact that Clustered ONTAP significantly and substantially transforms the cost structure of a legacy frame array.

We can go in there at an order of magnitude greater efficiency and enable lots more software features than they've historically had.

Thanks, John.

Thank you.

Thank you.

Thank you.

And our next question comes from Lou Miscioscia of CLSA.

Your line is now open.

Hey, George, sort of on that same line but looking at it a little bit more into the future, some very big companies like Verizon, GE, Capone, all have closed their data centers.

Can you give us some thoughts on the trajectory for the next two or three or four years of storage in general?

But, obviously, you've got a very nice quarter here.

So congratulations on that.

But just worried if you're running off a weak compare in that when you sort of get to the actual year-over-year compare it either flattens or goes down?

We'll give you more details of the long-term outlook at our analyst conference.

I can just tell you that we are increasingly seeing wins where people are using NetApp Private Storage solutions connected to public cloud providers, and what we've always said is we anticipate returning the Company to moderated revenue growth.

Our focus on transformation allows that moderated revenue growth to generate substantial returns to shareholders and we're delivering on that commitment right now.

Thank you.

Thanks, Lou.

Thank you.

And our next question comes from Brian White of Drexel.

Your line is now open.

Yes, George, I know you know you came in here at NetApp as CEO in mid-2015.

The Company's going through a lot of issues at that time.

You've really righted the ship and done a phenomenal job here.

What's the next big thing that we should think about that will move the needle for NetApp, and do you think NetApp will gain share over the next few years?

Thank you.

I think if you look at our results today, we are gaining share in the markets that we serve.

In the All-Flash Array market, there's no question we're growing faster than competitors big and small.

I think if you look at the storage and device management market can, we took over the number one position from EMC in that market.

We've made solid progress in Clustered ONTAP in terms of transitioning our installed base, and are doing so with greater operating margin leverage.

As we indicated on the call, we are working on a next generation hyperconverged solution which we think will allow us to do to the hyperconverged market what we did to the All-Flash Array market, serve the needs of mainstream customers with a platform that's differentiated with performance, analyzed data management capabilities, and hybrid cloud integration.

We think that's what the market wants and we're focused on delivering that, and you'll see us make some exciting announcements early next fiscal year.

Great.

Thank you.

Thanks, Brian.

Thank you.

And our next question comes from Aaron Rakers of Stifel.

Your line is now open.

Yes, thank you for taking the question.

George, building on that last comment, I'm just curious how you currently see the hyperconverged market?

Have you seen it compete at all relative to your traditional FAS systems, or as you push into this market how do we think about it from being an adjacent or incremental opportunity for NetApp to go after?

It is a net new market that we serve.

It will allow us to serve the system or virtualization administrator customers rather than the storage administrators.

The hyperconverged market today is sort of a first generation solution.

The solutions don't have enterprise data management features.

They have challenges with performance consistency which requires them to become a single workload configuration, and are, therefore, addressing the low end market, the departmental market.

There are few solutions that can really serve anything broader than that market.

What we're trying to bring to customers just like we did in the All-Flash Array market is a solution that allows customers the benefits of ease of administration, but with the unique benefits of performance and scalability, enterprise data management and hybrid cloud integration, which really gives us a net new market to address.

Thanks, Aaron.

Thank you.

And our next question comes from Mehdi Hosseini of Susquehanna.

Your line is now open.

Hi, this is David Ryzhik for Mehdi Hosseini.

Thanks so much for taking my question.

Some of your smaller emerging competitors use a third party -- a third party for system hardware procurement, which appears to be an enabler for higher product gross margin.

Is this a potential avenue for you to explore?

And it seems like SolidFire does this.

Any comment around the potential for this to expand across your core product portfolio?

Thanks so much.

As I said, as part of our transformation efforts, we have continued to deleverage the supply chain, the industry supply chain to build technology for us.

If you look at the recent A700S flash optimized fabric NVMe-fabric ready architecture, it was sourced by -- off an ODM model, right.

So we are expanding the range of usage of off-the-line platforms across the range of our business, both in SolidFire, as well as our traditional FAS business.

Great.

Thanks so much.

Thanks, David.

Thank you.

And our next question comes from Kulbinder Garcha of Credit Suisse.

Your line is now open.

Another question, I'm afraid, on gross margins.

Did you say, Ron, that the gross margins between the strategic and the mature segment are pretty similar?

Can you --

Could you speak up a little bit, please?

I'm sorry.

Hi.

A question on gross margins again.

Did you say that the gross margins between the mature and the strategic segments are pretty similar?

Yes, they are.

Between the two.

Yes, they are.

Okay.

And so when you look at your -- just the direction of your product gross margin over the last couple of years, apart from the memory cost maybe rises, is it the lack of scale that's been driving that down and pricing pressure and the wrong portfolio and that corrects itself?

Is that how we should think about it?

Yes, mostly -- I've talked about this before.

It's mostly discounting.

That's what most of the margin erosion is from.

We've had also been running promotions to get our customer base transitioned from 7-Mode to Clustered ONTAP.

As we announced this quarter, those promotions -- we've transitioned 50% of the capacity in our installed base to Clustered ONTAP.

So we're seriously evaluating whether we need to continue those promotions.

And so would you say we hit a trough on gross margins then?

I'd like to think so.

Again, what I said before is we still want to be competitive.

So we're trying to do that in a balanced way and it's hard to know.

I wouldn't want them to go any lower, but, again, we've got to be competitive.

Thank you.

Thank you, Kulbinder.

Thank you.

Our next question comes from George Iwanyc of Oppenheimer.

Your line is now open.

Thank you for taking my question.

Following up on the promotion and discounting comments that you just made, are those being competitively driven?

Or are there secular pressures that have forced those for the most part?

They're in response to competitive, especially the promotions.

One of them was unique to us, which George mentioned, and some of the other ones are in response to competitive.

The market normalizing on that front?

Again, we'll talk more about this when I give the outlook for next year in April.

That would be the thinking.

Thank you.

Thank, George.

Thank you.

And our next question comes from Jim Suva of Citi.

Your line is now open.

Thanks very much.

In your prepared remarks you mentioned operating expenses that you appear to be ahead of goal, progressing much faster.

Can you help us as we look ahead?

Does the goal move higher?

Is it you're getting the expenses benefits sooner and we shouldn't project even more savings because now products are doing well?

How should we think about the goals and where we're at because you are ahead of that goal.

Thank you very much.

The goal we established was last year, and we said from Q3 2016 to this going out rate of Q4 2017 we'd save a gross $400 million.

And then after some strategic investments, which include SolidFire, it would be a net of $130 million.

If you impute my guide for OpEx, you can almost get there on an annualized rate between Q3 OpEx of 2016 annualized and the guide I gave for Q4.

You can almost get to the whole $130 million.

And when you add the savings associated with the services work we've done, you can more than get there.

I haven't guided -- we haven't guided anything beyond that at this point.

But as I said, transformation will still exist as we go forward.

Thank you very much.

Thanks, Jim.

Thank you.

And our final question comes from the line of Rich Kugele of Needham & Company.

Your line is now open.

Thank you.

Good evening.

George, if we're going to look at the case study of the All Flash FAS progression, clearly innovating from the ground up with all your feature set, as well as supplemented by acquisitions was the right approach ultimately.

Now with hyperconverged, you really seem to be trying to go and leverage what you had acquired with SolidFire.

What can we tell investors to give them comfort that this would be the right approach, as opposed to what happened with all flash?

I think in both of those cases our perspective is the long-term winner as we have demonstrated in the All-Flash Array market is the one that can take an architecture and serve the mainstream customer segment.

There have been lots of companies that have gone after the early adopter segment with a subset of the features that enterprise customers really want and have failed in the long run.

And so first to market doesn't necessarily mean the big winner, right.

I think what we are trying to do with the hyperconverged segment is the same track record that we've demonstrated with the All-Flash Array segment, which is customers want mature enterprise data management features.

They want performance consistency and scalability so that they don't have to have operationally a siloed environment.

And hybrid cloud is really the architecture of the data center going forward, and they want true hybrid cloud integration.

So we think that by offering those capabilities to customers, we will redefine the hyperconverged market, just like we did to the All-Flash Array market.

Okay.

Thank you.

Stay tuned.

Thanks, Rich.

The transformation of NetApp is yielding solid results with a return to top line growth and increasing profitability.

We are expanding our opportunity by addressing an increasing range of strategic customer use cases.

We've completely refreshed our portfolio of hybrid and All-Flash Arrays, delivered an industry leading storage efficiency guarantee to the market, expanding our cloud based services and soon we will introduce a next generation hyperconverged solution.

All of this underpins our growing confidence in the future.

We hope to see you in April at our investor event where with will talk more about the evolution of NetApp to lead in the next era of IT.

Thank you.

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

This does conclude the program and you may all disconnect.

Have a great day, everyone.