Nutanix Inc (NTNX) 2017 Q2 法說會逐字稿

Good afternoon. My name is Mary Emma, and I will be your conference operator today. At this time, I would like to welcome everyone to the Nutanix Q2 FY17 earnings call.

(Operator Instructions)

I would now like to turn the call over to Tonya Chin, Investor Relations. You may begin your conference.

Good afternoon, everyone, and welcome to today's conference call to discuss the results of our second-quarter FY17. This call is also being broadcast live over the web and can be accessed in the investor relations section of the Nutanix website. Joining me today are Dheeraj Pandey, Nutanix's Chairman and CEO; Duston Williams, CFO; and Howard Ting, Chief Marketing Officer.

After the market close today, Nutanix issued a press release announcing the financial results for it's second quarter of FY17. If you'd like a copy of the release, you can access it in the press releases section of the Company's website.

We would like to remind you that during today's call, management may make forward-looking statements within the meaning of the Safe Harbor provisions of federal securities laws regarding the Company's anticipated future revenue, gross margin, operating expenses, net loss, loss per share, free cash flow, business plans and objectives, product features, technology and consumption models that are under development, competitive and industry dynamics, changes in sales productivity, expectations regarding increased software sales, future pricing of certain components of our solutions, our plans regarding and the impact of the adoption of new revenue recognition standards, potential market opportunities, and other financial and business related information.

These forward-looking statements involve a number of risks and uncertainties, some of which are beyond our control which could cause actual results to differ materially and adversely from those anticipated by these statements. These forward-looking statements apply as of today and you should not rely on them as representing our views in the future. We undertake no obligation to update these statements after this call.

For a more detailed description of these risks and uncertainties, please refer to our quarterly report on Form 10-Q for the second quarter of FY17 filed with the SEC on December 8, 2016, as well as our earnings release posted a few minutes ago on our website. Copies of these documents may be obtained from the SEC or by visiting the investor relations section of our website.

Also please note that unless otherwise specifically referenced, all financial measures we use on the call are expressed on a non-GAAP basis and have been adjusted to exclude certain charges. We have provided reconciliations of these non-GAAP financial measures to GAAP financial measures in the investor relations section of our website and in our earnings press release.

Now, I will turn it over to Dheeraj Pandey, CEO.

Thank you, Tonya. Hi, everyone. Thank you for dialing in. January 27 was a cherishable moment for Nutanix. November 11 through January 12 was our first full quarter of selling our earliest product. General availability of our one debut product happened exactly 5 years ago in January of 2012.

Most naysayers along the way thought we should sell the Company because it was going to be nearly impossible to build a new category of software infrastructure without the muscle and staying power of an incumbent. Rather than sell the Company, we packaged and sold product brute force and built a market around hyperconvergence largely because of our shared conviction for web scale engineering and consumer grid design.

Today, everyone is trying to copy us. Yet most except VMware are missing the point of this fundamental re-architecture enterprise computing so much more than a new form factor in hardware. It's all about the software defining infrastructure running on commodity servers powered by a cloud operating system, and OS that works the whole body of compute, storage, virtualization, networking, systems and operations management, web scale automation, and security.

We've meaningfully traded in the definition of this cloud OS at least twice in the last four years. Once in late 2013 when we fundamentally laid the groundwork for our own hypervisor that we now call AHV, and then 2016 a few months before the IPO when we acquired Calm.io to lay the foundation for app-centric automation. There's also a new convergence on the horizon with VMware and AWS announcing an intent to serve enterprise customers with a new hybrid cloud stack that melds AWS's hardware with VMware software.

This could be a lost opportunity if it's done arm's length like the way converged infrastructure was done with [Reblocks] and Flexbox. As we all know, they are largely fading away mostly not refreshed a second time.

Hyperconvergent [the on trim] owned with a public rented infrastructure has been a challenge if not bigger as converging things on -- (inaudible). It's as much an operating system's problem as it is a user experience and design challenge.

If we took a clean canvas approach like we have been taking for the last seven years, we stand to emerge as a pure play cloud company that uniquely merges the OpEx and the CapEx consumption models for our enterprise customers. Time will tell. Our 5.0 release of the software began shipping in the quarter and reflects our ambition of this cloud offering system.

AHV is the first enterprise grade hypervisor built in the era of convergence. For example, security, networking, and orchestration are baked in with the new architecture in mind. AFS and ABS manage file and block data in pure scale out software services rather than in proprietary hardware. Containers are an organic part for APIs in [cy-buckle].

Certifications of Oracle, SAP, and Citrix continue to push AHV deeper into the enterprise. It's an immense opportunity to make the infrastructure invisible with prism and self-service portal.

Shifting to go-to-market, we continue to expand our aggressive market opportunity with our diverse packaging options that provide maximum flexibility to our customers and how the consumer software. Our Dell relationship remains a strong contributor to our total sales, and we added nine new Global 2000 logos with them in Q2. Lenovo had their quarter since they started selling Nutanix hard appliances about a year ago, and we continue to identify new market opportunities to pursue together. Specifically around an S&P go-to-market where Lenovo's erstwhile IBM servers have had a strong foothold traditionally.

In addition to OEMs, we continue to sell our software directly to end customers to run our enterprise cloud operating system on Cisco UCS and other prequalified hardware. In Q2, we closed deals with a large credit card processor and a large US-based energy company, both Global 2000 companies, to deploy our software on Cisco UCS but also expanding our relationship with important Cisco channel partners as a result of these transactions. The software portion of our business is poised to exhibit strong growth in future quarters.

On the competitive landscape, we certainly see a rapidly evolving dynamic with new vendors such as NetApp, Cisco, and HPE announcing their entry or renewed focus on the hyperconverged market. In the era of the public cloud, conversion, compute, and storage alone is five years too late for the market. Simply changing the consumption model of storage is not enough for the enterprise where developers are demanding self-service for everything from compute, networking, storage, security, and containers.

Now let me review the financial highlights of the quarter. Revenues of $182 million were above street consensus and our guided range, growing 77% year over year. We saw several areas of strength in the quarter including international performance due from new customers and very strong AHV adoption.

Billings for Q2 were $227 million, up 59% year over year. We were able to hold gross margins to 60% even while facing very strong increases in component pricing. And finally, we delivered a better-than-expected net loss per share making consensus by $0.07.

Our win rates remained strong and consistent with prior quarters and we are pleased with our ability to demonstrate the value for a full stack operating system in competitive opportunities. With an annualized billing run rate of nearly $1 billion, it is increasingly important for us to cultivate and grow our pipeline and sales talent.

We added a record number of new customers in the quarter finishing up with over 900, up from 700 in the first quarter. This strong performance brings our total number of customers to over 5,300.

We also continue to see strong growth in the Global 2000 increasing in our total Global 2000 penetration to 473, up 68% from Q2 last year. Our peak multiple Global 2000 customers increased to 7.4 times in the quarter. As we've said before, Global 2000 customers represent a huge opportunity for us as they re-architect their applications and infrastructure to focus on sales service and automation.

Our land and expand model continues to do well with average the customer greater than 18 months purchasing 3.8 times their initial purchase. Our net promoter score on customer support and our unique emphasis on product quality have been quiet skill differentiators in this noisy era of hyperconvergence.

Quality and scale is an extremely difficult engineering challenge going by what we are seeing, our accounts where customers initially bought into the hype of this new form factor. We are extremely proud of our rapidly growing customer roster which includes some of the world's largest and most respected companies that depend on our platform to run their mission-critical applications.

Our solutions have been purchased by 5 of the top 10 and 56 of the top 100 companies on the Forbes Global 2000 list, along with a number one ranked company across at least 20 industry segments. Our vision of the full stack cloud operating system and the focused execution in quality and customer support continue to bear fruit in the segment. Large enterprises resist buying point products that do not scale or cannot be procured in software and have questionable quality and customer support.

In this quarter, we closed a large transaction with a new Global 2000 account, a $10 billion manufacturer of hospital supplies and equipment, to re-platform it's Oracle data business environment from Solaris to x86. Key factors in the win was the value for full stack including AHV and the simplicity of prism to manage the entire data center.

We expanded our relationship with JetBlue, the sixth largest US airline to power the Citrix platform that runs their mission-critical applications. We are also partnering with airline to explore new workloads to increase both in-flight and terminal efficiency.

I highlighted our progress with Dell earlier with my remarks, and we are pleased to close a number of fantastic wins with them in the quarter. For example, we furtherer our momentum in the Global 2000 with a key win at a 60,000 person global professional services firm that specializes in risk management. Following a very competitive bid process which included all the major infrastructure players and several large incumbents, we were selected as the complete infrastructure replacement for six global data centers over an 18 month rollout running all virtual workloads.

We also expanded our relationship with one of the largest hospitality companies in the world that operates in over 90 countries at over 4,000 hotels. They've completed the move of their core reservation system, which had been running non-virtualized in Solaris for nearly two decades to Nutanix-powered all-flash Dell XC nodes as part of a major application refresh.

A key driver for this win was AHV, it's because the customer was eager to adopt in order to reduce its virtualization costs. We added Hurst Technologies, one of the world's largest private companies, to our customer portfolio. Hurst was looking for infrastructure with simplified management to consolidate compute and storage to help transform the centralized IT group into a true internal cloud provider.

This quarter, we recorded our first win was one of the world's largest aerospace and defense companies in the world. After conducting an exhaustive evaluation of Nutanix alongside other [XA] solutions, the customer ultimately selected Nutanix and the Dell XC platform due to the performance, security, and scalability of our solution.

As we continue to expand our presence in Global 2000 accounts, we believe our hybrid cloud strategy is critical to our future success. We are seeing increased activity with our customers who want to bring workloads back from the public cloud because of underperformance and cost overruns. One of our notable wins this quarter is the largest, privately-held automotive dealership group in the US, which decided to bring back critical business applications that dealt with vehicle transactions and customer engagement.

An absolute requirement of these customers is being the preservation of the cloud agility, health service, and one click simplicity they've grown accustomed to. Whenever a public cloud goes down, cloud huggers blame the application and its architecture. But most of the SaaS in consumer applications that went down last week were written in the last four or five years by earlier doctoral West Coast developers.

Imagine the state of legacy apps and the late majority of developers around the world. A true lift and shift would only be possible with a cloud to subsume this disaster recovery and business continuity capabilities within the operating system. Having said that, we do realize the advantages of the public cloud for growing and shrinking consumption via an OpEx model.

We continue to work on product and go-to-market capabilities to become a Company that does not take sides on CapEx versus OpEx, and own versus rent. As we move towards our next $1 billion in business, we need to continue to fight complexity and waste, retain the maniacal focus within product design and engineering on end-user delight, scale a customer service that revels in bringing repeat business, and operate a go-to-market machine that celebrates leverage.

With that, I turn the call over to Duston for a more detailed review for Q2 results. Duston?

Thank you, Dheeraj. We delivered record revenue in Q2, above the target range. This performance coupled with lower than expected expenses enabled us to deliver non-GAAP EPS that was significantly better than our expectations. Revenue for the second quarter was $182 million, growing 77% from a year ago and up 9% from the previous quarter.

New business was up nicely in the quarter with new customer bookings growing to 40% of the total bookings, up from 35% in the prior quarter. We billed $227 million for the quarter representing a 59% increase from a year ago and a 5% decrease from the prior quarter. This quarterly billings performance was somewhat impacted by fewer than expected large deals. We define the large deals as customers buying more than $500,000 in any given quarter.

Over the last four quarters, deals over $500,000 averaged about 45% of our total bookings. In Q2, we performed somewhat below this level, primarily in North America.

With the focus on long-term sustainable growth, over the last quarter or so, we started to segment the North American salesforce with more focus around major accounts. The execution is ongoing but in the process, we may have underestimated the impact of productivity associated with this realignment, which included promoting some of our best performing sales reps into management roles.

This realignment is a natural step in our evolution as we prepare to deliver the next $1 billion in billings. We expect the North America productivity to rebound over the next few quarters, and you can certainly expect us to update you on our progress in this area next quarter.

Our international bookings came in very strong. I'm happy to report that both EMEA and APAC experienced record-booking quarters in Q2 by a wide margin with international bookings representing a record 48% of total bookings in the quarter.

We have invested and we continue to invest a significant amount of resource in these regions, and although international mix of business varies each quarter, we see clear evidence that these investments are starting to take hold. The build to revenue ratio came in about 1.25, and as we mentioned on last quarter's earnings call, we expect this ratio to continue to range in the more normalized level of around 1.25 to 1.3 going forward.

Our gross margins for the quarter was 60%; this is versus 63% in the prior -- a year-ago quarter and 61% in the prior quarter. The team did a nice job of managing margins during the quarter, and we were able to overcome most DRAM and NAND cost increases. To put this in perspective, on average we typically reduce total product costs by 4% to 6% on a quarterly basis.

In Q2, due to increases in memory prices, total product cost increase by 2% and despite this rapid shift in cost, we were able to operate within our 60% gross margin target. We do expect Q3 cost increases to be higher, and again, I will cover that in more detail when I discuss the Q3 guidance. Our operating expenses were fairly flat quarter over quarter due lower than expected headcount and outside services leaving us to a better than expected non-GAAP net loss of $40 million or $0.28 per share.

Next let me review a few balance sheet stats along with a few other key performance metrics for you. We closed the quarter with cash and cash equivalents of $355 million, up from $347 million in the prior quarter. DSOs on a straight average was 76 days, 5 days better than the 81 days we reported in the prior quarter. The weighted average DSOs reflecting the period of average receivables outstanding was 24 days in Q2, same as the prior quarter.

We generated $20 million from positive cash flow from operations marking five consecutive quarters of positive operating cash flow. We should note that approximately $10 million of the cash flow from operations came from ESPP contributions that will reverse out in Q3.

We also generated a positive $7 million of free cash flow during the quarter, although once again, this benefited by approximately $10 million from ESPP contributions. The continued strong adoption of AHV was evident with AHV nodes as a percent of total nodes improving to 21% versus 17% in the prior quarter using a rolling fourth-quarter average and software as a percent of total bookings based on a rolling four-quarter average was 15%, and this was consistent with Q1.

Turning to the guidance for Q3. Q3 guidance on a non-GAAP basis is as follows. Revenue to be between $180 million and $190 million, gross margins between 57% and 58%, and a per share loss of $0.45 to $0.48 using weighted average shares outstanding of approximately 44 million.

Let me now give you some context to understand the trends in passing our guidance. In developing our guidance range as we go into Q3, we took into consideration the fact that Q3 is a seasonably slow quarter as well as the efforts we're putting place to reaccelerate the North American sales productivity. That timing of this is a bit uncertain causing us to potentially reflect some conservatism in our guidance.

As I mentioned earlier, memory prices have also become more volatile. In Q3, we expect DRAM prices to increase 30% to 40%.

In response to this price increase, we raised our product list prices on February 1. It's too early to understand how effective this will be, and therefore, we have reduced our gross margin guidance for Q3. If our price increases hold, there is a chance for overperformance on the guidance; however, it's just too early to tell.

With these types of commodities, history always repeats itself, and we know at some point in time there will be an equally strong reversal in DRAM pricing. At this point in time, it's just too early to predict when this will occur.

Next, I'll touch a bit on the outlook for operating expenses. We did a nice job of controlling expenses in Q2. However, as we have continued to invest in the business and given a more moderate Q3 outlook, our projected expenses as a percent of revenue look a bit more aggressive than we would like.

We've already taken actions to limit planned headcount additions to primarily the sales and marketing related. Of course, any planned reductions in headcount adds will have a bigger impact to Q4 as opposed to Q3. It's obviously a delicate balance between overly controlling expenses and ensuring we are properly investing in the position of the Company to continue its superior growth well into the future, and I believe our plans balance these two objectives well.

Before I open the call up for questions, I want to spend just a few minutes on the expected revenue recognition changes that will take place under the new revenue recognition standard known as ASV606. We had previously communicated to you that we would be adopting the new standard starting in our fiscal Q1 2019 or in August of 2018. We're now taking a serious look at early adopting this new standard, effectively one year earlier starting in August of 2017 as opposed to August of 2018. Although we still need to close out on a few items, we believe it is feasible to early adopt the new standard and early adoption is our preference.

Our enterprise cloud platform can be monetized in many unique ways including via pure software in various forms. It is, however, becoming more obvious that as we stage the business for a higher percentage of software content, the current revenue standard will increasingly complicate the understanding of our financial statements and performance.

We believe the adoption of the new 606 revenue standard will give investors better insight into and appreciation of the true power and strength of the Nutanix business model. As an example, and based on tops down estimate, in Q2 alone under the new 606 revenue standard, gross margins could have been approximately 300 basis points higher than we recorded under the current existing revenue standard. We will give you a clear understanding of our timing to adopt the new revenue standard during our Q3 earnings call.

Operator, if you could now open it up for questions, that would be great. Thank you.

(Operator Instructions)

Jayson Noland, RW Baird.

Okay. Great. Thank you. I wanted to ask about the promotions that impacted productivity. Are those productivity issues expected to continue into the back half of this year?

I think we have done the right thing for the long term, which is six months out. We definitely believe that these people need to have a larger blast radius than just individual contributors, but we're hopeful that the way they actually will become player coaches rather than just being players will actually help us out in the next half and this coming half as well.

We've, obviously, Jayson, replaced those individuals with other great performers, some from the outside, some from inside, so that process takes place and as that process takes place, the productivity comes down a little bit. It looks like it has come down. It has come down in North America, specifically. There's no reason why that should not work up over time.

Okay, and then a follow-up, Duston, on the commodity constraints. Are you seeing any impact to lead times? And then is this -- is your expectation that this carries through the first half of this calendar year or at least your fiscal year?

Yes, it's not a perfect insight, but clearly, next quarter doesn't look a whole lot better. From a lead time, our ops guys have done a terrific job. We bought ahead a little bit in Q2 so that helped us out from a cost perspective. And SSDs have certainly been tight.

We've been able to manage that around and change the mix and a few things like that. We are going to other means as needed on DRAMs and things like that but so far, the team has done a really nice job.

We also looked at some dual-sourcing which goes to the consumer grade flash kinds as well which is not really consumer grade but have a little bit more endurance cycle that we think we can actually absorb in their platform with sales.

Okay. I will leave it there. Thanks, guys.

Nehal Chokshi, Maxim Group.

Thank you. The promotion of these top producers for player cultures, does this introduce a new sales management layer or this has been the mode of operation in prior years as well?

This has been like this, Nehal. Obviously, in the last one year we've had an increased surge in sales hiring which now requires a management hierarchy that is basically experienced in the storytelling as well as an understanding what it means to conduct a lot of these Enterprise conversations.

Why do you think then that it impacted the typical playbook for this quarter as opposed to what happened to prior quarters, [then]?

Calendar 2016 was a year when we had two surges of salesforce which was not evident in 2015 itself.

Okay. Thank you.

John Lucia, JMP Securities.

Hey, guys. Thanks for taking my question. Just wanted to ask, what kind of gives you the confidence that the sales issues you saw in Q2 in regard to productivity will improve over the next couple quarters? I haven't really heard a direct answer there, do you have any plans that you have to fix those issues or can you just walk us through that?

I will let Dheeraj give you some specifics there. But just again, to set context here, in Q2 the revenue was above guidance. So we were pleased from that perspective. Our internal plans didn't quite meet up to expectations. We did from a total perspective do okay there.

And please don't lose sight of what's happened in EMEA and APAC which has been -- had great quarters. We've got new leadership in EMEA; that's looking good. APAC was actually our best performing, most productive region last quarter so they had an outstanding quarter. Those two were our bright spots there.

And by the way, North America has performed pretty flawlessly over the last several years, so there's absolutely no reason in the world why they should not get back to their record productivity that they've had in the past. Dheeraj, do you want to --?

I think is well said, at the end of the day, North America has carried most of the rest of the world all the time, and the good thing that we have [major] really good portfolios of regions around the world, EMEA and APAC and federal and US commercial. I think we've managed a portfolio that's been diverse. It just happened to be quarter where EMEA and APAC carried the bulk of the portfolio doesn't mean that impact Americas won't come back.

Okay. Did I hear you right that you said you added nine Global 2000 customers?

With Dell XC only. Just with Dell XC.

Okay. What was the total?

49 in total, I believe.

49. Okay. All right. Thank you.

That was a good quarter Global 2000-wise.

Great.

Andrew Nowinski, Piper Jaffray.

Thanks. Pure Storage claims that hyper-convergence structure is only being used in smaller, less data-driven workloads than in branch offices. I know you said last quarter that the branch office is only about 8%, 9% of workloads and 75% is used for virtualization. Can you give us your view of where you see hyper-converged being used?

Those numbers haven't changed at all, and we pretty much are in the same ballpark. If you think about $1 billion annual run rate, we cannot be selling remote office, branch office systems and making $1 billion in annualized run rate. Definitely about more than 50% our workloads are with Tier 1 Enterprise workloads.

BBI is about a little less than 30% of our workloads. A lot of the Tier 1 workloads include Microsoft, SAP, Oracle, and as we give examples in the prepared speech, there's a ton of really mission-critical workloads that we're driving in Global 2000 as well.

Got it. Thanks. And just a question on the accelerated option of Acropolis. So when customers use Acropolis, are they still using VMware or on hypervisor for the rest of their data center for the workload that don't reside on the [mechanic's] array, or are they actually ripping out VMware entirely?

I'm just trying to understand net option curve of Acropolis and how easy it will be to sustain that accelerating rate.

Yes, so Acropolis hypervisor, and it's called AHV, basically goes in with at least one workload in mind and as I gave the example of one of our hotel customers, a large hotel chain. They start testing on a single workload and from then on as the confidence grows, they actually start to dial up the AHV consumption itself.

That's what we've seen. One of our largest retail customers to date has thrown Acropolis to us saying I want to get VMware out of my entire account with the AHV. So these things happen once the trust in the platform has actually grown.

Got it. Thanks.

Jason Ader, William Blair.

Thank you. First, I just wanted to see if you could give us any detail on the percentage of bookings from Dell? And second, on top of that, if Dell favors their own technology in their new comp plan, how does that impact your bookings over the next year?

Jason, I will take the first part. As you know, historically, we haven't broken out the OEM piece of the business. We've a little bit of a proxy maybe on the software content, which we talked about earlier at 15% of bookings. I will say we did shift more OEM nodes this quarter, a fair amount. More OEM nodes this quarter than we did last quarter.

I think on the just the prognosis of the relationship, Jason. People have speculated about the demise of this relationship ever since the Dell EMC merger was announced [18] months ago. And Dell has had EVO:RAIL and VxRail and vSAN ready nodes to sell for a long time now. They say they lead with VxRail- and VMware-only environments.

So it's our job then to convince the customer why Nutanix is a better fit to support their multi-hypervisor strategy. And with that, there's only one product in town that works at skill. We should not expect Dell to build our AHV brand or demand. That's what our sellers do with their direct touch with the end user.

Having said that, we continue to develop our go-to-market with Lenovo and Cisco, and we're increasingly taking the software layer out for some of our largest customers. We're also continuing to explore other win-win partnership opportunities with companies and channel partners who will see the need to build alternative revenue streams for themselves beyond the VMware stack itself.

Okay, so you're basically at this point you do not think that even if the comp plan creates incentives for the Dell salespeople to feed to their own technology that it's going to have a significant impact on your relationship with Dell. Is that what you're saying?

There is a front end comp plan but there's back-end rebates and gross margins. So a lot of those things, eventually it's the bottom line that eventually matters, and a lot of those things will be a combination of the front end comp plans and the back-end rebates and such.

Jason, this is Howard. Let me just add one thing. The other thing that I think we've been successful conveying to the Dell sellers is that this is a product that works in a broader set of scenarios and use cases than their own VxRail product, and its exhibited extremely strong repeat purchase rates.

So I think on those two basis also, there's a tremendous about of interest in their sales organization for this product.

Thanks, guys.

Simona Jankowski, Goldman Sachs.

Hi. Thank you. Just as a follow-up to the previous question, I think Dell EMC and VMware combined their go-to-market at the beginning of February in terms of their incentives. So just curious how -- what kind of impact should be noticed in terms of the run rate of bookings or wins in the month since that changed?

And then more broadly in the competitive environment, any comments you can share following the HP SimpliVity transaction would be so helpful as well.

The first one, we have done as much activity in terms of training and enabling the Dell EMC CPSD Team. This is a converged platform team. That was the erstwhile [ECE] Team that now has a portfolio that includes hyper-converged as well. Honestly, Simona, this is going to come down to the hustle in the street because EMC owned VMware in the past as well.

The sales managers, the RDs, the account managers, and how they actually work with each other and figure out what's the fastest product to retire their quotas, what's going to give them the least friction in terms of repeat business. Those things will actually matter more than just the strategy from the corporate itself. So we believe that Dell's CPSD strategy includes Dell XC as a big part of their overall portfolio as well.

And SimpliVity front, if you take a step back, if SimpliVity really were bringing their customer delight to its end users, it would not have ended up the way it did. We had predicted this six, seven months ago because we were hearing all this from the market. There's a reason why Cisco passed on them even though they were close quote-unquote partners. HP picked up a relatively distressed asset, which will buy them nothing more than some short-lived press.

If the products don't work, I think even the HP partner sellers don't care about back-end rebates. They sell whatever retires their quota the fastest and brings repeat business with restriction. So we are absolutely not concerned about HP or Cisco or NetApp in terms of competition. They are not software companies with experience in building full stack operating systems that address compute and storage and networking and security and overall management

Just to go back on Dell for a second, with their software bookings flat at about 15%, does that imply that assuming Lenovo continues to grow, then Dell rolls down on a sequential basis?

We don't break it out. Just on the calc itself, again, we do a rolling four quarters and this quarter on the rolling four quarters, we happen to drop out of a higher quarter and a lower quarter came in, which knocked it down a little bit. It would have gone up a little bit so that's a little bit of insight there.

I see. Thank you.

Rich Kugele, Needham & Company.

Thank you. Good afternoon. Two quick questions. First, Duston, is there a way of looking at AHV adoption on a customer basis versus node, and just to understand, perhaps you can have quite a few large customers who are just expanding their nodes under AHV versus something about broader adoption market-wise. And then I have a follow-up.

Richard, we have a very philosophical view on whether we want to really be part of an MQ for the hypervisor at all because like Amazon's Xen hypervisor is not part of an MQ for the hypervisor itself. I think the hypervisor is now a means to an end. It's not an end in itself. I think the way it was actually being sold for the last decade where virtualization was a strategy of the CIO. There's no more true.

So we don't believe in going and trying to build an MQ and then say, look, we are the leaders of the visionary quadrant. I think it is going to be stepping back five years into this whole thing. We have to bundle it. We have to give it out for free and yet say, look, you don't need a virtualization budget. You don't need a virtualization team to manage all this stuff. It's part of the overall solution itself. Does that answer your question?

Yes. Thank you. And then from a Global 2000 perspective, you did actually add a pretty similar amount to what you had added in the previous quarters. So when you're looking at your salesforce, this is strictly a very large customer, very large order issue in specifically North America. Correct?

Larger. I wouldn't say very large but larger, yes, in North America.

Okay. Are you concerned that the price increases, even if they are component related, can delay that recovery?

I don't think so. They're fairly modest when you look at the memory cost, the memory pricing, and then you look up a percentage of our COGS that memory has made up and then you look at the pricing and what we need to do to get somewhat even. It's not a substantial list price increase.

Okay. Understood. Thank you.

Mark Murphy, JPMorgan.

Thank you very much. I believe you said that you've consummated a price increase on February 1, and it sounds like it's not a large magnitude but I am curious with a month under your belt, how do you think at this point the elasticity of that pricing change will net out if you had to take a guess?

I think it's just too early to tell quite honestly. You're right. We are in a month but I think we need to let it play out a little bit to give you a solid answer.

Especially because the COGS that actually ended up as POs in February were all given out in January and maybe late part of December itself.

Okay, and then what is your -- (multiple speakers). I'm sorry, go ahead.

There some fleshing to do here on the older stuff, too.

Okay. What is your expectation for how long the component price increase phenomenon continues in terms of DRAM and NAND. I think we can see that it will extend into next quarter. I'm curious how much longer beyond that you think it will continue?

At this point, I think the price increases again next quarter not as severe. These things, they turn quick when they turn. But I think it's probably somewhat and probably mitigated a little bit more in our Q1 but it probably extends into Q1, and then we need to see from there how it plays out.

And I think in the meanwhile, we also have to work the whole body when it comes to what it means to deliver something in software for very large deals, and so on, so those are things that we will also be exploring in the coming quarters.

The last question I wanted ask you. The press release mentioned that you're evolving and refining your strategy including sales focus and alternate consumption models. I'm just curious if that's a gradual evolution along the same trend line that you've been on. And relating to the sales focus concepts that you mentioned already today, are you contemplating maybe some more material changes going forward that we are not aware of yet?

Not at this point. It's -- this new consumption model is a relatively young idea. Most things because of the inertia of rest, they take a while to actually get there. As and when it becomes something material, we will come back and talk more about it.

Thank you.

Katy Huberty, Morgan Stanley.

Yes, thanks, good afternoon. Duston, I wanted to ask you a couple questions first. One is, in the gross margin guidance for the next quarter, are you assuming that none of the pricing increases stick and are passed through to customers? Is that what's baked into guidance or is it something else?

And then the second question is, sales and marketing expense was up very slightly sequentially, much less than normal. Was that a slowdown of hiring that occurred in the January quarter or does that have to do with commissions given that as you said, the revenues came in below internal plan?

On the question there, sales will grow more this quarter. As you saw with our guidance there, we brought sales expenses up and we've got some sales meetings that will occur this quarter. We've got that going in the opposite direction. We've got a headcount that we added towards the end of Q2, which gets fully baked into Q3. There's a bunch of headcount there.

There's some more marketing demand spend which we'll spend certainly around larger account focus and things like that in Q3 also. We hired a fair amount of folks. We hired over 200 people in Q2. We will bring that down a little bit, probably obviously for Q3, but there wasn't a massive backing off of hiring, just some timing of expenses and sales meetings and when they fall and stuff like that. I'm sorry, the first question again, Katy?

The first question was what's baked into gross margin for the April quarter? Are you assuming that none of the price increases stick or are you assuming that some of that is able to push through?

I'm pretty much assuming none of the -- very little, if any, of the price increases stick. And again, we will see. Hopefully, that's not the case. That's not the plan. You can do the math too if you look at the cost increases in DRAM and memory as a percent of our total bomb and you could back into pretty much the -- starting at the 60% you can get to the 57% to 58% almost basically on the DRAM cost increases.

Okay, thanks. A quick question for Dheeraj as it relates to AHV adoption increasing. What does that mean from a financial modeling standpoint? Do those customers repurchase at a higher rate? Do they tend to pay for more software over time? How should we read that from a financial modeling standpoint that the Acropolis penetration is increasing?

I think the first thing there is stickiness. And how it helps the company actually get a full stack in front for customers. And beyond the stickiness is also how does the story, the way we actually talk to the CIO, especially in Global 5000, going complete with this idea of a public cloud rented model versus own.

So owned versus rented, we couldn't do this without really having a full-fledged cloud operating system itself. I think that's where it actually begins. We have been very consistent in saying that the way to monetize this is to actually look at the full stack as opposed to looking at a SKU which is the hypervisor in a separate line item in an invoice itself.

I think without AHV, we could never deliver things like paravirtualized storage IO pipeline. We could not deliver network virtualization in all this NSX goodness that you hear from VMware. All that is only possible because we own AHV. I mean, we're doing things with hybrid networking and things like that.

A lot of that stuff means that we had to own AHV as a strategic asset, and the fact that we have been developing it for the last three-plus years is now bearing some fruit in a lot of the core kernel of this infrastructure components beyond compute and storage.

Thank you.

Ittai Kidron, Oppenheimer.

Thanks. A couple for me. First on the billings comment that you mentioned that you had fewer larger deals over $500,000. I want to make sure that that directly maps to the changes in leadership and promotions you did in sales. It didn't happen in areas where you did not make material changes to your sales organization?

Correct. Again, EMEA had a good quarter and APAC had a really good quarter.

Is the pace of productivity improvements of new salespeople, is that changing? Are you still thinking nine to 12 months to get to full productivity?

We've got a four-quarter ramp but as we bring on large accounts, global type sales reps here. Naturally, those are going to take longer to ramp because they are bigger accounts. We need to give the reps the time to go obviously get those accounts up and running. It won't be a large percentage of our salesforce but a reasonable piece of it will have some elongated ramps just by the nature of the accounts that they're hunting.

Okay, and then lastly on the gross margin. Duston, you talked about the impact where typical cost declines you expect every quarter and that this quarter was actually up 2%. Is it fair to say that your gross margin would've been more around 62% or 63% in the quarter if this would have been a normal DRAM price decline?

All things being equal, that's a fair calculation. The only unknown there is what would have done with that 2%, and I'm pretty sure I know what I would've done with that 2%. It would have been 60% and the billings would have been higher.

Got it. Very good. Good luck, guys.

Mehdi Hosseini, Susquehanna.

Hello, thanks. This is David Ryzhik for Mehdi Hosseini. Duston, going back to the FASB 606 for 2Q, you mentioned it would have been 300 basis points higher. Just our base back-of-envelope math suggest that don't mean that software-only revenue would be around 20% of total product revenue. Is that about right? And I have a follow-up.

I haven't quite honestly done the direct calc there. There is some other movement in there and some other calculations that may not be perfect. You're probably not massively off.

And for your Q3 guide, what would gross margin be under the new revenue recognition, if you were to obviously have it for 3Q?

We haven't done that or calc it. What we did is we went back and took a tops-down look at the history and what it would look like for Q2, but we have not done that looking forward.

And just one quick one. You source all your hardware from third parties, and you mentioned that you built up, you strategically built up inventory. I wanted to understand how that worked since the third parties, I assume they would be the ones procuring the DRAM and the SSDs.

We're obviously involved in that but we don't carry inventories specifically ourselves.

Okay, got it. Thank you.

Alex Kurtz, Pacific Crest.

A couple questions for me. I'm sorry if this question has already been asked, but late last year there was a view that rep productivity from a large chunk of the salesforce hadn't really accelerated, and that was on the horizon as far as driving revenue acceleration.

So again, sorry if you already answered this, but what happened to that catalyst in the story from where we were late last year to now?

I think as we spoke, there was four or five really good account managers that we promoted to become RDs. And then basically, $0.5 million-plus deals which happens to be 45%-plus consistently, or around 45% for the last four quarters, dipped a little. So in the law of averages, these two things by themselves would have made Q2 look way better.

And then, Alex, also within that whole process, promoting some of the top performance is one piece of it, but within that process, we're also in some cases taking existing reps and refocusing for commercial to Enterprise because of the opportunities there. So naturally, you get a little -- what we've experienced is some downturn in productivity with that and then we're bringing in more folks to focus on that, too.

So you've got a combination of things. It's just not -- I wouldn't just focus on the promotions. It's more of the realignment of the salesforce again towards Enterprise business, more towards Enterprise business.

And this is my last question here. VxRail, head to head --

I'm sorry. Just to make sure you heard the statistic again. We've been pretty successful here. We've been running bookings roughly -- deals over $500,000 equalling about 45% of the total bookings. That's been reasonably consistent. So we've already been reasonably successful here. That just turned down a little bit in the current quarter.

I understand. And then just on VxRail, was there a change in the competitive percentage against VxRail quarter to quarter? Does it increase, decrease?

Not a material change. We are seeing more hyper-converged overall as the large incumbent systems vendors have starting to lead more with hyper-converge as opposed to trying to protect our traditional three tier. So overall, we are seeing a higher share of hyper-converged in the deals that we're competing. But the win rate remains high, and of the hyper-converged category, VxRail is probably the number one product we've seen.

Thanks, Howard.

Matt Hedberg, RBC Capital Markets.

Thanks for taking my questions. I had one other on the gross margin side. With the early adoption of 606 and assuming that component prices rebound, it would seem logical to me that gross margins could be at this 63% to 65% long-term model and maybe sooner than we expected.

Looking out a little further, would there be upside do you think to that gross margin expectation longer term or do you think you could continue to spend any upside there?

I think, Matt, we've talked about this a lot. I think I would continue to focus on around 60% for the immediate future.

But the assumption, though, that after post adoption, I think you said it was a 300 basis points potential tailwind.

Obviously, we wouldn't do anything extreme but we'd take advantage of some of it and maybe let some flow through but too early to make a call on that yet.

Okay.

We first have to get through the DRAM mess that's going on in the marketplace now and we'll let that clear out and then we will have a clearer view on things going forward.

Got it. And then late last year, I believe it was aboutNEXT in Europe, you talked about your move to network visualization. Curious if you could give up an update there on what you're hearing from customers there?

Yes, so we did release network visualization as part of our 5.0 release, but we are also working on micro-segmentation, service chaining, service insertion, so that you can really get the whole portfolio of what one can actually expect from an east/west network and security software defined security story itself.

So things like how do you insert parallel-to-firewall or a F5 load balancer, things like that. How do you do a one click micro-segment that actually goes and protects an application, all happening from the self-service portal itself. Those are the kind of things that you should come to expect from us in the coming quarter or two.

Great. Thanks, guys.

There are no further questions at this time. I will now turn the call back over to Tonya Chin.

Thanks, again, to everyone for joining us today. We are very excited about the opportunities in front of us and feel we hold a unique leadership position in a rapidly growing market. Our Enterprise cloud platform is the best in the industry and well positioned to capture increasing opportunity in the hybrid cloud market.

With NPS of 90-plus for the last several years, our superior value proposition to customers is clearly evident. We look forward to updating you on our progress on our next earnings call. It's okay to disconnect, operator.

This concludes today's conference call. You may now disconnect.