All right, folks, thanks for joining us for our fireside discussion here today with NetApp. We have with us CFO Mike Berry, and we're really thrilled to be able to have this time with you guys to discuss the company and all of the aspects of NetApp. So we're going to start with the Safe Harbor Agreement, and then we'll just get right into it.
All right, hi everyone. Today's discussion may include forward-looking statements regarding NetApp's future performance, which are subject to risk and uncertainty. Actual results may differ materially from the statements made today for a variety of reasons described in our most recent 10-K and 10-Q filed with the SEC and available on our website at www.netapp.com. We disclaim any obligation to update information in any forward-looking statement for any reason.
Excellent. So we always kick it off with a brief overview. So for those investors that maybe aren't as familiar with the story, maybe can you give us a quick recap of NetApp, what it does, and what the overarching dynamics are of the business?
Sure. So good morning, everybody. Victor, thanks for having us. Always thrilled to be here. So I'll talk about NetApp from a customer perspective and then from an investor perspective as well. So what NetApp does is we provide unified data storage solutions to our customers. And what you'll hear us talk about is our Intelligent Data Infrastructure. For us, it's all about helping them manage their data, not only on-prem in the cloud, but also hybrid. We provide any of the procurement options that they want. And the important thing that we talk about for our customers is our one operating system, which is called ONTAP. And that is what we run for them on-prem, as well as as a service, and then cloud as well. And it allows them then to modernize their infrastructure and use that across all of their deployment for their data.
And for us, it's all about allowing them to use their data as an asset. And it's not just storage. It's much more about security, protection, and simplicity as well. From an investor perspective, and you've seen over the last five years, we feel like we are indexed to the growth areas in our industry, not only secular trends, but also company-specific. And we'll talk about that as we go through that. We've also shown that, hey, the business model has leverage. We've been able to drive up operating income and then generate cash flow as well. And then we also have a very shareholder-friendly capital return policy from dividends and buybacks as well.
Excellent. Excellent. So my plan was to start off with a broader macro discussion. Given the recent developments over the last 24 hours, I feel like that's particularly appropriate. Understanding how tricky it is to factor in such a dynamic variable, given that it seems like we are moving forward with tariffs, maybe you can help us and the investors understand what areas NetApp is exposed to in that respect, and kind of what kind of impact and exposure you guys are factoring in when you're thinking about forward results and guidance around tariffs and the impacts of tariffs.
Sure. More news this morning or late last night, I'm sure it'll change again. We're trying to be flexible as well. From our perspective, we've largely mitigated any of the, I will call it, focus or around China with our supply chain. Now, we do have contract manufacturers around the world, and they ship from multiple countries, including Mexico. We have been working with them and will continue to work to mitigate any issues there in terms of moving some of that production where we build our products into other countries and away from those areas that we may have tariffs. We've obviously been watching this for a while. We'll stay very attuned to it. As far as it relates to components, if it moves down that path, and gosh darn, Victor, who knows what happens there, that would affect everybody in the industry.
But for now, we're really focused on the shipping of our products, diversifying that, and mitigating any impact. And we'll watch it every day.
To what degree does your guidance reflect that already and kind of what has been input into your guidance around that?
We guided where we were when we went into Q4, and we said very clearly on the last call, the guidance doesn't include any incremental tariffs as it relates to components. Again, we'll see what it means for the rest of the quarter. If they stay, we'll do our best to diversify in that. And for us, it's really the shipment of our product, not the component costs as it relates to that input cost.
Okay. Staying on the macro topics, NetApp has historically had a fairly high federal exposure. And given the recent developments with the new administration around that, maybe help us understand how that is possibly impacting the business as well?
Sure. So it's one of the, call it, segments that we disclose. We have two segments, but it's one of the business areas that we disclose. So U.S. public sector, which includes the U.S. federal business as well as state and local, kind of moves between, call it, 10%-15% of our revenue on a quarterly basis, and let's break that down. In that, there's state and local. So kind of carve that out for a second because they're spending their time in Washington, not in other state capitals. That U.S. federal piece is, call it, about 8%-10%, but in there, if you break that down further, there's the intelligence agencies, there's DoD, and then there's civilian, and they're largely about equal as it relates to that percentage. What we've seen the most of, we haven't seen any, call it, projects canceled.
There's been more scrutiny on the approvals, and that's what we've seen, just slower approvals to get deals done, mostly almost all focused around civilian, so you narrow that down, folks, you're talking about single- digits there, and again, it's the movement of those deals through the pipeline, not necessarily are the projects being approved or not, and we'll continue to watch it if it enters into some of those other spaces. I think now, look, long-term, technology is going to help, hopefully, the federal government continue to operate more efficiently, and that's great, and we're going to help them do that, so long-term, we think it's a good thing, probably just some short-term noise as it relates to approvals.
Have you observed any changes recently as of last quarter, any changes in dynamics and spending order patterns?
So again, no changes to overall projects. And keep in mind, too, that, and we've talked about this as well, Victor, especially under Continuing Resolution, there's not a lot of new dollars being approved. Most of our projects are going to be run rate projects throughout the year. And again, it's more getting dollars approved under that current authorization. We'll see what happens. Hopefully, they pass a new budget at some point, and then we'll see what happens. But for us, it's really a very small piece focused around civilian and, again, getting those approvals through not net new projects.
How about exchange rates? Is that something that we need to be aware of and how that impacts results?
Sure. So last quarter, we talked about it. We do about, if you look overall NetApp, about 70% of our revenue is U.S. dollar based. Like everybody else, we do a lot of business outside the U.S. The largest currencies for us are Euro, Pound, Yen, Aussie dollar, like a lot of technology companies. And we talked about last quarter, it was a headwind in terms of now it hurts revenue, helps OpEx a little bit. And then we included that in our forward guidance for Q4, assuming rates stay relatively consistent. A couple of days ago, I probably would have sat here and said, hey, we expect it to be relatively consistent. Gosh darn, who knows? What happens with the tax bill? What happens with interest rates? And you see other countries as well reacting. So I think this is something we'll all have to watch for a while.
Okay. Sure. Maybe we can pivot to some operational and executional topics. NAND memory pricing has been pretty volatile and dynamic over the past several years, kind of moving between oversupply and undersupply. So how did NetApp navigate that environment last year? And kind of what are your plans to mitigate and manage the pricing for that component going forward this year?
Yep. And we've talked about this. So let's just kind of set the context. If you look at our total COGS, our bill of materials, NAND is still less than half of that for NetApp, even though it is the majority of our revenue, the flash products that we sell. I think people think that it's the vast majority, and it's not, folks. So just let's set that there. Also, number two is that, hey, what our customers buy is, again, they're buying the Intelligent Data Infrastructure, and they're not buying infrastructure. So for them, it's all about the value is our software. We monetize our software through the sale of hardware. Obviously, NAND is a part of that. So let's talk about those prices. And yeah, the drama in the NAND market is pretty crazy.
So in about 18 - 24 months ago, when we saw a complete dislocation in the market where NAND prices fell materially, and then all the little, I hate to use this phrase, but a little oligopoly of suppliers pulled back on supply. So at that time, we took advantage of what we thought was probably a once in a lifetime drop in NAND prices. And we started to procure in advance, pre-buys, as we call them, to mitigate the price increases that we expected to come. And they did come. So we bought through most of our fiscal 2024 and then the first half of our fiscal 2025. Keep in mind that those prices kept going up as we were buying. And like everybody else, we use a version of FIFO. So as you expense it on the P&L, it reflected that as well.
As of hitting our Q4, for us going forward, the good news is that largely what we're expensing and what you can buy in the market now is about consistent because prices went way down, they came back up, and now we're starting to see them come down a little bit again. We expect prices to continue to decline into the first half of our fiscal 2024. Some of the suppliers have talked about inventory and managing that, and that's great. They'll do that. Keep in mind that the largest users of NAND are PCs and cell phones. The consumer plays a big part in this, as well as certainly the hyperscalers. At this point, we're not doing any more pre-buys. We expect that to continue to decline. That then bodes well for our product margins.
We've said that we think Q4 is the bottom of what we expect margins, and then they should start to increase as we go into next year. Did I say 2025? Sorry. So the first half of fiscal 2026. Sorry about that.
Are pre-buys something that you could potentially turn? Is that something that you might resume at some point if the prices fluctuate again in the opposite direction? Is that something that you guys might consider engaging in again at some point if it's necessary? Is that kind of a flexible aspect for you guys?
So nothing's off the table. We always look at it. We're always happy to use our balance sheet to help support the business. The pre-buys that we did before, we really thought that that was a dislocation that if we see it again, we can take advantage of it. At this point, as we enter the first half of fiscal 2026, it's not in the plans. But again, as you mentioned earlier, Victor, hey, the NAND market has been very volatile. We'll see where it goes. So at this point, no plans, but never say never.
Sure. Maybe can you go over some of your operating OpEx plans? I know some of your peers have started cutting back some. And kind of just wondering where NetApp is thinking about that and what the dynamic is for you guys for operating expenses, managing that going forward.
Sure. So as we've always talked about, and especially during my time here, hey, we always look at OpEx. And we always want to make sure that where we're spending dollars is driving a return. The team does an amazingly good job of always looking at where they're spending dollars and can they move money versus just increasing. So we do a really nice job of optimizing where we spend, putting dollars against those growth areas. So for instance, OpEx, year over year in fiscal 2024 versus fiscal 2025, largely dead flat. But during that time, we've introduced more new products than we had probably in the last three years from that time. So the team did a really good job of reallocating dollars to go drive that growth. So we'll continue to do that. Even after Q3, look, we're not panicking. We feel good about the business.
We feel good about being able to grow. So we're not going to do any material pullbacks. But we always look at where we can optimize. Going forward, the areas of focus for us in terms of, I will call it, smaller incremental dollars and reallocation is around two areas. One is, as we talked about, the value of NetApp is ONTAP software. We are a software company at heart. Over 80% of our software engineers are software engineers. And that's focused on ONTAP, on-prem, Keystone, and in the cloud, importantly, and our great relationships with the three hyperscalers. So we will always focus on that and introducing new products to support all the new movements in AI as that goes down the path. So that's one.
Number two is we always look at sales capacity and do we have enough to support the business and making sure that where we see areas for us to invest, again, prudently. I know several years ago we said, hey, we don't have enough sales reps. We're going to do a bigger investment. For us, it's been much more as we go. And then also, Victor, importantly, reallocating that within the sales team in terms of sales reps, sales engineers, partners, and Cesar and team do a great job, again, of reallocating to drive growth. So those will be the two areas that we consistently talk about.
Excellent. That's a good segue into the next area. Investors, obviously, are very interested in AI opportunities and how NetApp is exposed there. So I think generally, the industry assessment kind of describes storage as a second-order beneficiary of AI. Currently, most of the spend is concentrated around hyperscales and servers, and they're built out of AI clusters. This obviously benefits the server vendors. But what role does the storage market play in supporting AI? And how do we see that evolving as the use cases evolve from model training towards inferencing?
Toward inferencing and other things that they keep talking about, so I think keep in mind that NetApp has a great advantage here because we house most of the unstructured data in enterprises. And that is the feeding ground for AI, unstructured data. We got a call out from NVIDIA's CEO several quarters ago on that, so that's a big piece. Our enterprise footprint and unstructured data, we feel like, will drive AI, and as you talked about, there's a lot of investment in, call it, server and network. At some point, that absolutely will come to storage in terms of now you actually have to run it, and we talk a lot about the work that our customers are doing around data lake modernization, which is to get ready, so if the investment upfront is in the areas you talked about, our customers are trying to get ready.
Where is their data? Make sure it's in the right format where they can access it securely. AI is a great thing, but data security really matters. So that data protection is hugely important, making sure that they can do all the versioning and responsible AI. And we've talked about it in the last couple of calls. Over 100 wins in that data lake modernization. That's super important, Victor, because that gets them ready to run it in production, in inferencing, and RAG, and whatever else comes next.
How is your visibility into being able to kind of discern how much revenue is directly being tied to AI right now and your ability to track that metric?
So it's always a little nuanced. It's certainly when we know it's connected to a GPU, then we know that it's related to that. We get a lot, and Chris gets a lot of feedback. And our reps actually tell us if the workload is related to AI because there's some advantage for them to do that and some compensation. So we do track that. We know when that's a data lake modernization. So every quarter we go through, especially the larger deals. And the use cases that we have and our customers raising their hands saying, this is what we're using it for. We don't have any plans to disclose what % that is. But we do talk every quarter, and we'll continue to talk about the wins related to that. And it's not only the modernization of their data infrastructure.
There are some very large customers that are actually building AI training centers in their companies, and we've talked about those as well.
Have you shifted your strategy, your kind of marketing strategy to kind of position the products for AI and maybe specifically around AI? Or has NetApp always kind of been that product, the unstructured product? And has that always just been there? Or have you guys shifted your strategy at all in kind of bringing awareness to customers around AI capabilities?
So I think two questions related there. Our products have always unstructured data has always been a big asset of NetApp, especially with our file system. So that's always been something we've done. And we will continue to do that. There's a lot of focus around product development, making sure that we are being certified in SuperPOD and BasePOD , that we're able to support OVX for inferencing and RAG, as well as to be able to do the modernization and the data lake piece of the so that from a product development, yes. From a marketing perspective, I mean, we spend a lot of time with our customers making sure that they know we're able to support them in that journey. That's certainly a big piece, as well as our sales team, that they're able to talk about how we can help them continue down that path.
The one thing I would say is, again, AI is super important. The other piece is, hey, the enterprise footprint we have is great. And the data protection, versioning, and all the things that we bring them for responsible AI is as important as the product development.
Excellent. Shifting over to the PCS segment, that's another area of discussion that investors bring up fairly often. Can you maybe give us some color around the components of the PCS business and your expectations around growth for each?
Sure. So our Public Cloud services. We'll start a couple of quarters ago, and then we'll go to where we're going. Is we had cloud storage and Cloud Ops. Let's talk about cloud storage, which is the majority of that. And the biggest piece of that is our first-party and marketplace. So not only are we the only provider that has one native service in clouds, we have all three, where we have a first-party relationship with the three biggest clouds where they basically sell our product. And that is with ANF, Azure NetApp Files, FSx for ONTAP is Amazon, and then GCNV, Google Cloud NetApp Volumes. I think I got all those acronyms right. And those are all first-party relationships with the big three.
And then you talk about marketplace, which is in and of itself a vortex where, and Amazon's done a wonderful job, and the other two are following, where they offer marketplaces where you can buy products in their marketplace. The key there is you can burn down your commits when you buy through the marketplace. They're all a little bit different. And I won't speak for them. But to be able to buy in the marketplace to burn down your big commits is hugely important. So what we're seeing is in cloud storage, we have first-party marketplace and then third-party. Think of that as bring your own, Victor, where they buy the product from us and then they deploy it in the cloud. We're going to continue to see that third-party move to first-party and marketplace largely because of that pull, gravitational pull of marketplace.
But also, it's a native solution within each of the big three. So it's fully integrated. It is actually their product. And so customers, we're going to expect to see that pull.
What's the mix of that right now?
So first-party and marketplace after the Divestiture Spot is now over 70% of the cloud business, and that is growing at 30%-40% a year, so that's where the growth is. The rest of it is our Data Infrastructure Insights, which is the old Cloud Insights, and then Instaclustr, which helps with their workload. And all of that supports storage, so that's the big piece of that. The other great thing is just to give a shout out because everybody asks about NAND. Hey, the cloud business now has gross margins approaching the upper end of our 75%-80% margin goal that we gave, and if you look at the components of growth in gross margin, it's now a lot of it is being driven by cloud. And we expect that to continue, especially with the Divestiture of Spot, to keep pushing up.
That business is doing really well. First-party and marketplace continues to grow very strongly at gross margins higher than the company average.
That's subscription, third-party subscription-based predominantly?
First-party and marketplace is mostly consumption because that's how the hyperscalers sell. Third-party is subscription. Again, most of that will be consumption-based. It's almost 80% now. And that mix is relatively consistent even with the Spot divestiture.
Okay. And then just kind of shifting into competitive dynamics. So the big three also have competing solutions that compete as well. So how do they position that? And how do you position your product to compete with them in that aspect, given that they do offer you as a first-party, but then they also compete with you as well? It seems to be a contradicting dichotomy there.
It's a big market. They've always had those products. I won't speak for any of the three biggest companies in the world. We'll let them speak for themselves. We have a great relationship with them. They're all a little bit different, but they're all great. They do all offer their own file storage solutions. We believe they partnered with NetApp because of the performance requirements that they needed, especially related to high-performance workloads. As they wanted to go to market, they saw the success. We started our longest relationship was with Amazon a long time ago. The first-party really got started with Azure NetApp Files. That was focused around high-performance workloads that they were not able to bring to their customers, that we were able to help them. From that perspective, hey, file storage is hard. It's hard.
And to run high-performance workloads, it can't be the bottleneck to bring workloads to the cloud. And that's what it was becoming. So we helped that solution. And keep in mind, that's where we deploy hardware and software in the data centers. We've talked about that. The Amazon solution is actually just all software. So ONTAP runs on their white box hardware in all of the Amazon regions. And then GCP is a combination of both. So again, and they're all different in terms of the workloads that we address. Azure has been more focused on high performance. Amazon's been more focused on bringing the cloud natives and moving those workloads over, moving up into the enterprise. And again, GCP a little bit of both. So again, all the relationships are great. There's a lot of work that they have to do.
We have to do to integrate and make that a fully native solution. We feel really good about the investment there. Our view is that we allow them to go work on and focus on other things like AI. Don't let storage be the bottleneck. Let us support you.
Okay. Excellent. I think we have time for a couple more questions, maybe just quickly into the competitive dynamics. What's NetApp's strategy for differentiating? You have a lot of incumbents in the space. Dell has always been a primary competitor. And channel checks suggest that the peers, you're seeing them in more and more deals. And now you have new guys like VAST and WEKA. So how does NetApp differentiate itself? And what's the strategy for kind of improving your share position?
Well, and you've seen us gain share, especially in flash. So our focus has been in the flash market. Everything that we do, we've talked about it, is that intelligent data for our customers. And ONTAP is the competitive advantage. We are the only ones that offer across on-prem as a service and then multi-cloud to be able to use one operating system across all of those deployment options. And again, we're the only ones that do that. We have introduced a ton of new products around flash. We have our high performance. We have our capacity flash that we introduced about two years ago. And that was the most successful product launch in the company's history. And that really went after those capacity, called lower performance workloads that one of the competitors you talked about have.
And then certainly, our new block offering is going after the largest player, Dell. And what you've seen is now flash is well over a half of all of our revenue. And it's a much bigger part of our sales on a quarterly basis. And that's where we're focused around flash. We've gained share in that market. The other ones have either lost or stayed flat. And that's our continued focus as well, is offering that full range of solutions. And we feel like we're very well aligned to the growth areas in the market. As those 10K hard drives continue to go to QLC flash, that's a secular shift that we'll continue to take advantage of. If we have mid-teens market share in total, here's the great news. 85% of the workloads going from on-prem to the cloud are somebody else's workloads, not ours.
And so that's a great spot for us to get net new customers and get new market share. And then we'll continue to focus on growing our flash market share as well.
Excellent. And I guess we always like to end it with kind of your take on what do you think is the least appreciated aspect of the NetApp story?
There's a lot of them, but I don't have a lot of them. I think the two that I would highlight is, hey, the value of ONTAP and what we provide, I think, is underappreciated. For good or bad, I think we still, from this group especially, get viewed as a hardware company. We're not. We're a software company that monetizes our software through the sale of hardware, and what we provide to our customers is a data infrastructure, not a piece of equipment to go run their product. We are integral to so many of our customers' data operations that I think that that's underappreciated, and then from the finance perspective, we've shown the model has leverage. It clearly does. Five years ago, we had operating margins in the lower 20s. We've hit 30% twice now recently, and it has leverage. It generates cash.
It has a lot of earnings power. It's those two things. By the way, they're connected because the infrastructure and the investment that we make is based in software. Software has much better variable contribution. Those two are connected.
Excellent. Thank you very much for your time.
Thank you. Appreciate it.
Thank you for joining us.