Hi, everybody. Thank you for joining. Tim Long, IT Hardware, Comm Equipment at Barclays. Very happy to have Wissam here from NetApp, CFO. Relatively new CFO, but oddly enough, I did a fireside chat with this fine gentleman at their headquarters a few weeks ago, so we get to turn the tables a little bit here, so maybe I think you gotta read a little disclosure, and then we'll start it up.
Yeah, just make sure I read the Safe Harbor. So 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 NetApp's most recent 10-K and 10-Q filed with the SEC and available on our website at netapp.com. NetApp disclaims any obligation to update information in any forward-looking statement for any reason. Thank you.
Okay. Thank you. Appreciate the time. I know it's pretty crazy times for everybody, so got a few kinda hot topics here, but maybe we'll start off. You're, you know, still relatively new to the CFO seat at NetApp, so maybe talk a little bit about kinda your first year and maybe the priorities that you're focused on, and then we'll get into some of the parts of the business.
That's great. First, thank you so much, Tim, for having me and happy to be here. Yes, first year at NetApp, very excited. It's a great company with great technology and great future. The key priorities are, no surprise, focusing on revenue growth as well as profitability expansion. Basically from top line to the bottom line, focusing on various elements including our investment on the portfolio side, making sure that we're investing in growth opportunities with high ROI, all of our projects from an R&D perspective, and also looking at the go-to-market space, selling and marketing, and making sure that we're investing our resources where we get the highest return on investment from a revenue generation perspective. Obviously with the focus on growth and profitability, the fallout of that is continuing to improve on free cash flow generation.
The company has had a great record of being very disciplined in investment, very, very disciplined in where the OpEx goes, and also very disciplined in cash generation, and so my goal is to improve on that as well as continuing to focus our capital allocation like we've done in the past on continuing to invest in the business, as well as returning capital to our shareholders. As you know, this year we're returning up to, actually over the last few years, including this year, we're returning up to 100% of our free cash flow to our shareholders through dividends and buybacks.
Okay.
So happy to be here.
Great. Great. Thank you. Yeah, let's get into some of the, you know, topics that we obviously get a lot of questions on, and we gotta start with product gross margin. Really great performance last quarter. You got the question a million times, rising NAND environment. How do you deal with it? So maybe walk us through how you see the moving parts around product gross margin? I think it was a very big surprise. Most in the hardware world had pretty nice surprises. You know, we can never tell with pricing or what's in inventory. So just give us your view of, you know, how to frame, the outlook for product gross margins, particularly in the light of at some point you're gonna be facing more directly the increased NAND costs.
Yeah. So we ended our Q2 with a product gross margin of 59.5%, which was a nice sequential improvement relative to the first quarter of the year. A lot of it was driven by improved costs, our cost structure. We did lock in some good pricing on NAND for this fiscal year. And so, for the remaining couple of quarters for fiscal 2026, we expect product gross margin to be more or less stable, and the way we sort of think of it in the future is obviously if commodity prices are higher and we see headwinds on the product gross margin line, you know, in the storage industry, we would pass increased prices or commodity prices as price increases to our customers.
Just like also, you know, in a deflationary environment, we also pass benefits in terms of price adjustments to our customers.
Yeah. It's a good, I mean, I tend to think of this as if the prices are up for the key components, you're raising pricing. Most customers are probably buying on a dollar basis, so maybe they wind up buying less bits. But from a financial standpoint, it could be similar revenues and gross margin percent. Is that a good way to think of it?
I think that's a reasonable way to think of it. You know, our customers tend to plan and budget on a dollar basis. And so let's say they have budgets of X millions or X dollars, then they would basically come to us with what, what problems they're trying to solve, and we work together to define the best solution for them in terms of what type of kit or what type of hardware/software we basically are offering. And you know, in the years where NAND prices are higher, they may get a little bit less of a footprint. In the years where NAND prices are lower, they may get more of a footprint. So that's a reasonable way of looking at it.
Okay. Yeah, and in past cycles, I know you weren't there, but I'm sure you've looked at it. You can just talk a little bit how the company has managed through the changing commodity environments.
Yeah. And look, we have a very experienced team on the supply management side as well as, obviously, on the leadership side. And in past cycles, we've managed to through it really well. In fact, during those periods also, we saw increased EPS. And so, we have good processes, and we're very focused on that as you would expect. The way to think of this whole situation though, if I sort of wanna step back and look at our financial statement or our P&L, we really also focus on gross margin. I mean, our gross margins are very healthy last quarter. We delivered a gross margin of 72.6%, which is really healthy when you look at the competitive landscape.
We focus on gross margin, but we also focus on gross profit dollars, and this is a key leverage for the sort of leverage points for the P&L. And so if I sort of want to look at that line and dissect how the various components of the gross margin line, we talked about the product gross margin, but there's a few other things that are happening within that line as well. One of them, if I wanna sort of stay in the Hybrid Cloud segment, one of them is our Keystone business, which is smaller but growing at a very healthy pace. In the first half of fiscal 2026, the business grew approximately 80%. This also has an accretive effect on the professional services margin.
Within the same business, we have, sorry, same segment, we also have our support revenue that attracts 92+% margin, very healthy. And then, when you look at the rest of the components, our public cloud business, Public Cloud segment that has been growing at a really healthy pace, last quarter, if we adjust for the divestiture of Spot, that segment grew around 18% and delivered 83% gross margin. And so, we're also targeting in that segment 80%-85%. So we're sort of towards the middle of that range. But the point is that segment is growing. And so from a portfolio perspective, we have high growth and high margin components of the revenue as well. And so the mix is favorable for us, going forward relative to gross margin.
Okay. Great. Great. Yeah. I did wanna transition to public cloud, so it's good you brought that up. You mentioned the 18% growth ex- Spot. You know, optically, it's still gonna be overall challenged on the growth rate until your anniversary divestiture Spot. But how are you thinking about, you know, the growth of that business on an organic basis? Obviously, the first-party storage is very strong. So maybe give us your sense of how well that piece of the business is growing and what will that growth rate kinda look like once Spot is fully gone?
Yeah, of course. So, yeah. So, by the first quarter of 2027 would be probably the first quarter where it's sort of year on year totally clean, because we still have the tail end of Spot in the fourth quarter of fiscal 2025, and so when you look at the business itself, as I said, the Public Cloud segment ex- Spot grew at around 18% last quarter. Within that, the first-party and marketplace, the business, the portion of the business you mentioned grew at around 32%. So it's growing at a fast pace. This is really the growth engine of the Public Cloud segment, and it's growing really for a couple of reasons. One, we continue to see healthy growth just basically driven by the growth rate of the cloud.
In addition, we continue to enhance the capabilities and the offering, so we continue to add features into our public cloud across the three hyperscalers. Basically, we are with Microsoft, Amazon, and Google. When the business first started, it was very much in a narrower swim lane focused on public cloud environment, and now we're beyond that. There's also exposure into the sovereign cloud and distributed clouds, and so there's more with the more features and capabilities, so we're able to sort of expand the presence and the offering. Most recently, we brought block to our offering at Google in addition to the Amazon with our offering at Amazon, so we continue to make improvements.
In fact, we also, a couple of weeks ago, there were some announcements around integration with AWS AI on the Amazon public cloud service, basically our native solution there. And so that we continue to expand the capabilities. And the business itself, as I said, we're targeting 80%-85% gross margin in that segment. Last quarter, we were at 83%. And you know, there's no reason for it to improve from there.
Okay. That's helpful. Yeah, it's, you know, basically 10% of revenues now, so it's pretty differentiated from, you know, competitive storage companies, peer groups. So, are you, you guys have a very big lead in this cloud-based storage as a service. Are you starting or expecting to see some of the more traditional on-prem peers trying to develop this type of business model, or is it they're so far behind, it's gonna be difficult for them to replicate the success you've had?
Look, at the end of the day, we're focused on our capabilities and our offering, and, so far, we haven't seen similar offering in the marketplace.
Mm-hmm.
We have quite a bit of differentiation also in the offering itself because it's sort of, it's all based on ONTAP , where you can also, for customers who use ONTAP , Hybrid Cloud, and Public Cloud, they have the capabilities to sort of move also seamlessly between the two. And so there's quite a bit of differentiation in that service.
Okay. And I believe there's a pretty healthy mix of NVIDIA and NetApp too as well in the public cloud. So talk about how you get those wins? I mean, it helps to be cross-selling and have the hyperscaler sales force, you know, selling the solution on their own. So is that the main driver of the non-NetApp on-prem piece of that business?
This is a great point. So yes, I mean, it is a different, another route to market for us. If you think of it as sort of our go-to-market routes, that's another route to market for us. And it does also attract the new customers to NetApp, especially if you think of the customers that we typically don't reach with our on-prem business, you know, smaller to medium-sized businesses, for instance, that don't typically fall within the large enterprise target audience for our on-prem business. Those tend to be obviously new adds to NetApp. And it's, you know, as they grow, obviously, they could also expand into cross-selling into the on-prem business as well. So all in all, it's a great segment for us, and it's seen great growth.
Okay. Great. Maybe if we go over to the tech conference, we gotta talk AI, so you know, in the context of NetApp and storage, obviously, it's been, you know, a lot of the AI has been large language models on big cloud, so there hasn't been a lot of, you know, storage arrays being sold, but you talk about a lot of data lake modernization, so a lot of customer accounts really growing, so maybe walk us through how you think, you know, AI more on the enterprise side is gonna benefit NetApp.
Yeah, of course. And so, you know, as we see, AI moving from training to sort of training large language models to inferencing within this would also create opportunity for data storage or data storage modernization on the enterprise side. And so we talked about having 200 wins last quarter, which if we compare it to the same quarter the prior year has almost doubled the number of wins. It's just we continue to see good momentum in terms of activity and wins in that space. We view these when we look at these wins, we categorize them into three categories. One is data prep. This is where enterprises are getting ready to implement for AI workloads, you know, things like data lake modernization and data infrastructure modernization that enables them to have sort of a unified view of the data.
And so that's one category. The second one is training and fine-tuning of large language models. Either they're training their own model or fine-tuning sort of a pre-trained model to optimize it for their own data. And then the last category is inferencing. So you can think of inferencing or RAG- type of applications. And so if we look at those sort of 200 wins, they're roughly around 45% of them was in the data prep type of category, around 25% in the training type of category, and around 35% in the inferencing side. Now, we think the last category, which is the inferencing, is what drives really data infrastructure and sort of our part of the market as it grows.
If AI were to be successful, obviously, more and more inferencing will be adopted by enterprises, and that, in our mind, would create a nice tailwind and, sort of, growth engine for the data infrastructure.
Okay. Yeah. Investors like to see a, you know, revenue number, percentage, whatever. Do you envision these different AI use cases that NetApp is involved in a year or two from now translating into you having an ability to say, you know, X% of our business is now driven by AI, or will it be too difficult to parse out with kind of the core business?
This is the goal, Tim. I mean, as it becomes more sizable portion of our revenue, then we should be able to quantify it and talk about it more in terms of dollars and cents.
Okay, and would there be any margin differentiation or difference with these type of more advanced use cases relative to kind of the traditional storage business?
It's probably too early to tell. I mean, for me now, I would say probably not necessarily. Now, if there's a certain element of data services, let's say services or software, bigger software element, then there could be some. But for now, I'm assuming that it's sort of in line with the current business.
Okay. Okay. Maybe back to, you know, you gave a forecast of, I think, 3% or so growth for next year at the midpoint. Talk a little bit about kind of the moving parts when you think of the businesses. Obviously, we're gonna have very good growth on the cloud ARR piece. What's kinda underpinning the rest of that, you know, growth dynamic into 2025 into fiscal 2026?
Yeah. So, there's, I would say, a couple of things. In addition to the cloud continuing to grow at a healthy rate, I mean, we talked about the 18% ex- Spot, so expect it to be in the sort of the high teens range. We expect, obviously, continuing growth in all- flash for the remainder part of the year. In fact, we're forecasting the second half of the year to be growing, to be accelerating relative to the first half of the year. I think ex- Spot, we're projecting around 5% or so growth for the second half of the year. Within that, there's also, when we look at the U.S. public sector, we did see some weakness in Q2. We also see subseasonal growth in Q3. But we think by the time we get into Q4, we would be getting back to normalcy.
Obviously, this was a short-term effect from the shutdown, and we don't expect it to have a long-term effect on the business, and so when you put all this together, that gives us sort of, we're close to that sort of 3% you mentioned.
Okay. And you mentioned all-flash array. It's been a, you know, pretty good move for NetApp. Obviously, it still tends to be a little bit better margin. Maybe two years ago or so, two or three years ago, really more aggressive with QLC, NAND . So maybe talk a little bit about what you see that all-flash mix doing and the little bit more exposure to QLC, maybe for some secondary workloads. What is that doing to kinda market share and, you know, ability to enjoy better margins, maybe at not the highest end of the market, but that mid-tier of the market?
Yeah. So, what if you look at our market share development over the last couple of years? We did gain share in all-flash. And part of that is some of the dynamics you mentioned. Obviously, part of that is also our fresh portfolio and our ability to compete very effectively. And of course, ONTAP is a big element of that. So when I look at these dynamics going forward, those are the same type of dynamics that should allow us to continue to sort of be more traction and potentially gain share in the space. As of last quarter, we had around 2/3 of our Hybrid Cloud segment very much on all-flash. And so that continues to grow as a percent of the.
Okay. And it's still a pretty small percentage of the installed base that's on it. So how does that translate to upgrades and, you know, as you're looking at the next few years?
Yeah. If you think of the installed base, we're around 46% of the installed base sort of refreshed from hard drive, and so if you think of the way we've seen it develop and the way we think of it also going forward, we think that should continue to increase approximately one percentage point a quarter. So, you know, to get to that sort of 60%, let's say, it's gonna take us a few years. We still have a few years of growth ahead of us. Those, obviously, as you said, our all-flash array business tends to attract a little bit better margins. So that also, in a way, provides us sort of a tailwind to the margin for the future.
Okay. Yeah. When you're looking at kinda just the overall mix of the business, obviously, the public cloud is gonna be faster growth, Keystone's smaller, but very high growth, and the maintenance, you know, services business, pretty, you know, stable growth. So is this a dynamic where the recurring revenue percentage as well, given some of those pieces underneath, will continue to tick higher, for the company?
That's exactly how this works. I mean, you described it much better than I would, Tim. But that's exactly how we think of it.
Okay. You mentioned public sector. You know, you do, you do have a fair amount of exposure there. So I guess the next quarter still a little subseasonal. So that's just some conservatism around when we'll start to get, you know, approvals flowing and that type of thing. But outside of that, there's a lot of focus from the federal vertical, it seems, to modernize. So do you think once we get out of this, you know, post-shutdown mode, we'll see that segment of the business, you know, in a, in a much better growth algorithm heading, heading forward?
Yeah. So as I said earlier, what we've seen in Q2 and what we're seeing in Q3 is temporary. This is all sort of a result of the shutdown. We don't see a long-term effect on the business, and so to the extent that IT spending from the government side sort of increases in the future, we would be beneficiaries of that, and we should see that materialize in the business.
Okay. And one of the areas, other verticals that was a little bit more challenging was EMEA. A lot of macro situations over there. It seems like it was a little better last quarter. Where are we in the cycle for the Europe business?
So, the nice thing about EMEA is, we talked about it being sort of down in Q1, but in Q2, it came back nicely. I mean, what we see in Q2 is, you know, places like U.K. and Germany did well. You know, it has a lot to do with GDP growth and how the GDP growth develops in various countries. We do have really a strong presence in EMEA. Our team did really great in the second quarter. And so, we expect to continue to do well there.
Okay. You know, maybe just going back to the public cloud business, I think there was a period, maybe it was Spot, but there was some elements of the business that were just far too lumpy and not predictable. When that's anniversary and you got more of this first-party and marketplace storage, do you envision other offerings and other technologies? I mean, you're getting block in, you're doing kinda some of the, blocking and tackling and getting all the, you know, relevant offerings into the big three. Do you envision either M&A or other, you know, solutions that NetApp can offer to leverage the pretty big install base you have with those customers?
Look, from an M&A perspective, you know, we're a technology company, and we'll continue to look at options for value-enhancing tuck-ins that would be basically good, nice complementary for our product portfolio. At the end of the day, we wanna make sure we have the most competitive product portfolio that allows us to continue to drive the growth of the business, the profitability, and value creation.
Okay, and then just back to Keystone, you mentioned the 80% growth, very impressive, off a smaller base. Are you seeing customers wanting that type of consumption model? Is it a push model still? Is it a pull model? How do you see that happening? And how is the sales force at adding on this? You know, could be challenging if I'm selling an array for $100 compared to a Keystone for, you know, $30 over, you know, three years in a row, four years in a row. How do you manage that transition? And, you know, will that limit revenue growth a little bit until you get it up to more scale?
Yeah. Well, look, we typically go. We're very customer-centric. We typically go wherever our customers wanna go. We're always happy to propose to our customers the best solution that suits their needs. And so in the event where Keystone is that, we're happy to work with them there. And if it's not, then obviously an on-prem sort of a CapEx solution would work. That's sort of one view. In addition, I would say it also depends on the customers. Some customers who aren't as sort of who are more sort of focused on the prefer a subscription model or a consumption model would go for a Keystone agreement. From a NetApp perspective and from a sales team perspective, the team is compensated either way. So there's no sort of incentive.
Right.
One way or the other, the team is incentivized to sell all of our services and provide the best.
Okay.
Service to our customers.
Okay. Maybe one last quick one. Would you say, 'cause others are trying for that on-prem business to turn into as-a-service business, everyone wants less hardware and more recurring. The strong position you have with the hyperscalers and how mature that model is? How does that translate to helping Keystone? You know, be differentiated from what a Dell or an HP or others wanna do?
I mean, the hyperscalers, the public cloud business is an as-a-service business.
Yes.
Right? And it's nice. It's all consumption-based. Some of it is subscription. And so it's a nice complementary service and business to the Keystone's business. So if you think of, let's say, if I go back to some of the comments I made earlier about some smaller-size customers who are not necessarily very large enterprises who would prefer to sort of get exposed to NetApp through the public cloud business, they could also be good customers or good sort of target customers for our Keystone service.
Okay.
So that's also. These two businesses are very complementary.
Okay. Great. Great. I think we're running up on time. Thanks for, I think, being the last presentation of the day, I believe. So, really appreciate you coming out. Thanks, everyone, for listening. And, thanks a lot.
Thank you so much, Tim.
Happy to be here.
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