NetApp Q2 2023 Earnings Call Transcript

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Provided by Quartr
November 29, 2022

Key Takeaways

  • NetApp delivered all-time Q2 highs for billings, revenue, gross profit dollars, operating income and EPS, driven by disciplined operational management and tightly aligned strategy execution.
  • Public cloud ARR reached $603 million with a 140% net retention rate, but growth decelerated as customers optimized cloud spending and large project workloads concluded, leading to a revised year-end ARR target of ~ $700 million.
  • Innovation milestones include the launch of BluXP—a unified hybrid multi-cloud control plane—and new VMware native cloud storage services, alongside energy-efficiency and carbon reporting features that earned an EcoVadis gold ranking.
  • Facing increased budget scrutiny, smaller deal sizes and FX headwinds, NetApp trimmed its FY23 revenue outlook to 2–4% growth (with a 5-point FX drag) and lowered EPS guidance to $5.30–5.50.
  • To drive shareholder value, the company enacted a hiring freeze, cut discretionary and real estate costs, paused cloud-ops acquisitions, and aims for over $1.4 billion in operating cash flow while returning more than 100% of free cash flow via dividends and share repurchases.
AI Generated. May Contain Errors.
Earnings Conference Call
NetApp Q2 2023
00:00 / 00:00

Transcript Sections

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Operator

Good day, welcome to the NetApp second quarter fiscal year 2023 earnings conference call. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing star then zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on a touch-tone phone. To withdraw your question, please press star then two. Please note this event is being recorded. I would now like to turn the conference over to Kris Newton, Vice President of Investor Relations. Please go ahead.

Kris Newton
Kris Newton
Vice President of Investor Relations at NetApp

Hi, everyone. Thanks for joining us. With me today are our CEO, George Kurian, and CFO, Mike Berry. This call is being webcast live and will be available for replay on our website at netapp.com. During today's call, we will make forward-looking statements and projections with respect to our financial outlook and future prospects, such as our guidance for third quarter and fiscal year 2023, our expectations regarding future revenue, profitability and shareholder returns, our alignment with industry megatrends and expectations regarding the future growth in number of cloud customers and their usage of cloud services, our ability to deliver innovation and focus on strategic growth opportunities while optimizing our operating costs, and our ability to drive sustained growth in both our hybrid cloud and public cloud segments in a turbulent macroeconomic environment, all of which involve risk and uncertainty.

Kris Newton
Kris Newton
Vice President of Investor Relations at NetApp

We disclaim any obligation to update our forward-looking statements and projections. Actual results may differ materially for a variety of reasons, including macroeconomic and market conditions such as inflation, rising interest rates and foreign exchange volatility, the continuing impact and uneven recovery of the COVID-19 pandemic, including the resulting supply chain disruptions and the IT capital spending environment, including the focus on optimization of cloud spending, as well as our ability to keep pace with the rapid industry, technological and market trends and changes in the markets in which we operate, execute our evolved cloud strategy, and introduce and gain market acceptance for our products and services, and manage our gross profit margins and generate greater cash flow.

Kris Newton
Kris Newton
Vice President of Investor Relations at NetApp

Please also refer to the documents we file from time to time with the SEC and available on our website, specifically our most recent Form 10-K and Form 10-Q, including in the management's discussion and analysis of financial condition and results of operations and risk factor sections. During the call, all financial measures presented will be non-GAAP unless otherwise indicated. Reconciliations of GAAP to non-GAAP estimates are posted on our website. I'll now turn the call over to George.

George Kurian
George Kurian
CEO at NetApp

Thanks, Kris, welcome everyone to our Q2 FY 2023 earnings call. Coming off a strong Q1, our team delivered a solid quarter with all-time highs for Q2 billings, revenue, gross profit dollars, operating income and EPS. We remain focused on disciplined operational management and the execution of our strategy, which is tightly aligned with customer priorities. On today's call, I will walk through four topics. One, we delivered a good quarter in a dynamic environment. However, we are disappointed with the deceleration of growth in our cloud services. Our conviction in the cloud opportunity and our ability to execute against it is unwavering. Two, we are aligned with the durable megatrends of data-driven digital and cloud transformations. We continue to deliver innovation that furthers our already strong position.

George Kurian
George Kurian
CEO at NetApp

Three, we believe strongly in the opportunity ahead, but have slightly tempered our revenue outlook for the remainder of the fiscal year due to near-term macro headwinds. Four, we understand the imperative to deliver shareholder value in a slowing environment and will focus on our strategic growth opportunities while continually optimizing our operating costs. Let's start with the first point, our performance in the quarter. Q2 public cloud segment revenue increased 63% year-over-year to $142 million, and dollar-based net revenue retention rate remained healthy at 140%. However, public cloud ARR of $603 million fell short of our expectations. As our cloud partners discussed on their earnings calls, growth has slowed as customers look to optimize cloud spending. This macro-related optimization caused some slowing of growth in our cloud storage services as well.

George Kurian
George Kurian
CEO at NetApp

We had a few customers with very large project-based workloads, like chip design, that came to their natural conclusion, resulting in capacity reductions in those environments. We expect these customers to kick off new projects early next calendar year. As the number of cloud customers and their usage of our cloud services grows, the impact of this type of workload will be smoothed over a much broader customer base. In our cloud operations portfolio, Spot is benefiting from the same desire to optimize cloud spending that was a headwind to our cloud storage services. Spot's value proposition is a strong engine for new logo acquisition, and Q2 saw an acceleration of new Spot customer additions from Q1. As we discussed on past calls, we continue to refine our approach to Cloud Insights and are seeing early positive signs with the growth of new Cloud Insights customers in Q2.

George Kurian
George Kurian
CEO at NetApp

We continue to see healthy growth of new-to-NetApp customers and of existing NetApp enterprise customers adopting our cloud services. Those customers are growing in scale as well. The number of customers with greater than $1 million in ARR has more than doubled from Q1 last year. Our public cloud services are highly differentiated and create customer preference for NetApp. We have a multi-year advantage over our traditional competitors in this critical market, positioning us well to deliver sustained growth. Compared to Q2 a year ago, hybrid cloud revenue grew 3%. Our All Flash Array business increased 2% to an annualized revenue run rate of $3.1 billion. Adjusting for the significant FX headwinds, hybrid cloud grew 8% and All Flash grew 7% in constant currency. All Flash penetration of our installed base grew to 33% of installed systems.

George Kurian
George Kurian
CEO at NetApp

To the second point, our alignment to the industry megatrends and our continued innovation. The world's moving faster than ever, raising data-driven digital and cloud transformations to business necessities. NetApp helps meet these objectives with a modern approach to hybrid multicloud infrastructure and data management that we term the evolved cloud. We provide customers the ability to leverage data across their entire estate with simplicity, security, and sustainability, which increases our relevance and value to our customers. We believe strongly in the sizable, durable, and growing opportunity created by these megatrends. As many of you know, we bring significant value to customers running VMware environments on-premises. With a series of announcements made in conjunction with VMware, we are now able to bring that same value to customers in the cloud.

George Kurian
George Kurian
CEO at NetApp

Our native cloud storage services integrated with VMware helps customers quickly, easily, and cost-effectively migrate enterprise workloads to the cloud and accelerate modern application development using Kubernetes. We are the only certified and supported third-party cloud storage solution for VMware Cloud, which creates significant new opportunity for us. As those VMware environments move to the cloud, we can capture the data that resides on competitors' on-premises systems. At the start of November, we introduced BlueXP, the next big step in fulfilling our vision to give customers the simplicity, security, savings, and sustainability needed for an evolved cloud. It delivers true hybrid multi-cloud operations by bringing storage and data services together in a single unified control plane. BlueXP is a highly differentiated solution that enables customers to deploy, discover, manage, and optimize not only infrastructure and data, but supporting business processes across multiple clouds and on-premises environments.

George Kurian
George Kurian
CEO at NetApp

In addition to bringing forward technical capabilities, we are helping customers achieve their environmental goals by creating energy-efficient products. We've added power and temperature reporting in Cloud Insights to give customers a real-time view into energy expenditure. Our carbon footprint reports provide a reasonable estimate for the carbon impact of their NetApp systems. We enhanced our storage efficiency with a four-to-one efficiency guarantee for SAN workloads to help customers minimize their storage footprint and lower energy usage. We not only help customers practice sound environmental stewardship, we practice it ourselves. I'm proud to announce that EcoVadis, the leading evidence-based ESG rating agency, awarded NetApp a gold ranking, placing us within the top 7% of evaluated companies. The third point, the macro environment and our business outlook.

George Kurian
George Kurian
CEO at NetApp

As we moved through the quarter, we saw increased budget scrutiny requiring higher-level approvals, which resulted in smaller deal sizes, longer selling cycles, and some deals moving out of the quarter. In Q2, we felt this most acutely in the Americas high-tech and service provider sectors. We see no change to our underlying opportunity and are confident in our position. However, current economic realities and unprecedented FX headwinds are and will continue to impact IT spending, causing us to temper our revenue expectations for the second half. Finally, point four, driving shareholder value. In response to the slowing top line, we are being agile and taking action to lower operating expenses. Already, we have implemented a broad-based hiring freeze and are reducing discretionary spending, as well as further optimizing our real estate footprint.

George Kurian
George Kurian
CEO at NetApp

We will remain disciplined as we continue to shift resources away from lower yield activities to our biggest opportunities. In closing, we are clearly aligned with our customers' strategic priorities and remain confident in our long-term opportunity despite the current external headwinds. By focusing on what we can control, we will aggressively seek to maximize the near term return on our product and services portfolio while leveraging our leadership position in all-flash, cloud storage, and cloud infrastructure optimization. I would like to thank the entire NetApp team for delivering a strong first half. In a challenging environment, we remain focused on innovation, execution, and operational discipline. I'll now turn the call over to Mike.

Mike Berry
Mike Berry
CFO at NetApp

Thank you, George. Good afternoon, everyone, and thank you for joining us. Before we go through the financial details, I think it would be valuable to walk you through the key themes for today's discussion. Number one, as George highlighted, we delivered a strong Q2 in a dynamic environment with all-time Q2 company highs for billings, revenue, gross profit dollars, operating income, and EPS. Number two, we have adjusted our outlook for the second half of the fiscal year due to an increasingly challenging macroeconomic environment and unprecedented FX headwinds. Number three, as we navigate through the current macro environment, we are laser-focused on driving operating margins and free cash flow generation. As George noted, we have taken actions to reduce our full-year expense envelope and will remain fluid in assessing further opportunities to take costs out of the business.

Mike Berry
Mike Berry
CFO at NetApp

Number four, as a result of these cost-saving measures, the entirety of the op margin and EPS guidance revision for the full year is being driven by the incremental 1-2 points from the deepening currency cost we have seen since our Q1 call. Number five, we continue to expect to generate greater than $1.4 billion in operating cash flow and $1.1 billion in free cash flow for the full year. From a capital allocation perspective, we will continue to pause cloud operations acquisitions for the remainder of fiscal 2023. We now plan to return more than 100% of fiscal 2023 free cash flow to investors through dividends and incremental share repurchases. To the details. As a reminder, I'll be referring to non-GAAP numbers unless otherwise noted.

Mike Berry
Mike Berry
CFO at NetApp

Q2 billings were $1.6 billion, up 3% year-over-year. Revenue came in at $1.66 billion, up 6% year-over-year. Adjusting for the 540 basis point headwind from FX, billings and revenue would have been up 9% and 12% year-over-year, respectively. Even with the challenging Q2, our cloud portfolio continues to positively impact the overall growth profile of NetApp, delivering 3.5 of the 6 points in revenue growth. Hybrid cloud segment revenue of $1.52 billion was up 3% year-over-year. Product revenue of $837 million increased 3% year-over-year. Total Q2 recurring support revenue of $607 million increased 3% year-over-year, highlighting the health of our installed base.

Mike Berry
Mike Berry
CFO at NetApp

Public cloud ARR exited Q2 at $603 million, up 55% year-over-year. Public cloud revenue recognized in the quarter was $142 million, up 63% year-over-year and 8% sequentially. Recurring support and public cloud revenue of $749 million was up 11% year-over-year or 16% in constant currency, constituting 45% of total revenue. We ended Q2 with $4.1 billion in deferred revenue, an increase of 5% year-over-year or 10% in constant currency. Q2 marks the 19th consecutive quarter of year-over-year deferred revenue growth, which is the best leading indicator for recurring revenue growth. Total gross margin was 66.3% in line with our guidance.

Mike Berry
Mike Berry
CFO at NetApp

Total hybrid cloud gross margin was 66% in Q2, including a 2-point year-over-year headwind from FX. Within our hybrid cloud segment, product gross margin was 50%, including a 3-point year-over-year headwind from FX. Our growing recurring support business continues to be very profitable, with gross margin of 93%. Public cloud gross margin of 68% was accretive to the corporate average for the 8th consecutive quarter. We remain confident in our long-term public cloud gross margin goal of 75%-80% as the business scales and an increasing percentage of our public cloud revenue is driven by cloud and software solutions. Q2 highlighted the strong leverage in our business model with operating margin of 24%, including 2 points of FX headwinds. EPS of $1.48 came in nicely ahead of guidance and included a $0.21 year-over-year FX headwind.

Mike Berry
Mike Berry
CFO at NetApp

Cash flow from operations was $214 million, and free cash flow was $137 million. Q2 included our annual repatriation tax payment and continued cash outflows for certain inventory and premiums for constrained trailing edge analog parts. Additionally, collections were lower than expected due to a back-end loaded quarter for invoicing linearity that you see in the higher accounts receivable balance. Our component purchasing strategy allows us to meet as much customer demand as possible, but remains a clear headwind to cash flow and gross margins. We are seeing signs of relief in supply availability. The timing of a full supply recovery remains uncertain. However, as our inventory levels start to normalize, it will be a tailwind to free cash flow as we go through the second half of fiscal 2023.

Mike Berry
Mike Berry
CFO at NetApp

During Q2, we repurchased $150 million in stock and paid out $108 million in cash dividends. In total, we returned $258 million to shareholders, representing 188% of free cash flow. Share count of 220 million was down 4% year-over-year. We closed Q2 with $3 billion in cash and short-term investments. Now to guidance. As George discussed, we have seen softening in the macro backdrop, with customers taking a decidedly cautious approach to spending. Additionally, currency headwinds have only continued to increase. We now expect fiscal 2023 revenue to grow 2%-4% year-over-year, which includes 5 points of FX headwind versus the 4-point headwind assumed in our prior guidance.

Mike Berry
Mike Berry
CFO at NetApp

We now expect to exit fiscal 23 with public cloud ARR of approximately $700 million, which equates to our public cloud segment driving 3 points of total company revenue growth for the full year. Three drivers are impacting the near term growth rate of cloud ARR. Number one, in this macro environment, we project continued optimization of storage services as we help our customers manage their spending, which benefits Spot, but will offset some incremental near term storage services ARR. Number two, we expect that project-based workloads will grow in both number and scale, but as they ramp, it will take some time to materialize into sizable ARR. Number three, we continue to tighten up the Cloud Insights sales motion, but we don't expect this meaningful cross-sell opportunity to materialize until we head into fiscal 2024.

Mike Berry
Mike Berry
CFO at NetApp

In fiscal 2023, we continue to expect gross margin to range between 66%-67% as elevated component costs and FX headwinds weigh on product margins. As you know, the vast majority of our bill of materials is procured in U.S. dollars. We are optimistic that supply constraints will ease further in the second half of our fiscal year, reducing our dependence on procuring costs at significant premiums. We should also see a benefit from declining NAND prices in Q4. While the timing is uncertain, we remain confident that our structural product margins will normalize back to the mid-50s in the fullness of time. For the full year, we expect operating margin of approximately 23%, which now includes approximately 2 points of FX headwind and EPS of $5.30-$5.50, which now includes more than $0.70 of currency impacts.

Mike Berry
Mike Berry
CFO at NetApp

It's important to reiterate that we are offsetting the full year revenue adjustment with an extremely disciplined approach to our spending envelope. As a result, the entirety of the op margin and EPS guidance revision for the full year is being driven by the incremental 1-2 points from the deepening currency costs we have seen since our Q1 call. We continue to expect to generate greater than $1.4 billion in operating cash flow and $1.1 billion in free cash flow for the full year. From a capital allocation perspective, we will continue to pause cloud operations acquisitions for the remainder of fiscal 2023 as we sharpen our portfolio focus by refining the Cloud Insights value proposition

Mike Berry
Mike Berry
CFO at NetApp

Sales motion, accelerating the integration of Spot and CloudCheckr into a single FinOps suite, and driving the successful integration of Instaclustr. As I have said earlier, we now plan to return more than $100 of fiscal 2023 free cash flow to investors through dividends and incremental share repurchases. On to Q3 guidance. We expect Q3 net revenues to range between $1.525 billion and $1.675 billion, which at the midpoint implies a 1% decrease year-over-year or 4% growth in constant currency. We expect consolidated gross margin to be approximately 67% and operating margin to range between 22% and 23%. We anticipate our tax rate to be between 21% and 22%, and we expect earnings per share for Q3 to range between $1.25 and $1.35 per share.

George Kurian
George Kurian
CEO at NetApp

Assume that our Q3 guidance is net interest income of $5 million and a share count of approximately 220 million. In closing, I want to thank the entire NetApp team for their continued commitment in such a dynamic environment. I'll now hand the call back to Kris to open the call for Q&A. Kris?

Kris Newton
Kris Newton
Vice President of Investor Relations at NetApp

Thanks, Mike. Operator, let's begin the Q&A.

Operator

Thank you. We will now begin the question-and-answer session. To ask a question, you may press star then one on your touch tone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. If at any time your question has been addressed and you would like to withdraw your question, please press star then two. At this time, we will pause momentarily to assemble our roster. Our first question will come from Amit Daryanani with Evercore. Please go ahead. Pardon me, Amit, your line might be muted.

Analyst at Evercore

Can you hear me?

Kris Newton
Kris Newton
Vice President of Investor Relations at NetApp

Yeah, we can hear you now.

Analyst at Evercore

Hello? Okay, this is Abdullah speaking in for Amit. I think you guys cloud ARR expectation is coming down by $100 million versus prior expectations. I just wanted to ask whether you guys could perhaps touch on the softness there. Is this more on compute, storage, or analytics? Maybe if there's one cloud provider where the RAMs are more challenged versus not. I would appreciate any details here. Thank you.

George Kurian
George Kurian
CEO at NetApp

I think we expect to see the continuation of some of the trends that we saw in Q2, which is the consumption-oriented cloud offerings in our portfolio, which are cloud storage services, were most impacted by customers wanting to reduce their spending. It could involve either them reducing the amount of capacity they use on our offerings or us proactively helping them migrate some of their workloads from a high-performance tier to a more cost-effective tier so that they will continue to see value and benefit with us. That's one. Second, we saw in Q2 some project-based workloads, for example, large-scale semiconductor design, that came to its natural conclusion. We anticipate some of those workloads coming back in the early part of next calendar year, we're being cautious about that.

George Kurian
George Kurian
CEO at NetApp

Finally, with our Cloud Insights, you know, product, we have continued to work to sharpen the focus and the use case of the products. We saw some early success in terms of new customer wins, new to Cloud Insights customer wins. We're being cautious about the, you know, future growth rate of that product until we see further evidence of success. I think those were the three. I did not see anything materially different between the different cloud providers. Clearly, our relationship with Microsoft is the largest of the three, given that we've worked with them for the longest, they saw the biggest impact this quarter.

Kris Newton
Kris Newton
Vice President of Investor Relations at NetApp

All right. Thank you. Next question, please.

Operator

Our next question will come from Mehdi Hosseini with SIG. Please go ahead.

Mehdi Hosseini
Senior Equity Research Analyst at SIG

Yes, thanks for taking my question. Two follow-ups. George, if I just take your guide and commentary, you suggest that all-flash array revenues should show a quarter-over-quarter and year-over-year decline in January quarter?

George Kurian
George Kurian
CEO at NetApp

We didn't guide anything specific in terms of all-flash array revenue. We have guided at the total company level. We're being cautious about our outlook given what we saw in the quarter and the continued macroeconomic environment. We are not guiding any specific product category, Mehdi.

Mehdi Hosseini
Senior Equity Research Analyst at SIG

Sure. It's just that's what I walked away with. Is that a realistic assumption for all-flash array revenues were to decline?

Kris Newton
Kris Newton
Vice President of Investor Relations at NetApp

We're not guiding down to the product line, Mehdi. Sorry that we can't help you with that.

Mehdi Hosseini
Senior Equity Research Analyst at SIG

Yeah. That's, that's fine. At least I tried. Just and then follow-up to your comment about the chip design. There's obviously a product migration. They're expected to introduce new products for AI application. You also suggested that that should help you with rebound in the cloud data services. I wanna better understand what are your underlying assumption. Do you think that product transition is going to ramp in early calendar year? Is your guide on cloud data services completely de-risked given this transition? Sometimes these transitions take longer, and I'm just wondering what are the key assumptions there.

George Kurian
George Kurian
CEO at NetApp

I think with our cloud outlook, we've been cautious to, you know, address three topics, right? One is consumption services on the cloud are being impacted by customers reducing spend, either by optimizing the performance level that they use or the total capacity they use in our cloud storage services. Then we will see buildback. We don't see that yet in the outlook. I think with regard to project-based workloads, listen, there are lots of different customers with different projects. I think in this case, we saw a few large projects come off our environment. We're being cautious about how many of those come back in terms of our outlook. It will take time for them to come back as new projects and new chip designs.

George Kurian
George Kurian
CEO at NetApp

We are the only option in the public cloud for semiconductor chip design technologies to be, you know, verified as a cloud service. We expect over time, more and more customers will use our cloud services, but that will take time. I think in our CloudOps portfolio, as I said, we are, you know, pleased with the work that we've done so far. There's still more work to be done, and so we're being appropriately cautious about how fast that product portfolio, especially Cloud Insights, grows in the second half of this year.

Mehdi Hosseini
Senior Equity Research Analyst at SIG

Thank you.

Operator

Our next question will come from David Vogt with UBS. Please go ahead.

David Vogt
David Vogt
Managing Director and Senior Equity Analyst at UBS

Great. Thanks, guys, for taking my question. Hi, George. Hi, Mike. Maybe just a big picture question on macro and linearity and how you thought about the quarter as it progressed. You know, 'cause, you know, obviously you did a good job of cutting costs, managing the business to the economic backdrop. All-flash arrays were relatively weaker in the quarter, suggesting that, you know, obviously you probably knew early in the quarter that customers were looking for more maybe cost-conscious or cost-effective solutions. You mentioned a lot of decisions were kicked up to the CTO level or the CFO level. Can you kinda discuss what you saw as the quarter progressed from a demand perspective?

David Vogt
David Vogt
Managing Director and Senior Equity Analyst at UBS

Was there a, you know, a pivot point, or was it just sort of a gradual bleed as we walk through each of the months? How did it relate to, let's say, 90 days ago when we had this conversation? Thanks.

George Kurian
George Kurian
CEO at NetApp

I think it got progressively worse through the quarter. I think you see us being appropriately cautious in our guide as a result as well. I think that the, you know, the rate increases getting compounded at a very fast clip certainly impacted customers' business confidence, and that got, you know, the range of customers that were affected with their business confidence grew through the quarter and the depth of the impact on spending grew. I don't think we saw any particularly meaningful shifts between product mix in the quarter. You know, hybrid-flash has performed well for a few quarters now, and all-flash has been, you know, as a percentage of our total mix, has been more steady than as a growing percentage of our mix. I think...

George Kurian
George Kurian
CEO at NetApp

You know, I don't think that our view of the product portfolio affected as much as the view of the total business, opportunity available in customers. I'll let Mike add any color.

Mike Berry
Mike Berry
CFO at NetApp

Yeah. Thanks, George. David, per George's comments, when we saw linearity in the quarter, month one was relatively consistent with what we've seen in I'll call it non-Q4 quarters. What we really saw was month two push into month three, and typically we will see, call it mid 40% of transactions and invoices in month three. That pushed to almost 60% this quarter. What you saw was in the second month of the quarter, it really started to push into the third month, and that's when we saw that really backend linearity that I spoke about in my prepared remarks.

David Vogt
David Vogt
Managing Director and Senior Equity Analyst at UBS

Got it. Maybe just a quick follow-up for you, Mike, you know, just maybe on the currency headwinds, that incremental one or two. I know your business is primarily denominated in dollars, but can you kinda help us understand that transition from -3 to -4 to -5? You know, the U.S. dollar has weakened a bit as of late. Just kinda wanna get a better understanding kind of what's under the surface there and what's kind of driving that incremental headwind from an FX perspective. Thanks.

Mike Berry
Mike Berry
CFO at NetApp

Yeah, sure, David. Happy to. The significant foreign currencies we have, like most international companies, it's Euro, GBP, Yen and Aussie dollar. What we saw again, across most of those is August and September was when the dollar was the strongest. That's when the most significant impact hit. That stayed largely through October. What we saw after our quarter ended is, hey, it got a little bit better in November. The dollar weakened a little bit.

David Vogt
David Vogt
Managing Director and Senior Equity Analyst at UBS

Right.

Mike Berry
Mike Berry
CFO at NetApp

Yeah, we'll see if that holds. Everything we've put in front of you, we have used FX rates as of the end of October.

David Vogt
David Vogt
Managing Director and Senior Equity Analyst at UBS

Got it. Okay.

Mike Berry
Mike Berry
CFO at NetApp

Yeah, if it stays a little bit better, that would be good. Making our living betting on FX rates, we're not gonna try that. We use the October rates for the rest of the year.

David Vogt
David Vogt
Managing Director and Senior Equity Analyst at UBS

Yeah, that's helpful. End of the month is great. Perfect. Thanks, Mike. Thanks, George.

Mike Berry
Mike Berry
CFO at NetApp

Thank you, David.

Operator

Our next question will come from Samik Chatterjee with JP Morgan. Please go ahead.

Angela Jin
Summer Trading Analyst at JPMorgan Securities LLC

Hi, this is Angela Jin on for Samik Chatterjee. My first question, I think in your prepared remarks, you mentioned that customer weakness was concentrated in America's high-tech and service provider sectors. Could we just dive more into the dynamics of each of your customer verticals and segments? You know, were there certain ones that held up better, you know, enterprise versus SMB, for example, and you know, what types of specific behaviors or patterns did you see in each vertical?

George Kurian
George Kurian
CEO at NetApp

We don't have any specific vertical that is a material contribution to our revenue. Let me start there. I think what we saw through the quarter was public sector did well, both in the Americas and internationally. I thought that our European team performed exceptionally well to deliver a strong result in the face of increasing headwinds. In our outlook for the international markets, we are appropriately cautious about Germany, where our team did phenomenally well in Q2, but there's just growing pressure economically. I think with regard to the North American market, the midsize enterprise segment team did a good job. We saw good results there. We're cautious about the potential in that segment, given their historic vulnerability to, you know, recession and macro exposure, but our team did well in Q2.

George Kurian
George Kurian
CEO at NetApp

I think the larger enterprise in those specific verticals were the ones where we saw the most, you know, substantive change in spending, and we expect them to be cautious go forward. Last year, on a year-on-year compare, last year, you know, the high-tech and service provider and the large enterprise segment did well for us. This is a year-on-year compare as well that we are, you know, working through.

Angela Jin
Summer Trading Analyst at JPMorgan Securities LLC

Got it. For my follow-up, you know, with the cloud ARR target lower to $700 million, you know, looking ahead to the out years, I'm not asking for you to project how deep or long a potential downturn could be, but, you know, how are you thinking about risk to that $2 billion cloud ARR target by fiscal year 2026? What gives you confidence that you can accelerate ARR in those out years?

Mike Berry
Mike Berry
CFO at NetApp

Hey, Angela, it's Mike. Hey, as we both talked about, look, we still feel really good about the cloud business, both cloud storage and cloud ops. We have some things to work through this year. Even though Q2 was not what we would like, we still feel really good about the future. We will update our views of fiscal 2024 and the $2 billion when we give you guidance for next year. We'll ask you to wait until we update our fiscal 2024 numbers in a couple quarters.

George Kurian
George Kurian
CEO at NetApp

I think where we are focused on at the moment with our cloud business is to make sure that we are a good partner to our customers so that we can optimize their spend where they need help doing that. We are going to be continuing to accelerate our focus on selling more of our cloud products to our install base, where today it's about 15% of our hybrid cloud customers have our cloud products. And we have grown the number of cloud customers and the number of them that have buying more than one cloud service. There's lots of opportunity ahead. We're focused on blocking and tackling and executing on the opportunities in front of us.

Angela Jin
Summer Trading Analyst at JPMorgan Securities LLC

Thank you.

Operator

Our next question will come from Krish Sankar with Cowen and Company. Please go ahead.

Krish Sankar
Krish Sankar
Managing Director at Cowen and Company

Yeah. Hi, thanks for taking my question. I have two of them. I'll ask both of them up front, either George or Mike. Thanks for the color on the cloud, customer scenario. I'm kind of curious, like one of your competitors 2 weeks ago mentioned, the storage demand was still pretty strong from cloud customers. I'm kind of curious, is the weakness you're seeing NetApp customer specific, or is there any kind of shared loss due to competitive threats? That's the first question. The follow-up is on the cloud ARR from $800 million-$700 million, yet you spoke about a high retention rate. Is the challenge now finding new customers with ANS due to the ramp of AWS FSx? Any color there would be helpful on the ARR cut. Thank you.

George Kurian
George Kurian
CEO at NetApp

I think with regard to what we saw in the quarter was really, you know, we have unique cloud services which are native first party cloud services. Those are consumption offerings that we give customers. They were the ones most impacted. None of our competitors have native first party consumption cloud services. They offer it through the marketplace. The marketplace business for us stayed relatively consistent. That is what you would expect. The subscription, you know, business is less susceptible to near-term changes in usage than the consumption business. The benefits of consumption being you can turn it on and off also shows up when customers want to optimize spend. We want to be a good partner to the customers that want to do that.

George Kurian
George Kurian
CEO at NetApp

We are working with our hyperscaler partners to give them access to more options to be more cost effective with their spend. Spot, which is the compute optimization platform, actually did well in the quarter. While the storage consumption was impacted by spend, as I noted in my remarks, Spot, which is a vehicle to optimize computing spend, did very well in the quarter, we continued to help our customers through that journey. With regard to, you know, growth opportunities, listen, as I said, we felt very good about the number of customer adds. We felt very good about the amount of cross-selling we are starting to see. Dollar-based net retention rate has been strong. You know, several good things in our cloud business.

Krish Sankar
Krish Sankar
Managing Director at Cowen and Company

On the ARR side?

Mike Berry
Mike Berry
CFO at NetApp

On the ARR point, there's been a couple questions about the $800 million down to the $700 million. When we looked at that, originally when we had given the $800 million, we expected to be, call it somewhere around $650 million as of the end of Q2. Taking a look at the second half now, we expect to grow about $100 million. That's all organic because we don't have any acquisitions baked in. We expect that to continue to grow across cloud storage, specifically ANF, FSx and GCP. We all expect to see some good growth. We have tried to be conservative or cautious, I will say, around the consumption business because we do expect that to come back in the second half. We're just not really sure if it's gonna be Q3 or Q4. We feel really good about the $700 million.

Mike Berry
Mike Berry
CFO at NetApp

Still a significant growth in that business, but stepping it down a little bit based on the Q2 results and also taking a step back a little bit on Cloud Insight. I'll call it, Krish, the product view of the rest of the year.

Krish Sankar
Krish Sankar
Managing Director at Cowen and Company

Got it. Thanks a lot, George. Thanks a lot, Mike.

Mike Berry
Mike Berry
CFO at NetApp

Thank you.

Operator

Our next question will come from Sidney Ho with Deutsche Bank. Please go ahead.

Sidney Ho
Sidney Ho
Equity Research Analyst at Deutsche Bank

Thanks for taking my question. Maybe a couple more on the public cloud side. On the reported quarter, your public cloud revenue on an annualized basis was lower than your ARR exiting last quarter. Is it fair to say that there were some cancellations and maybe some restructuring of some of the deals based on the three dynamics that you guys talked about earlier? If so, how do you feel comfortable about the future ARR will not be reduced from the current level? Maybe I'll just throw in the next question here. If you look at your revised ARR for the $700 million, if I e-exclude the inorganic growth and then make some certain assumptions about dollar-based net retention, you still need quite a bit of ARR coming from new customers.

Sidney Ho
Sidney Ho
Equity Research Analyst at Deutsche Bank

In terms of new customers, which offerings are you seeing the most traction at this point? Thank you.

Mike Berry
Mike Berry
CFO at NetApp

Hey, Sidney, it's Mike Gott. Let me do the first one. Great question. We finished Q1 at $584 million in ARR. If you simply take, divide that by four, you get about $146 million that you'd expect to recognize in revenue. The revenue recognized in the quarter was $142. The nuance here is that typically you can do that calculation. It's gonna flow very nicely. Because of the things that we talked about in terms of some of the consumption being reduced during the quarter, some of the project-based initiatives, especially the larger chip design ones, those happened during the quarter, thus we did lose some revenue that was in the ARR as of the beginning of the quarter. That's the nuance.

Mike Berry
Mike Berry
CFO at NetApp

We don't expect to see that happen in the future. It's a great question, but it was largely due to that. The third part is the back end of linearity on some of the subscription business that follows the NetApp, I'll call it core business as well. It's really those three things attributed to that revenue coming in lower than simply taking the ARR divided by four.

Sidney Ho
Sidney Ho
Equity Research Analyst at Deutsche Bank

Great. In terms of the new customers, ARR from new customers?

George Kurian
George Kurian
CEO at NetApp

Listen, we had a good quarter in terms of new customer additions. We have two major vehicles for new customers additions. The first being the native cloud services that we help our cloud provider partners, Amazon, Microsoft, and Google sell for us. Those continue to be good vehicles for new customer additions. Spot has continued to be a strong vehicle for new customer additions. I feel good about the pace of net new customers.

Sidney Ho
Sidney Ho
Equity Research Analyst at Deutsche Bank

Great. Thank you very much.

Operator

Our next question will come from Simon Leopold with Raymond James. Please go ahead.

Victor Xu
Victor Xu
Analyst at Raymond James

Hi, guys. This is Victor Xu in for Simon Leopold. You noted several customers that concluded several large projects and then drove capacity reductions. Can you help clarify, you know, what changed, you know, versus your expectations exactly? The way that you kind of described it, that the conclusions were kind of natural and then, you know, so we assumed it would have been somewhat expected. Did they conclude earlier? I think you mentioned there were some chip design kind of timing related issues. Can you just help us clarify, you know, why this dynamic was, you know, not expected?

George Kurian
George Kurian
CEO at NetApp

Listen, I think we have seen in the past projects get concluded in a quarter and other projects get started up within the same quarter or by other customers within the quarter. This time we saw some particularly large projects that concluded in the quarter, where the start of the next project is beyond the finish of the quarter and further out than we would like. I think that was the nature of what happened in the quarter. I think we would honestly want to get better visibility. We're working on that. you know, I think this is when we have another partner selling the service to the end customer, our sales teams are working to get better visibility into the end part, you know, the end customers', you know, kind of priorities and spending timelines. That's on us.

George Kurian
George Kurian
CEO at NetApp

We can do better on that, and I acknowledge that.

Victor Xu
Victor Xu
Analyst at Raymond James

Okay. Just quickly, regarding your commentary on macro hedges, are you observing explicit behavioral trends? Are you having explicit discussions with customers that makes you confident that the slowing is specific to the macro environment versus a more secular shift like accelerating, you know, workload migrations to the public cloud?

George Kurian
George Kurian
CEO at NetApp

I think we are closely engaged with a large number of the enterprise customers through our direct sales force. In the mid-size enterprise market, as you know, we go to market with the channel providers. In terms of the customer behavior we saw in the quarter, it is very reflective of a typical macro cycle. You know, more approvals for deals, smaller deal sizes, projects being broken up into phases rather than one large purchase, and some deals moving out of the quarter. That did not mean that other customers did not start projects with us and move them forward. We know that those projects are, you know, that we did not lose share to somebody else because we are in ongoing dialogue around the other phases of the projects that are yet to come online.

Victor Xu
Victor Xu
Analyst at Raymond James

Got it. That's helpful. Thank you.

Operator

Our next question will come from Meta Marshall with Morgan Stanley. Please go ahead.

Meta Marshall
Meta Marshall
Cybersecurity, Network, and Equipment Analyst at Morgan Stanley

Great, thanks. I just wanted to get a sense of whether we could get just what the size of high-tech and service provider is as a percentage of the cloud revenue or just kinda any vertical concentration that we should be mindful of. Then maybe last quarter you had given kind of the storage services as a percentage of cloud ARR. If we could just have an update there, that would be helpful as well. Thanks.

George Kurian
George Kurian
CEO at NetApp

Yeah, you know, listen, Meta, we're not going to break out specific verticals. I would just say that we saw a broad-based. High tech is quite a broad segment, and we saw a fairly conservative posture across that segment. Service provider is also broadly defined. It could be telco, it could be hosting provider, it could be, you know, some form of cloud provider. So these are broader categories than a very specific definition. We saw fairly conservative postures across most of those customers.

Mike Berry
Mike Berry
CFO at NetApp

Amit, it's Mike. On your second question, two data points for you. Cloud storage continues to be almost exactly 60% of the total, that includes, as of the end of Q2, Instaclustr and CloudCheckr, which are in CloudOps. There you see the great growth we've seen in Cloud storage 'cause overall, as a total number, it stayed right around 60%. The other important number is we've talked about consumption versus subscription. As of the end of Q2, it's pretty close to 50/50, a little bit, a couple percentage points higher for consumption. We do expect by the end of the year with that $700 million for that to get much closer to 60% because that's where we expect the growth across ANF, GCP, and FSx, those products as well.

Mike Berry
Mike Berry
CFO at NetApp

Those are the two data points we gave you that break down that cloud ARR number.

Meta Marshall
Meta Marshall
Cybersecurity, Network, and Equipment Analyst at Morgan Stanley

Great. Thanks so much.

Mike Berry
Mike Berry
CFO at NetApp

Thank you.

Operator

Our next question will come from Ananda Baruah with Loop Capital. Please go ahead.

Ananda Baruah
Ananda Baruah
Senior Equity Analyst at Loop Capital Markets

Hey, thanks guys for taking the questions. Actually, two clarifications if I could. Mike, just the remark you made a couple times in the prepared comments about this is really the clarification. FX driving, you know, sort of some portion of the guide down or whatever that context was. Could you clarify that, could you clarify that? Then I have a quick follow-up clarification as well.

Mike Berry
Mike Berry
CFO at NetApp

Sure, Ananda, happy to. That was in reference to on the Q1 call we had given, this is directly related to EPS. We had given $5.50 as the midpoint. Since that time, because of the continued strengthening of the dollar and the weakening of the FX situation, the $5.40 is actually above what that number would have been on an FX adjusted basis. That's about $5.37. The point there being, hey, we're seeing even in the second half with the lower outlook around revenue, we're doing all we can around costs and other efficiencies to ensure that we continue to still drive that EPS number consistent with the number we gave you last time on the call.

Ananda Baruah
Ananda Baruah
Senior Equity Analyst at Loop Capital Markets

I got it. That's super helpful. The second clarification is to one of the questions you mentioned, you gave some context around timing of pickup and it was something along the. Well, it was sort of that was sort of the gist of it. I think, Mike, the comments you made were you expect demand to come back in the second half, though you weren't sure if it was Q3 or Q4. Could you clarify that? Is it fiscal Q3, Q4, or is it calendar 2023 Q3, Q4, in addition to the clarification? Thanks.

Mike Berry
Mike Berry
CFO at NetApp

Sure. I've been trained, Ananda, I only talk about fiscal years, not calendar years. This was second half fiscal, and that was directly related to the cloud ARR growth. We finished at $603. We've guided end of year to $700 million. We are not gonna guide Q3. We feel good about the second half because, again, these are some of those, these large project-based as well as consumption. When does that flow in? Is it in our fiscal Q3 or Q4? We feel confident about the second half. There's a little bit of nuance around whether it's Q3 or Q4, hence we're only doing the end of the year.

Ananda Baruah
Ananda Baruah
Senior Equity Analyst at Loop Capital Markets

That's super helpful. Is that to say, Mike, that, you know, anecdotally, you guys are experiencing, and George, feel free to jump in on this too. Anecdotally, you're experiencing a little bit of a, of a sideways here, call it a pause. You anticipate that it's gonna last, you know, I guess, like, kind of max 6 months, 8 months. Let's say it starts slowing mid-quarter, could last an additional 6 months. You do expect, you know, sort of a then pick-up in some context after that. Anecdotally, is that sort of the gist of what you guys are communicating?

Mike Berry
Mike Berry
CFO at NetApp

Well, keep in mind, Ananda, all this is related to the cloud ARR. This is not talking about.

Ananda Baruah
Ananda Baruah
Senior Equity Analyst at Loop Capital Markets

Understood.

Mike Berry
Mike Berry
CFO at NetApp

Yep, the hybrid cloud business. This is more of just us talking about when we expect it to come back in the second half. Again.

Ananda Baruah
Ananda Baruah
Senior Equity Analyst at Loop Capital Markets

Yep.

Mike Berry
Mike Berry
CFO at NetApp

Because of the large project base. That's really the nuance on this more than anything versus us calling, "Hey, we expect to see things pick up after April.

Ananda Baruah
Ananda Baruah
Senior Equity Analyst at Loop Capital Markets

Got it. Got it, got it, got it. Okay, cool. Thanks, guys. Appreciate it.

Mike Berry
Mike Berry
CFO at NetApp

Thank you.

Operator

Our next question will come from Jim Suva with Citigroup. Please go ahead.

Jim Suva
Jim Suva
Managing Director at Citigroup

Thank you. Good afternoon. George, on your outlook, and Mike, on your outlook, you mentioned about slowing economic comments, which is understood. Any thoughts around inventory digestion? Is your sense that there's inventory digestion out there? If so, how long or any double ordering? Is it just purely kind of economic pausing and elongation of cycles?

George Kurian
George Kurian
CEO at NetApp

We did not see any order cancellations or any of those things. As we have mentioned repeatedly, we have good line of sight into our customers' spending priorities and behaviors, and are directly engaged with the largest of them. I think as we saw in this quarter, and we continue to be cautious about looking at the second half of the year, these are clearly related to IT budget revisions, right? Where they are reducing deal sizes or scrutinizing projects and saying, "We'll defer a portion of that project to a subsequent quarter or a subsequent part of the calendar year." We have good visibility into the activities in our customers, and we did not see cancellations of, you know, orders because of, you know, prior orders or double ordering.

Jim Suva
Jim Suva
Managing Director at Citigroup

Great. Thanks. On the inventory digestion, any thoughts of were there any inventory that's still being digested that may allow corporates or service providers to prolong these revisions? Is any concern about inventory out there?

George Kurian
George Kurian
CEO at NetApp

Typically, during macro situations like these, we have seen customers sweat their assets, right? What we mean by that is they will drive a system to a higher level of utilization so that they can defer either capacity augmentation or system upgrades for a period of time. That's not forever, right? Storage is consumed because data keeps growing. There's always that trade-off. We certainly see some of that behavior going on, Jim. I think certainly in our service provider segment, we see that. In some of the high-tech verticals, we saw that as well.

Jim Suva
Jim Suva
Managing Director at Citigroup

Great. Thank you so much for the details and clarifications.

George Kurian
George Kurian
CEO at NetApp

Yep. Thank you.

Operator

Our next question will come from Tim Long with Barclays. Please go ahead.

George Wang
George Wang
VP and Senior Analyst at Barclays

Hey, guys, it's actually George Wang on for Tim Long. I have two questions. Firstly, George, maybe you can elaborate on the current state of a de-deal integration in terms of Spot, Instaclustr, and any thought process behind the pulling deal until FY 2024.

George Kurian
George Kurian
CEO at NetApp

Listen, we have a good portfolio of technologies already, and what we are really focused on is sharpening the use cases that are best suited to the current macro environment and making those use cases easy for the customers to adopt, expand, and renew, right? That operational focus is our highest priority. There's work to be done to integrate the CloudCheckr capabilities into the Spot suite so that it becomes one broader offering rather than two parallel offerings. We have made good progress along the way. There's more work to be done. In Instaclustr, there are two unique value adds that we bring. One is the integration of our cloud storage services and Spot services into Instaclustr, and the second is the fact that it is a truly, you know, open source data services platform.

George Kurian
George Kurian
CEO at NetApp

We have the first of those two being worked. We feel like there's a lot of value we already have in our portfolio. There's work to be completed, and we wanna keep our teams focused on that work on the technology side. On the go-to-market side, we also have more broad enablement and training for our sales teams to be able to position Spot and Instaclustr and CloudCheckr into the account. We feel good about the work we're doing. We gotta finish it before we look at other things.

George Wang
George Wang
VP and Senior Analyst at Barclays

Okay, cool. Yeah. Quick follow-up is on the cost cuts. Maybe you can elaborate on the kind of, you know, disaggregate just components for the cost cuts, whether that's, you know, sales and marketing, you know, the SG&A or kind of more some of the R&D. Any color would be appreciated.

Mike Berry
Mike Berry
CFO at NetApp

Hey, George, it's Mike, just I wanna make sure your question was, what are we looking at for cost reductions in the second half? Was that the question?

George Wang
George Wang
VP and Senior Analyst at Barclays

Yes.

Mike Berry
Mike Berry
CFO at NetApp

Yep, perfect. Thank you. A, there's several that I think you're gonna see flow through the P&L. I'm gonna start all the way at the top, which is we do expect to finally see some relief from our significant expenditures related to premiums. The supply chain is getting a little bit better. It gets better every day, that's gonna help the second half. In addition, NAND pricing will help us as well. We do have a little bit of inventory to work through, and you'll see that still in Q3, we expect by Q4 you'll see that as well. On the OpEx side, look, George talked about it. We've already done a headcount freeze. We're taking a look at all discretionary spending, including travel, programs, outside services.

Mike Berry
Mike Berry
CFO at NetApp

Just like everybody else who has embraced the hybrid work environment, we'll take a hard look at our facilities costs as well. you know, we've already started down the path on several of those, as I talked about. we'll continue to look at those as we go into the second half. there's numerous areas for us to focus on. In addition, keep in mind too that in OpEx there's a good bit of that cost structure related to incentive comp and commissions, and certainly those will come down in the second half as well.

George Wang
George Wang
VP and Senior Analyst at Barclays

Okay, great. Thank you.

Operator

Our next question will come from Nehal Chokshi with Northland Capital Markets. Please go ahead.

Nehal Chokshi
Nehal Chokshi
Managing Director at Northland Capital Markets

Yeah, thanks. The total revenue guidance lowered by 400 basis points is characterized as 100 basis points due to incremental FX, another 100 basis points due to lower PCS AR target. The remaining 200 basis points either due to weaker billings results on a constant currency basis during the quarter, or is it a weaker billings result that has started to transpire during the third quarter, again, on a constant currency basis?

Mike Berry
Mike Berry
CFO at NetApp

For the second half, Nihal, that is mostly related to product revenue, which would be largely booked in recognized in the quarter. There's backlog is largely at the normal rates, the seasonal normal rates that we would expect, so that is gonna be systems in the second half, I think is the third part of your question.

Nehal Chokshi
Nehal Chokshi
Managing Director at Northland Capital Markets

Excellent. Okay. Then dollar-based net revenue retention rate declined quite significantly, 192% to 140%. Is this largely because of the project related stuff?

George Kurian
George Kurian
CEO at NetApp

Dollar-based net revenue retention was 150 last quarter, and it's now 140. It stepped down as the base of customers expand, and we did see some churn in our consumption business, as we noted on our call, so we don't see that as materially different than what we would expect.

Mike Berry
Mike Berry
CFO at NetApp

To George's point, Nihal, we've been calling that for several quarters, which is as that AR number gets bigger, that dollar-based net retention percentage will come down. You know, we like to call it the 120%, 130% where we think it'll land, but we have been calling that percentage to continue to decline as that number increases.

Nehal Chokshi
Nehal Chokshi
Managing Director at Northland Capital Markets

That you have. Okay. Just finally, Mike, the PCS GM did come down both quarter-over-quarter and year-over-year. Why is that?

George Kurian
George Kurian
CEO at NetApp

The PCS gross margin-

Nehal Chokshi
Nehal Chokshi
Managing Director at Northland Capital Markets

Oh.

George Kurian
George Kurian
CEO at NetApp

...came down because of the revenue scale relative to the infrastructure that we have deployed. Note that the consumption business, some elements of those are based on our deployed systems, right, in the cloud provider environments. When they have less scale, you see less utilization, you see, you know, less gross margin.

Mike Berry
Mike Berry
CFO at NetApp

Yep. It came down from 69.7 to 68.3, down slightly. To George's point, that's largely due to scale. You know, we continue to feel good, as I mentioned in my notes, about the 75%-80% as we drive that scale.

Nehal Chokshi
Nehal Chokshi
Managing Director at Northland Capital Markets

Thank you.

Operator

Our next question will come from Wamsi Mohan with Bank of America. Please go ahead.

Wamsi Mohan
Wamsi Mohan
Senior Equity Research Analyst at Bank of America

Yes. Thank you. I appreciate the fiscal year guide, George, you were talking earlier about IT budgets and some caution around that. I was wondering if you could share some color on what you're hearing from customers more around calendar 2023 IT budgets. What's your view on how you expect the storage market to grow in 2023 and your growth relative to that? I will follow up.

George Kurian
George Kurian
CEO at NetApp

I think with regard to 2023, we're being cautious. We aren't guiding next fiscal year, but we're being cautious about the start to calendar year 2023. We have seen typically in these macro situations that new budget outlays to start a calendar year probably take longer than typical, so we're being cautious about the start to the new calendar year. With regard to the storage market overall, I think it's gonna be, you know, it's gonna be paced by new workload deployments. I think there will be customers that will be forced to upgrade systems because their existing systems are coming to either end of useful life or end of, you know, they're just out of capacity or performance. I think the majority will prioritize new workload deployments and/or system consolidation for cost and energy benefit use cases.

George Kurian
George Kurian
CEO at NetApp

We continue to see while the cloud migrations are slowing down a bit, we continue to see that as a long-term trend that customers are gonna take on for a whole bunch of reasons. So I think cloud will, you know, outpace on-prem in the broader market. In the on-prem world, we see NAND helping flash be a bigger part of the mix going forward. Our capacity flash products had a good, you know, good quarter. Our hybrid flash products had a good quarter. They are typical about, you know, where customers are cost conscious.

Wamsi Mohan
Wamsi Mohan
Senior Equity Research Analyst at Bank of America

Okay. That's helpful, George. Just to follow up on your last comment about the NAND market. Every few years you see the significant dislocation in pricing, this one's quite severe. You guys noted the benefit that you will recognize in gross margin terms. Can you just remind us on how you're thinking about the impact to revenues based on the NAND price decline? Are you expecting a deceleration in AFA revenues, or are you expecting elasticity or demand to offset that? Thank you.

George Kurian
George Kurian
CEO at NetApp

Customers budget in dollars. The current macro environment has them spending less dollars, but they'll probably shift the mix to AFAs if there's more value in the, you know, the offering, right? We see them budget in dollars, Wamsi.

Wamsi Mohan
Wamsi Mohan
Senior Equity Research Analyst at Bank of America

Okay. In aggregate terms, would you say that the customer budgets would be up or down, like in full in aggregate, whether it's cloud or on-prem all put together?

George Kurian
George Kurian
CEO at NetApp

I think overall, year-over-year, I think 2023 we expect to be moderated and down relative to 2022, certainly at the start of the year. 2022 had a good start to the year, our start of the new calendar year, which is baked into our outlook for the second half of our fiscal year, we think people are going to be more cautious overall, Wamsi.

Wamsi Mohan
Wamsi Mohan
Senior Equity Research Analyst at Bank of America

Okay. Thank you so much, George.

George Kurian
George Kurian
CEO at NetApp

Yep, thank you.

Operator

Our next question will come from Shannon Cross with Credit Suisse. Please go ahead.

Shannon Cross
Shannon Cross
Managing Director at Credit Suisse

Thank you very much for taking my question. I was just wondering what you're hearing from customers on your NetApp Keystone offering. You know, I think as-a-service offerings are becoming a bit more attractive in a, you know, economic downturn, I'm wondering what kind of traction you're seeing there.

George Kurian
George Kurian
CEO at NetApp

It's early, but good traction. We are focused with a few channel partners who are enabled on selling Keystone. We've had good customer wins, good momentum in terms of our offerings. We have brought new innovation to market in the last quarter, both a unified control plane so that you can use either a Keystone-based, you know, consumption offering in your environment or our public cloud offerings, and you can move workloads and licenses across those. A good amount of innovation. You're correct, we'll continue to see opportunities to help customers around whatever their, you know, kind of buying model is in this environment.

Shannon Cross
Shannon Cross
Managing Director at Credit Suisse

Great, thanks. Mike, look forward to seeing you on Thursday at our conference.

Mike Berry
Mike Berry
CFO at NetApp

I as well look forward to seeing you Thursday.

Operator

Our final question will come from Kyle McNealy with Jefferies. Please go ahead.

Kyle McNealy
Kyle McNealy
SVP of TMT Equity Research at Jefferies

Hey, good afternoon. Thanks very much for the question. You touched on this a bit earlier, but not directly. But does the budget scrutiny that you're seeing right now from some subset of customers impact their decisions for provisioning, you know, the mix that they're provisioning of all-flash versus hybrid arrays, at least for new projects? I know you mentioned that your all-flash portfolio has leading cost efficiency, but do you expect the mindset to change on how much customers are willing to embrace more all-flash? Will the pockets of slowdown that you're seeing potentially pull everything back and the mix stays relatively on the same trajectory? Thanks.

George Kurian
George Kurian
CEO at NetApp

I think, thank you for the question. We didn't see customers sort of reevaluating technical decisions about what type of infrastructure to buy. I think they allowed the technical team to choose what was the most value, they make decisions based on the relative cost effectiveness of, you know, disk versus flash, right? I think what we saw was a approval level going up for the same deals. What would have been approved by a director now got taken up to a VP. What was approved by a VP probably goes up to a CTO. That is what, you know, elongated deal cycles in the quarter and/or people shrinking how much they wanted to buy at one time and phasing projects into multiple phases.

Kyle McNealy
Kyle McNealy
SVP of TMT Equity Research at Jefferies

Okay. Thanks very much. That's helpful.

Kris Newton
Kris Newton
Vice President of Investor Relations at NetApp

All right.

George Kurian
George Kurian
CEO at NetApp

Thank you.

Kris Newton
Kris Newton
Vice President of Investor Relations at NetApp

Thanks, Kyle. I'm gonna give it back to George for a couple closing thoughts.

George Kurian
George Kurian
CEO at NetApp

While there are near-term economic challenges for every company, we know that our opportunity ahead is substantial, durable, and growing. The fundamentals of our business are strong, and the value we bring customers is undeniable. Our strategic growth opportunities, all-flash arrays, cloud storage, and cloud infrastructure optimization are tightly aligned to customers' top priority and represent the potential for long-term, sustained, and profitable growth. We will continue to be disciplined stewards of the business, focusing on our strategic growth opportunities while continually optimizing our operating costs to drive shareholder value. Thank you.

Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.

Executives
    • George Kurian
      George Kurian
      CEO
    • Kris Newton
      Kris Newton
      Vice President of Investor Relations
    • Mike Berry
      Mike Berry
      CFO
Analysts
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