NetApp, Inc.

Good day and 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 Chris Newton, Vice President of Investor Relations. Please go ahead.

Hi, everyone. Thanks for joining us. With me today are 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. 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. 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.

Thanks, Chris, and welcome, everyone, to our Q2 FY23 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. 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. Due to 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. Additionally, 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've 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 Insight customers in Q2. We continue to see healthy growth of new to NetApp customers and of existing NetApp Enterprise customers adopting our cloud services. And 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%, and 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 install base grew to 33% of installed systems. Our lower-cost, capacity-oriented all-flash arrays and PaaS hybrid flash arrays both performed well. On 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 multi-cloud 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. 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. 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, and 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. Now the third point, the macro environment and our business outlook. As we move 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 America's 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. And 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. 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.

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. 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 one to two points from the deepening currency costs we have seen since our Q1 call. And 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 23. We now plan to return more than 100% of fiscal 23 free cash flow to investors through dividends and incremental share repurchases. Now to the details. As a reminder, I'll be referring to non-GAAP numbers unless otherwise noted. 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 three and a half of the six 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. 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. Total hybrid cloud gross margin was 66% in Q2, including a two-point year-over-year headwind from FX. Within our hybrid cloud segment, product gross margin was 50%, including a three-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 eighth consecutive quarter. We remain confident in our long-term public cloud gross margin goal of 75% to 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 two points of FX headwinds. EPS of $1.48 came in nicely ahead of guidance and included a 21-cent year-over-year FX headwind. 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 23. 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 23 revenue to grow 2% to 4% year-over-year, which includes five points of FX headwinds versus the four-point headwind assumed in our prior guidance. We now expect to exit fiscal 23 with public cloud ARR of approximately $700 million, which equates to our public cloud segment driving three 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. And 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 24. In fiscal 23, we continue to expect gross margin to range between 66 and 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 two points of FX headwind and EPS of $5.30 to $5.50, which now includes more than 70 cents of currency impact. 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 one to two 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 23 as we sharpen our portfolio focus by refining the cloud insight value proposition and sales motion Accelerating the integration of Spot and CloudChecker into a single FinOps suite and driving the successful integration of InstaCluster. As I have said earlier, we now plan to return more than $100 of fiscal 23 free cash flow to investors through dividends and incremental share repurchases. Now 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. 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 Chris to open the call for Q&A. Chris?

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

We will now begin the question and answer session. To ask a question, you may press star then 1 on your touchtone 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.

And our first question will come from Amit Daryani with Evercore.

Please go ahead. Pardon me, Amit, your line might be muted. Can you hear me? Yeah, we can hear you now.

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

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, but we are being cautious about that. And then 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 NetApp, new to Cloud Insights customer wins, but we're being cautious about the, you know, future growth rate of that product until we see further evidence of success. So, 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, and so they saw the biggest impact this quarter.

All right. Thank you. Next question, please.

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

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 QAQ and a year-over-year decline in January quarter.

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 maybe.

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

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

Yeah, that's fine. At least I tried. Just a little 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. And I want to better understand what are your underlying assumptions. 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?

I think with our cloud outlook, we've been cautious to consider 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 that will happen for a period of time and then we will see build back 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, and 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. We are the only... option in the public cloud for semiconductor chip design technologies to be you know verified as a cloud service so we expect over time more and more customers will use our cloud services but that will take time And then 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.

Thank you.

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

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. Because obviously you did a good job of cutting costs, managing the business to the economic backdrop, but all flash arrays were relatively weaker in the quarter, suggesting that obviously you probably knew early in the quarter that customers were looking for more maybe cost-conscious or cost-effective solutions. And you mentioned a lot of decisions were kicked up to the CTO level or the CFO level. Can you kind of discuss what you saw as the quarter progressed from a demand perspective? Was there a pivot point or was it just sort of a gradual bleed as we walk through each of the months? And how did it relate to, let's say, 90 days ago when we had this conversation? Thanks.

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 rate increases getting compounded at a very fast clip certainly impacted customers' business confidence, and that got worse. 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. So 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.

Yeah, thanks, George. So, 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. So 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 back-end linearity that I spoke about in my prepared remarks.

And maybe just a quick follow up for you, Mike, you know, just maybe on the currency headwinds, that incremental point or two. I know your business is primarily denominated in dollars, but can you kind of help us understand that transition from negative three to negative four to negative five? You know, the U.S. dollar has weakened a bit as of late. Just kind of want to 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.

Yeah, sure, David, happy to. So the significant foreign currencies we have, like most international companies, it's euro, GBP, yen, and Aussie dollar. And what we saw, again, across most of those is August and September was when the dollar was the strongest. So that's when the most significant impact hit. That stayed largely through October. Now, what we saw after our quarter ended is, hey, it got a little bit better in November. The dollar weakened a little bit. 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. So if it stays a little bit better, that would be good. But making our living betting on FX rates, we're not going to try that. So we use the October rates for the rest of the year.

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

Thank you, David.

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

Hi, this is Angela Ginn for Samik Chatterjee. And my first question, so I think in your prepared remarks, you mentioned that customer weakness was concentrated in America's high-tech and service provider sectors. Can 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 segments? for example, and what types of specific behaviors or patterns did you see in each vertical?

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. And 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 mid-sized 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 recession and macro exposure, but our team did well in Q2. 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 to go forward. Last year, on a year-on-year compare, last year public, you know, the high-tech and service provider and the large enterprise segment did well for us. So this is a year-on-year compare as well that we are, you know, working through.

Got it. And then for my follow-up, you know, with the cloud AR target lower to $700 million, you know, looking ahead to the out years, I'm not asking for you to predict how deep or long a potential downturn could be. But, you know, how are you thinking about risk to that $2 billion cloud AR target by fiscal year 26? And what gives you confidence that you can accelerate AR in those out years?

Hey, Angela, it's Mike. So 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. So even though Q2 was not what we would like, we still feel really good about the future. We will update our views of fiscal 24 in the $2 billion when we give you guidance for next year. So we'll ask you to wait until we update our fiscal 24 numbers in a couple quarters.

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 crowd 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 are buying more than one cloud service. So there's lots of opportunity ahead. We're focused on blocking and tackling and executing on the opportunities in front of us.

Thank you.

Our next question will come from Krish Sankar with Calvin & Company. Please go ahead.

Hi, thanks for taking my question. I had 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. One of your competitors two weeks ago mentioned the storage demand was still pretty strong, some cloud customers. I'm kind of curious. Is the weakness you're seeing NetApp customer-specific, or is there any kind of share loss due to competitive threat? That's the first question. And then the follow-up is on the cloud ARR from 800 to 700 million, yet you spoke about a high retention rate. So is the challenge now finding new customers with ANS? This is the ramp of AWS SSX. Any color there would be helpful on the ARR cut. Thank you.

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. And so that is what you would expect. The subscription business is less susceptible to near-term changes in usage than the consumption business. And so 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. And so we are working with our hyperscale of partners to give them access to more options to be more cost effective with their spend. spot which is the computer optimization platform actually did well in the quarter so while the storage consumption was impacted by spend as i noticed as i noted in my remarks spot which was a which is a vehicle to optimize computing spend did very well in the quarter and so we continue 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 ads. We felt very good about the amount of cross-selling we're starting to see. Dollar-based net retention rate has been strong. And so, you know, several good things in our cloud business.

And on the ARR side?

So on the ARR point, so there's been a couple questions about the 800 down to the 700. So when we looked at that, originally when we had given the 800 we expected to be call it somewhere around 650 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 and 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 going to be Q3 or Q4. So we feel really good about the 700s, 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 insights. So that's the, I'll call it, Krish, the product view of the rest of the year.

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

Our next question will come from Sydney Ho with Deutsche Bank.

Please go ahead. Thanks for taking my question. Maybe a couple more on the public cloud side. So 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? And if so, how do you feel comfortable about the future ARR will not be reduced from the current level? And maybe I'll just throw in the next question here. If you look at your revised ARR for the $700 million, if I 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. So in terms of new customers, which offerings are you seeing the most traction at this point? Thank you.

Hey, Sydney, it's Mike. So let me do the first one. So great question. So 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. And the nuance here is that Typically, you can do that calculation. It's going to 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 ALR as of the beginning of the quarter. So that's the nuance. 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-ended linearity on some of the subscription business. That follows the NetApp, I'll call it core business as well. So it's really those three things attributed to that revenue coming in lower than simply taking the ARR divided by four.

Great. And in terms of the new customers, ARR from new customers?

Listen, we had a good quarter in terms of new customer additions. We have two major vehicles for new customers addition, 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 addition, and then Spot has continued to be a strong vehicle for new customer addition. So I feel good about the pace of net new customers.

Great. Thank you very much. Our next question will come from Simon Leopold with Raymond James. Please go ahead.

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

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. So 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 customer's you know, kind of priorities and spending timelines. So that's on us. We can do better on that, and I acknowledge that.

Okay. And then just quickly, regarding your commentary on macro headings, are you observing explicit behavioral trends or, you know, 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?

I think we are closely engaged with a large number of the enterprise customers through our direct sales force. In the midsize 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.

Got it. That's helpful. Thank you.

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

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 kind of any vertical concentration that we should be mindful of. And 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.

Yeah, you know, listen, Meeta, 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. And we saw fairly conservative postures across most of those customers.

uh and hey amy that's mike on your second question so two data points for you cloud storage continues to be almost exactly 60 percent of the total uh and that includes as of the end of q2 insta cluster and cloud checker which are in cloud ops so there you see the great growth we've seen in cloud storage because overall as a total number it stayed right around 60 percent 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. So those are the two data points we gave you that break down that cloud ARR number.

Great. Thanks so much.

Thank you. Our next question will come from Ananda Barua with Loop Capital. Please go ahead.

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

Sure, Nanda, happy to. So that was in reference to on the Q1 call we had given. This is directly related to EPS. We've given 550 as the midpoint. Since that time, because of the continued strengthening of the dollar and the weakening of the FX situation, The 540 is actually above what that number would have been on an FX adjusted basis. That's about 537. 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.

I got it. That's super helpful. And then the second clarification is to one of the, to one of the questions you mentioned, you get some context around timing of a pickup and it was something along the, well, it was sort of that, that was sort of the gist of it. But I think Mike, the comments you made were you expect, expect the man to come back in the second half, though you weren't sure if it was Q3 or Q4. Could you clarify that? And is it, Is it fiscal Q3, Q4, or is it calendar 23, Q3, Q4, in addition to the clarification? Thanks.

Sure. So I've been trained, and I only talk about fiscal years, not calendar years. So this was second half fiscal, and that was directly related to the cloud ARR growth. So we finished at 603. We've guided end of year to 700 million. We are not going to guide Q3. We feel good about the second half because, again, these are some of those, these large project-based as well as consumption projects. 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 three or four. Hence, we're only doing the end of the year.

And that's super helpful. And so is that the same, Mike, that, you know, anecdotally you guys are experiencing? And, George, feel free to jump in on this too. Anecdotally, you guys are experiencing a little bit of a sideways here, call it a pause. you anticipate that it's going to last, you know, I guess like trying to max, spirit of max six months, eight months, let's say it starts slowing mid-quarter, could last an additional six months. But you do expect, you know, sort of a then pickup in some context after that. And a goal, is that sort of the gist of what you guys are communicating? Yeah.

Well, keep in mind, Ananda, all this is related to the cloud AR. This is not talking about the hybrid cloud business. This is more of just us talking about when we expect it to come back in the second half. And, again, 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.

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

Thank you. Our next question will come from Jim Suvo with Citigroup. Please go ahead.

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? And if so, how long or any double ordering? Or is it just purely kind of economic pausing and elongation of cycles?

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. So we have good visibility into the activities and our customers, and we did not see cancellations of, you know, orders because of, you know, prior orders or double ordering.

Great. Thanks. But 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 or is any concern about inventory out there typically during macro situations like these we have seen customers sweat their assets right and so what we mean by that is they will drive a system of to a higher level of utilization and so that they can defer either capacity augmentation or system upgrades for a period of time. Now, that's not forever, right? is consumed because data keeps growing. And so 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. And in some of the high-tech verticals, we saw that as well.

Great. Thank you so much for the details and clarifications. Yeah, thank you.

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

uh hey guys it's actually george wayne uh on for tim long yeah i have two questions uh firstly uh george maybe you can elaborate on the current state of the deal integration in terms of spot insta cluster and any thought process behind the polling deal until fy24 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? And that operational focus is our highest priority. there are some this work to be done to integrate the cloud checker 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, but there's more work to be done in Insta cluster. There are two unique value adds that we bring. One is the integration of our cloud storage services and spot services into Instacluster. And the second is the fact that it is a truly open source platform. data services platform we have the set the first of those two uh being worked and so we feel like there's a lot of value we already have in our portfolio there's work to be completed and we want to 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 Instacluster and CloudChecker into the account. So we feel good about the work we're doing. We got to finish it before we look at other things.

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, you know, sales and marketing, you know, the SG&A or kind of more some of the R&D. Any color would be appreciated.

Hey, George, it's Mike, and just I want to make sure your question was what are we looking at for cost reductions in the second half? Was that the question? Yes. Perfect. Thank you. So, hey, there's several that I think you're going to see flow through the P&L. I'm going to 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. So that's going to help the second half. NAND pricing will help us as well. Now, we do have a little bit of inventory to work through, and you'll see that still in Q3, but we expect by Q4 you'll see that as well. On the OpEx side, where 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. Just like everybody else who has embraced the hybrid work environment, we'll take a hard look at our facilities costs as well. So, 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. So 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.

Okay, great. Thank you. Our next question will come from Nihal Chokshi with Northland Capital Markets. Please go ahead.

Yeah, thanks. The total revenue guidance lowered by 400 basis points is characterized as 100 basis points due to incremental effects, another 100 basis points due to lower PCSAR target, and then 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?

So for the second half of the haul, that is mostly related to product revenue, which would be largely booked and recognized in the quarter. Backlog is largely at the normal rates, the seasonal normal rates that we would expect. So that is going to be systems in the second half, I think is the third part of your question.

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

Dollar-based net revenue retention was $150 last quarter, and it's now $140. So it stepped down as the base of customers expands, 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.

And to George's point, we've been calling that for several quarters, which is as that ARR 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.

That you have. Okay. And then just finally, Mike, the ACSGM did come down both QMQ and year-over-year. Why is that?

The PCS gross margin 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. And when they have less scale, you see less utilization, you see, you know, less gross margin.

Yeah, it came down from 69.7 to 68.3, so down slightly into Georgia's point. That's largely due to scale. You know, we continue to feel good, as I mentioned in my notes, about the 75 to 80% as we drive that scale. Thank you.

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

Yes, thank you. I appreciate the fiscal year guide, but, 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 23 IT budgets, and what's your view on how you expect the storage market to grow in 23 and your growth relative to that? And I will follow up.

I think with regard to 23, we're being cautious. We aren't guiding next fiscal year, but we're being cautious about the start to calendar year 23. 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 of the new calendar year. With regard to the storage market overall, I think it's going to be, you know, it's going to 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. But I think the majority will prioritize new workload deployment and or system consolidation for cost and energy benefit use cases. 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 going to take on for a whole bunch of reasons. And so I think cloud will outpace on-prem in the broader market and in the on-prem world we see NAND helping flash be a bigger part of the mix going forward our capacity flash products at a good you know good quarter our hybrid flash products at a good quarter they are typical about you know where customers are cost conscious okay that's helpful George and and just to follow up on your last comment about um

the NAND market, every few years you see the significant dislocation in pricing, and this one's quite severe. You guys noted the benefit that you will recognize in gross margin terms, but 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 of demand to offset that? Thank you.

Customers budget in dollars. The card macro environment has them spending less dollars, but they'll probably shift the mix to AFAs if there's more value in the offering, right? So we see them budget in dollars once.

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

I think overall, year on year, I think 23 we expect to be moderated and down relative to 22, certainly at the start of the year. 22 had a good start to the year. And so 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. Okay.

Thank you so much, George.

Yep. Thank you.

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

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

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've brought new innovation to market in the last quarter, both a unified control plane so that you can use either a Keystone-based consumption offering in your environment or our public cloud offerings, and you can move workloads and licenses across those. So a good amount of innovation, and 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.

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

I as well. Look forward to seeing you Thursday.

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

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 the mix that they're provisioning of all-flash versus hybrid arrays, at least for new projects? And 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.

I think – thank you for the question. We didn't see customers sort of re-evaluating technical decisions about what type of infrastructure to buy. I think they allowed the technical team to choose what was the most value, and 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 deal. 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.

Okay, thanks very much. That's helpful.

All right, thanks, Kyle. I'm going to give it back to George for a couple of closing thoughts.

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 priorities 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.

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