NetApp, Inc.

Good day and welcome to the NetApp second quarter of fiscal year 2024 earnings call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. Please note, this event is being recorded. I would now like to turn the conference over to Chris Newton, Vice President, Investor Relations. Please go ahead.

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, including without limitation, our guidance for the third quarter and fiscal year 2024, our expectations regarding future revenue, profitability, and shareholder returns, and other growth initiatives and strategies. These statements are subject to various risks and uncertainties which may cause our actual results to differ materially. For more information, please refer to the documents we file from time to time with the SEC and on our website, including our most recent Form 10-K and Form 10-Q. We disclaim any obligation to update our forward-looking statements and projections. During the call, all financial measures presented will be non-GAAP unless otherwise indicated. Reconciliations of GAAP to non-GAAP estimates are available on our website. I'll now turn the call over to George.

Thanks, Chris. Good afternoon, everyone. Thank you for joining us today. Q2 improved on our solid start to FY24 in what continues to be a challenging macroeconomic environment. We delivered revenue above the midpoint of guidance, while our operational discipline yielded company all-time highs for gross margin, operating margin, and EPS. We remained relentlessly focused on managing the elements within our control while driving better performance in our storage business and building a more focused approach to our public cloud business. We are seeing positive results from these actions with increased profitability and a stronger position for delivering long-term growth. In Q2, we held our Insight User Conference, where I witnessed the tangible excitement for the silo-free innovation our unified data storage provides. It was invigorating to be with the thousands of attendees and hear stories of the extraordinary outcomes NetApp delivers for our customers. NetApp is at the forefront of the evolution of the storage industry, helping our customers turn disruption into opportunity with intelligent data infrastructure. Today's organizations need storage infrastructure that harnesses the power of public and hybrid clouds while keeping data secure and protected from ransomware attacks. They need infrastructure that supports dynamic workloads like AI, cloud-native, and open-source applications, and they need infrastructure that helps to create more sustainable data centers. Only NetApp delivers an entire architecture of unified data storage solutions based on one operating system, ONTAP, that supports any application, any data type, and spans on-premises and multiple cloud environments. This comprehensive architecture delivers unparalleled simplicity of management, simplicity of deployment, and consistency of automation, all unified by common APIs and a single control plane. We further elevate the customer experience with our Blue XP sustainability dashboard and NetApp Advance, a common set of programs and guarantees that include storage lifecycle program, which removes the burden of upgrade cycles, as well as storage efficiency, ransomware recovery, and data availability guarantee. Intelligent data infrastructure combines unified data storage, integrated data services, and intelligent operations so customers can operate with seamless flexibility to deploy new applications, unify their data for AI, and simplify data protection in a world of limited IT resources, rapid data growth, and increased cybersecurity threats. Looking at the results of the quarter, momentum from new products and the go-to-market changes we made at the start of the year drove 10% quarter-over-quarter growth in hybrid cloud segment revenue to $1.4 billion. Our all-FlashArray business benefited from the growth of the AFF C-Series, increasing 14% from Q1 to an annualized revenue run rate of $3.2 billion. The AFF C-Series all-FlashArray continues to exceed our expectations, delivering new to NetApp customers and numerous wins over the competition. In the quarter, we successfully competed against an all-flash competitor with C-Series to win a $16 million deal at an infrastructure as a service company. The customer was looking for new storage to host a broad variety of critical applications. Our ease of management for large storage environments, unique data resilience, common toolkit across all our storage systems and the right price performance ratio secured our win despite the competitor's attempt to use price once they realized their value proposition was insufficient. ONTAP One, our all-in-one software license that gives customers access to the industry's most comprehensive data management suite, has laid the groundwork for future tech refresh and expansion opportunities. Building on the success of the C-Series, we introduced blocked optimized and AI-ready versions. The ASA C-Series family is a solution tailored to deliver high performance and guaranteed high availability storage for critical applications, databases, and VMware infrastructure coupled with capacity flash to make enterprise grade block storage more affordable and sustainable than ever. We added the AFFC series to the ONTAP AI architecture, lowering the overall cost of entry to scalable AI without sacrificing performance. Keystone, our storage as a service offering, is also growing rapidly. In Q2, We added performance and availability guarantees to Keystone, expanding on the existing sustainability and storage efficiency guarantees, creating a comprehensive program to keep storage operations running optimally. We also announced NetApp Storage on Equinix Metal, powered by Keystone, providing customers with a single subscription to a full stack of compute networking and storage infrastructure with low latency interconnection to all major public clouds. Turning to public cloud. As we said last quarter, our priority is growing first-party cloud storage services. We aligned our cloud sales specialists to our hyperscaler partners' go-to-market structures at the start of the fiscal year and are seeing new customer additions and growth in those services. However, that growth has been masked by weakness in subscription services which have declined to 23% of public cloud ARR. During the quarter, we engaged in a strategic review to sharpen the focus of our cloud portfolio. As a result, we will continue to prioritize cloud storage offering delivered through the hyperscalers while refocusing some services such as Cloud Insights and Instacluster to complement and extend our hybrid cloud storage offerings, creating greater differentiation and additional value for customers. We will integrate other services that are sold as standalone subscriptions today, such as data protection, into the core functionality of cloud volumes. We will also carefully manage the transition of cloud storage subscription services to align to customer preference for consumption offerings. And we have decided to exit the SAS backup and virtual desktop services. We anticipate ARR headwinds of approximately $55 million from exited services and unrenewed subscriptions in the second half of fiscal year 24. Growth in first party and marketplace services are expected to partially offset this decline. positioning us to enter FY25 with a more focused and much healthier business from which to grow. Now to the results of the quarter. Public cloud segment revenue in Q2 was $154 million, flat from Q1 and up 8% year over year. Our first party and marketplace offerings are highly differentiated and are tightly aligned with customers' buying preferences. These services grew over 30% from Q2 a year ago. We continue to see customer expansion and deepening partnerships, as well as increases in customer count, capacity, revenue, and ARR in this part of the portfolio. In Q2, we extended our partnership with Google with the introduction of Google Cloud NetApp Volumes. Now, we are not only the only vendor to have a natively integrated storage service in the public cloud, but we are natively integrated into all three of the leading hyperscale vendors. And we're not standing still with this advantage. Just two months after introducing the GCNB service, we announced the availability of a new lower cost tier of Google Cloud NetApp volumes, expanding the offering to address a greater range of workloads. These partnerships uniquely position and enable us to participate in the innovation and adoption of AI services in the public cloud. As examples, during Q2, we announced support for Google Cloud's Vertex AI with Google Cloud NetApp volumes, as well as cross-protocol hybrid cloud AI pipeline on Amazon FSx for NetApp on tap, with support for SageMaker Studio Notebooks. Our position with the hyperscalers also enables us to displace legacy on-premises competitors as customers migrate workloads to the cloud. A U.S.-based medical equipment company chose FSX for NetApp ONTAP to replace a competitor's SAN systems when they move their database workloads to the cloud. This is the customer's first engagement with NetApp. Following a successful initial deployment, they are evaluating FSXN for workload consolidation and disaster recovery. Looking forward, our focus is clear and is delivering results. We expect the momentum we saw in Q2 to continue through FY24, despite continued softness in the demand environment due to the challenging macro. Customers value our modern approach to hybrid multi-cloud infrastructure and data management, which enables IT organizations to leverage data across their entire estate simply, securely, and sustainably. With recent innovations that enable us to address a broader set of markets more efficiently, I'm confident that we are well-positioned to deliver positive outcomes for customers and stockholders. I'll now turn the call over to Mike.

Thank you, George, and good afternoon, everyone. Q2 was a very solid quarter in what continues to be a challenging macro environment with soft IT spend. Our relentless focus and consistent execution delivered results that met and exceeded our guidance ranges and drove record-setting non-gap profitability measures across consolidated gross margin, product gross margin, operating margin, and EPS. Before I get into the financial details, let me walk you through the key themes for the quarter. As a reminder, all numbers discussed are non-GAAP unless otherwise noted. Our modern, innovative solutions are resonating with customers, and our disciplined operational management drove profitability margins to a record high. As we look ahead, We expect our industry-leading solutions and unwavering focus to drive revenue growth and profitability in the second half of the fiscal year. Q2 consolidated gross margins of 72% were at an all-time high, driven by product gross margins of 61%, also at an all-time high. Gross margin leverage and the returns on our strategic investments drove record operating margins of 27% and record EPS of $1.58. During the quarter, we returned approximately $403 million to stockholders through cash dividends and share repurchases, reducing share count by 4% versus Q2 23. Over the course of the year, we expect to return at least 100% of free cash flow to stockholders. Given our growth, profitability, and working capital improvements, we expect operating cash flow for the full year to normalize and track relatively in line with net income for the full year. Due to our solid execution and operational efficiencies, we outperformed the second quarter and expect our continued focus and discipline to deliver year-over-year revenue growth in the second half of the year. As a result, we are raising all our guidance measures for fiscal year 24. Now to the details of the quarter. Q2 billings of $1.5 billion decreased 9% year-over-year, and revenue of $1.6 billion decreased 6% year-over-year as IT budgets remain constrained in a challenging macro environment. Adjusting for the FX tailwind of 160 basis points, billings and revenue would have decreased 11 percent and 8 percent year-over-year, respectively. Hybrid cloud revenue of $1.4 billion decreased 7 percent year-over-year, and product revenue of $706 million decreased 16 percent year-over-year. As discussed last quarter, The first half of fiscal year 23 revenue and most notably product revenue benefited from elevated levels of backlog entering fiscal year 23. For the second half of fiscal year 24, year over year comparisons should be more apples to apples. Support revenue and attached to our install base and indicative of the value of our products grew 3% year over year to $623 million. We are pleased with the momentum of our product portfolio and our go-to-market initiatives implemented at the start of fiscal year 24. Public cloud revenue increased 8% year-over-year to $154 million and was relatively flat from Q1 24. As George noted, year-over-year growth was driven by hyperscaler first party and marketplace services, partially offset by continued declines in subscription services. Now for our operating results. Q2 consolidated gross margin increased 580 basis points year-over-year to 72 percent, and product gross margin increased 1,080 basis points year-over-year to 61 percent. Product gross margin benefited from three main factors. Number one, a mixed shift to higher margin and higher capacity products. Number two, favorable COGS stemming from lower component costs and our strategic purchase agreements for NAND. Number three, price discipline in a cost-sensitive competitive pricing environment. I want to be very clear on this point. There were no unusual or one-time transactions that drove the higher product gross margin results. As we discussed in prior calls, we continue to make strategic purchase commitments to lock in NAN pricing and mitigate margin pressure from rising prices in the future as NAN prices largely bottomed out in Q2. Operating expenses of $706 million were flat year-over-year and grew $3 million quarter-over-quarter. Within a relatively consistent OpEx envelope, we will continue to reallocate investments to areas of higher opportunity to drive long-term growth. In Q2, operating margin increased 320 basis points year-over-year to 27%, which includes 80 basis points of FX tailwind EPS grew 7% year-over-year to $1.58, which includes a 7-cent FX tailwind. These record results demonstrate the strength of our business model, product relevance, and unwavering focus and execution. As expected, Q2 operating cash flow of $135 million was impacted by seasonally lower collections and repatriation tax payments. DSO was 46, and inventory turns were 15. More importantly, year-to-date operating cash flow of $588 million grew 19% year-over-year compared to a decline of 8% the same period a year ago. Free cash flow came in at $97 million, bringing the year-to-date amount to $515 million, up 46%. year over year. During the quarter, we returned $403 million to stockholders through share repurchases and cash dividends, ending the quarter with approximately $230 million in net cash. Our balance sheet remains healthy. Total deferred revenue as of the end of Q2 was $4 billion. The slight decline year over year is driven by lower multi-year support and public cloud subscription billings. We ended the quarter with approximately $2.6 billion in cash and short-term investments. Now turning to guidance. Given the success of our product portfolio and consistent execution on operational improvements, we are raising our fiscal 24 guidance in still a soft IT spending environment. We now expect fiscal year 24 revenue to be down approximately 2% year over year and improvement from our previous guidance. We expect to see continued strength in product and hyperscale of first party and marketplace services as we work through minor headwinds from public cloud subscription services. Consolidated gross margins are expected to be approximately 71%. For the second half, we expect product gross margins to range between 58% to 60%, driven by continued mixed shift to all-flash products and taking into account the current pricing environment and our commitment to maintain pricing flexibility. Operating margin is expected to be approximately 26%, and EPS to be in the range of $6.05 to $6.25, with the assumption of net interest income of approximately $30 million and share count of $212 million. Operating cash flow is expected to move in line with net income, although there will be some quarterly variance based on working capital. In Q3, we expect revenue to range between $1.51 billion and $1.67 billion which at the midpoint implies an increase of 4% year over year. We expect Q3 consolidated gross margins to be roughly 71% and operating margin to be approximately 28%. EPS is expected to be in the range of $1.64 to $1.74. In closing, I want to thank our customers employees and investors once again for their steadfast commitment and investment in NetApp. I remain confident in our ability to manage the elements in our control and focus our key priorities to help customers successfully achieve their digital and cloud journeys. Our portfolio is well aligned to priority IT investments and we are committed to delivering sustainable long-term value for our stockholders. I'll now turn the call over to Chris to open the Q&A. Chris?

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

Thank you. If you would like to ask a question, please press star then 1 on your telephone keypad. If you are using a speakerphone, we ask that you please pick up your handset before pressing the keys. To withdraw your question, please press star then 2. Today's first question comes from Mehdi Husseini with SIG. Please go ahead.

Excuse me. Thanks for taking my question. Two quick follow-up. Given the updated fiscal year 24 revenue guide, should we assume that the July product revenue of 590 was essentially the bottom and you would continue to see a sequential improvement in the second half? And the second question has to do with momentum with some of these higher margin, higher capacity to product. To what extent should we assume this market share has enabled you to ride out a tough IT spin environment?

I'll take the second one, and then Mike will take the first, maybe. Good afternoon. We feel very good about the momentum with our C series portfolio. We are able to serve customer workload and use cases, particularly at a time of soft IT spending where we are aligned to the value that we bring. And the software value of ONTAP is particularly useful in these all-flash configurations. We are also expanding the total addressable market. with the all-SAN array configuration of the C-Series and of the high-performance Flash products. So I'm excited about what the future holds for our Flash business, and it is because of that momentum and the focus of our go-to-market that we've taken up our guidance for the full year.

Thank you, George. Good afternoon, Manny. On your question on product revenue, certainly for fiscal 24, implied in the guidance is continued growth in the second half for the product line. Total revenue growth averages about 4% for the second half. We have not guided for fiscal 25 yet, but we certainly would feel good about going into 25 as it relates to our product portfolio and our operational improvements.

Thank you.

Thanks, Betty. Thank you.

Yes, ma'am. And our next question comes from Meadow Marshall with Morgan Stanley. Please go ahead.

Great. Thanks. A couple of questions. Just one, you know, realizing that you're saying there's no kind of major contributor to the gross margin upside, but just how do you see... NAN prices increasing, just kind of an outlook on how you see gross margins developing throughout the year and whether these are sustainable. And then just as a second question, do you attribute kind of the more confidence in the year to the early success that you're having with C-Series? Do you kind of attribute it to signs you're kind of seeing coming out of Insight? Just kind of what gives you more confidence on the year just given the dampened environment? Thanks.

I'll take the first one and then George will take the second one. The comment in the script was specifically related to no one-time transactions that drove the overachievement in product margins. As we look forward through the rest of fiscal 24 to 25, let's start with the second half of 24. We're currently guiding product gross margins between 58 and 60%. As we all know, we continue to benefit from the lowest component costs we've seen in many years. We have included some room in our guidance to be flexible in pricing as well as mix and capacity. And as we've all seen from the industry analyst reports, we do expect that component pricing has bottomed out in our Q2 and will rise as we go throughout the rest of 24. We do feel very good about our position for the rest of the fiscal year as it relates to purchase agreements that we have struck as well as pre-buys. Similar to 24, we are looking to extend that into 25, and we'll continue to work with our suppliers as we go through the rest of the year. I'd also note that, hey, historically we all know storage industry pricing evolves as component pricing changes, and we expect that trend to continue. So all that being said, we feel good about the second half of 24 as we've included in our outlook. As we head into 25, we'll see how things progress as it relates to mix, pricing, and component costs. And we'll guide 25 when we get to our Q4 call. With that, I'll hand it to George.

With regard to your question on the underlying factors that support our optimism in the guide, first of all, from a macro perspective, it's still a challenged macro with a soft demand environment. We saw incremental improvement in North America, but equally a deceleration in certain parts of Europe, mirroring the economic landscape in the public domain. I think within the large enterprise, we see a case-by-case situation in terms of demand and we continue to see a more robust product business in the commercial or mid-market customer base. So no real fundamental change in the demand environment. With regard to the two underlying factors for confidence, One is we are a much more focused go-to-market organization, and we are seeing the second consecutive quarter of pipeline and performance from the changes we made at the start of the fiscal year. And so I want to credit our go-to-market teams for their focus and the results that they have delivered this quarter, and that is one of the key contributors. The second is the really strong performance of our all-flash portfolio. We talked in the prepared remarks about a large competitive win against a purely flash competitor, and we see that, you know, across multiple segments where we are seeing competitive wins with our portfolio. So those are the two fundamental reasons. Go-to-market focus and execution and confidence in our portfolio. Great.

Thank you.

And our next question today comes from Chris Sankar with TD Cowen. Please go ahead.

Yeah, hi. Thanks for taking my question. I actually have two questions for George. George, first one, kind of like, what are the lead times for the storage products today, and what does that imply for your visibility when you look into calendar 24? And the second question is, curious on the storage content per customer, has you seen any increase in it because of AI, or do you think that will happen maybe at some point in the future, or is there any way to put some timeline surrounded?

With regard to lead times, we are at normal lead times for our portfolio, and we reached those normal lead times a few quarters ago. With regard to the question on storage demand for AI, listen, I think we have been in the AI business for predictive AI or industrial AI for five years. And there are large data sets that are built out to support training of those models and the implementation of those models across the enterprise. So we have a good and robust business there. We are starting to see early signs of trials and use cases with generative AI. Generative AI is particularly well-suited for NetApp's capabilities because it operates on unstructured data, files, documents, video, audio, and so on. And so we have large repositories of those in customers, and we are able to use that data set and add to that data set to support you know, AI use cases. This quarter, we won a large AI implementation at a very large U.S. bank that was really focused on generative AI, document summarization, analysis, and so on, and we are the infrastructure foundation for that. So it will take time for generative AI to become a demand driver. We are seeing early positive signs there.

Thanks, George.

Thank you. And our next question comes from Stephen Fox of Fox Advisors. Please go ahead.

Hi. Good afternoon. I had two questions on the product business. So first of all, I'm not fully understanding what you were saying about the pricing environment. At one point you said you maintain disciplined pricing, and then at another point you said you would be flexible going forward with pricing. So can you sort of give us a sense for, you know, how challenging or not challenging it is to hold pricing in these gross margins. And the second one is related to the product gross margins. I'm just still trying to get a sense for how sustainable this last quarter and the guidance for the next quarter is in terms of product gross margins, even if we adjust for the changes in NAN pricing. Thanks.

On pricing, we've been in this industry for a very long period of time, and while there will be people who are, you know, vendors who are aggressive in a particular transaction or other, depending on their own strategic reasons, overall, we don't see fundamental changes in the pricing environment. Clearly, the room with lower component costs gives you an opportunity to do more in terms of you know, pricing flexibility. But I think that our past quarter's gross margin results are a demonstration of the fact that we've been able to maintain pricing discipline at a time where demand is soft. And it talks to both the differentiation of our product portfolio and the execution in our field teams. I'll have Mike talk a bit about your second question.

Thanks, George. And I'll refer to George's comments, Steve, when I talk about the sustainability. So we finished at 61% product margins in Q2. We got at a range of 58 to 60 in the back half. We feel very good about our component costs and the view of that for the rest of our fiscal 24. The reason why we got it slightly lower than Q2 from a margin perspective is exactly what George talked about, which is we feel really good about our pricing discipline and our products. but we want to make sure and leave room to be flexible should we need that in the second half. That's the one part of the equation that we don't control as much as the cost. So hopefully that helps. We would not have guided that range if we didn't feel good about it for the second half, Steve.

Yeah, that's very helpful. Thank you.

Thank you. And our next question today comes from Asia Merchant with Citi. Please go ahead.

Great, thank you. Maybe just a little bit on the macro, clearly you're executing really well. And should we expect slightly better than seasonal growth for you guys in the second half, just given the fact that you guys are ramping on a new product? And then just broadly on the macro, are we starting to see more adoption of Flash across the customer base? in general, as people start to appreciate maybe more, you know, pricing being more attractive? Or is this something that was specific to NetApp, just given the success that you're seeing in your C-series? Thank you.

I'll take the second, and Michael will cover the first. Thank you for the question. Listen, I think that with regard to customer adoption of Flash-based technologies, They are, you know, we saw the high performance landscape move to flash several years ago, and there's been a steady movement of that footprint to flash. That is about 15 to 20% of the overall storage market, maybe 20%. The next tranche of use cases are more in the general purpose application footprints. these are you know in the process of migrating over multiple years we are in the early innings of that migration and so we feel very good about the position of our flash portfolio to attack that part of the market it is essentially the 10k hard drive market that is about you know, 30 to 40% of the hard drive market. So you'll see that move over time. And so I'll let Mike talk to the first question you had.

Sure. On your question, I see as it relates to linearity, we did see a nice quarter-on-quarter pickup in Q2, which was really driven by the factors that George discussed earlier. And if you look at the midpoint of guidance for the year, we do expect it to be relatively consistent with the numbers we'd like to talk about, which is the 48% in the first half and 52% in the second. Again, keep in mind that a good bit of our revenue, thankfully, comes from support, very predictable. Hopefully, we can do a little bit better, but that is the midpoint of guidance is pretty much right on linearity.

Great. Thank you.

Thank you. And our next question today comes from Wamsi Mohan with Bank of America. Please go ahead.

Hi, yes, thank you so much. I was wondering, George, if you could comment a little bit on the public cloud revenue trajectory in fiscal 24, given some of the changes that you noted. And given those changes in cloud ops, how does that change your long-term revenue outlook for that business on a relative basis? I think before you were thinking 40%. of total public cloud, wondering where you're thinking that that might shake out now in the long term.

So let me provide some baselines before I jump into the, you know, the strategy review takeaways and the implications. First, cloud is roughly 10% of total revenue. Subscription is 23% of cloud revenue, down from about 35% a year ago. So it's a small percentage of the total cloud revenue and an even smaller percentage of the total company revenue. The mix of cloud storage and cloud ops is still relatively consistent, approximately 60-40. We focused our strategy review on all elements of our cloud portfolio. and had five key takeaways that I outlined in my prepared comments. Sharpening the focus on first-party and hyperscaler marketplace storage services. These performed very well in the second quarter and continue to be uniquely differentiated both to end customers of our on-premises solution and a vehicle to acquire net new customers alongside our cloud partners. we would carefully manage the transition of some of the storage subscriptions to our consumption offerings. As we roll out 1P services, customers that used to buy storage subscriptions prefer to now go towards the 1P offering, and we'll manage that carefully. We will integrate some standalone services like data protection and privacy into our cloud storage offerings so that they bring more value to the base offering. And we'll refocus other services like Cloud Insights, which are subscription services, and Instacluster to differentiate NetApp in the cloud storage workload motions that we are focused on. We've decided to exit some standalone services like virtual desktop and SaaS backup services. And all of this will lead to about a $55 million ARR headwind from these actions in the second half of fiscal year 24. The reduction in public cloud subscription services will be partially offset by the good growth of our consumption cloud storage services in particular. And so our plans for the second half of the year assumes that we will have a modest decline in cloud revenue. We're not going to guide it. but we assume that, and we have built that into the guidance for the fiscal year 24, which we took up by approximately $100 million. We're not going to comment today on the outlook for the overall cloud business. We will talk to you when we update our long-term models to that effect.

Okay, thanks, George. And if I could, Mike, your margins were really, really strong, both sequentially and on an absolute basis. Wondering, as we think about free cash flow margins, would all this EBIT margin improvement flow through into free cash flow margins? And secondarily, just on the EBIT margins, is there a way to dimension out of the three things that you noted, maybe rank order or order of magnitude so that we can get some sense around the confidence of sustainability, especially as it relates to commodity pricing, which you seem to indicate won't really matter too much sequentially, but just wondering what was the biggest sequential driver of that margin improvement? Thank you.

Sure. So, Manasi, two questions there. First of all, on cash flow, and I'll do operating cash flow, we do expect for the year, I talked about it in the prepared remarks, operating cash flow to move relatively consistently with non-GAAP net income so to your question yes as the income increases so should operating cash flow short of any quarterly fluctuations in working capital so all good there in terms of free cash flow margins largely moving with operating cash flow. And then on the second question, and I'll answer this on a sequential basis, not a year-over-year basis. As we look from Q1 to Q2, certainly the mix shift was a significant impact. We did receive some benefit on costs as those Older inventories are now completely gone. And then, of course, pricing discipline is in there as well. So I would rank from a sequential perspective the order that I did it in my prepared remarks in terms of mix shift, which is both product and capacity, then favorable cogs, and then pricing discipline. So hopefully that helps.

Yeah, thanks a lot, Mike. Thanks, sir.

Thank you. And our next question comes from with Northland Capital Markets. Please go ahead.

Great. Thanks for taking my question. You guys mentioned 30% growth in first party store services. What's the NRR underlying that?

We don't break those out. I think we feel very good about we have brought in the number of workloads that we serve We have brought in the number of hyperscalers now with Google coming online. We have brought lower price points for Azure and Google, and we have brought higher price points for Amazon. So I feel really, really good about the momentum in our first-party cloud storage services.

Maybe phrasing it in a different way, the driver of that growth is expansion or LANs?

the combination of both new customer ads and new workload use cases within existing customers as well as expansions.

Great. And then a quick follow-up question. George, you talked about how you had a $16 million win with the C-Series, and you mentioned four drivers behind that. Which of those four drivers was really probably the biggest element of that win?

I think we have a really strong operating system capability for performance and simplification at scale. Many of the other vendors that start simple run into real trouble when you try to build a large enterprise environment, and we have a really good portfolio to do that. I think that was probably the number one, you know, reason. And the number two reason is now that we have the C series, we have a price point to deliver to customers that we used to not have it.

Awesome. Thank you.

Thank you. And our next question comes from Simon Leopold with Raymond James. Please go ahead.

Great. Thanks for taking the question. First, just a quick clarification. On the strategic review update, I just want to confirm it sounds like you've concluded that review apart from sort of regular business kind of reviews. I just want to confirm that that's the case. And then really the element I'm trying to sort of tease out here is you've taken out $55 million of ARR, so roughly $15 million of revenue yet your outlook is higher. What is informing the higher outlook? What's been the biggest surprise and the biggest delta contributing to the higher outlook? Thank you.

So first of all, let me hit that in three parts, right? First, we have concluded the strategic review. We have a set of good decisions we've made that we need to now go implement. that will result in a more focused cloud business and a healthier subscription base, albeit a smaller one, to build off. We believe that these actions should allow us to get back to growth in fiscal year 25 of our healthier business mix in cloud. We always will do reviews of various aspects of our portfolio as ongoing parts of our business, but the focus strategic review I would say is mostly complete. I think the second is with regard to the confidence we have. Listen, we said that when we guided the second half of the year, we took up the overall guide by close to 100 million. That is mostly based on the momentum of our all-flash hybrid cloud storage portfolio. We've raised the second half guide by substantially more than we beat in the second quarter. And it also accounts for the fact that we will have some headwinds through the rest of fiscal year 24 in our cloud subscription business, which will only be partially offset by growth in our cloud consumption business.

Thank you. Thank you.

And our next question today comes from Aaron Akers with Wells Fargo. Please go ahead.

Yeah, thanks for taking the question. A lot of them have been asked and answered, but I wanted to go back to some prior discussion around this notion of AI. And, you know, we hear a lot about like AI, you know, large language models becoming smaller and implemented more maybe pervasively over time in traditional enterprise environments. We've even, you know, heard more about inferencing and and how that might evolve in enterprises. I'm just curious, are you seeing at all any signs of that pulling either discussions or early signs of demand? And if so, is it a prerequisite that that has to pull all flash storage with that kind of footprint? And the reason I ask is there's a lot of discussion about a lot of this existing infrastructure that's going to have to be upgraded to support these acceleration of AI in infrastructure? Sorry for the long-winded question.

No problem. I'll address that in three steps. I think first is the use of smaller models as opposed to the very, very large model. Yes, that term is distillation. We do see that going on in customers. Whereas they kind of run these different models, they begin to realize that you can get as effective an outcome with much faster results than, you know, and a smaller number of parameters. For example, the demonstration, the live demonstration that we showed at NetApp Insights actually was a distillation. We started with a much larger LLM and we brought it to a much smaller range of parameters because you get the same benefits. So that's going on. The second is with regard to training environments, which is the part of the data lifecycle in AI where you aggregate a data set and you train the algorithm or the language model for better answers to be able to either predict a good outcome or generate a relevant outcome, you do need very high performance storage. because the GTUs that drive those algorithms need very, very fast parallel access to data. And with our unstructured data scale-out file system, we feel very well positioned for that. And then the third is with regard to inferencing. Inferencing is the part of the data lifecycle where you've taken a model, and now you want to put it into production on a data set. It could be on a factory floor. It could be in a distributed office. There, it really depends on the data set and the use case. what type of storage you need. You may need it for larger environments like shop floors, but you may not need super high-performance storage and compute for a very small office, like a claims office, for example, in insurance.

That's very helpful. And as a quick follow-up, real quickly, who is your predominant competitor that you see on the block-optimized C-level all-flash arrays or C-series arrays?

It's all the, you know, the block market is a crowded market. We feel very good about our offerings in the mid-range especially and the ability to offer a single solution with common automation, common administration, common lifecycle management for both files and blogs. And no other vendor in the market can do that. And Sophie feels very good. I think the large competitors are clearly Dell and HPE in the mid-range, and then you occasionally see some cure.

Thank you.

Thank you. And our next question today comes from Sam McChatterjee with JPMorgan. Please go ahead.

Hi. Thanks for taking my questions. I guess if I start with the public cloud strategic review that you discussed, I just want to clarify based on the changes you're making there, are there any cost implications, other changes? I'm assuming that allows you to focus your go-to-market a bit more, but Is there any sort of cost implication where you're enabling some cost takeout there? And secondly, Mike, you mentioned sort of the 58% to 60% gross margin on the product revenue in the second half. When we think about sort of pre-buys that you might do going into fiscal 25, how should we think about the trajectory of the gross margin into fiscal 25 and any levers that you have to offset sort of the flow-through of that to the operating margin that you're really reporting at a very strong level right now? Thank you.

On the cost side, listen, I think we will, for the most part, just repurpose those resources to drive growth in our first-party cloud storage. We feel good about the demand environment there, and we want to continue to accelerate that

whatever cost opportunities they are it's been factored into the second half guidance that we gave you okay and then thanks for the question samik on the on the question especially going into fiscal 25 from the product margin i'll go over a little bit uh my answer to meet him when she has the same question so as we've all seen from the analyst reports we have we do expect that nan is largely bottom uh we're at the lowest component pricing we've been at in a while We did a really nice job, again, kudos to the supply chain team for doing the pre-buys and purchase agreements for 24. We will certainly look at those and continue to look at those in 25, but it has to make sense for both NetApp and our suppliers. So as we go into 25, there are certainly some levers. The big question there, Sameek, that I don't have an answer to is what does the market do and pricing do over the next six months? That's why we're going to wait. We will guide the margin number when we guide for the full year because we really want to get through the next couple quarters, see how component pricing goes, what we expect the mix to be, and then what happens from a pricing environment perspective. Okay. Thank you. Thank you.

Thank you. And our next question comes from Ananda Barua with Loop Capital. Please go ahead.

Yeah, good afternoon, guys. Thanks for taking the question. I guess, you know, Georgia, an inference-related question, you know, maybe two quick parts. Are you hearing any of your customers talk about legislation around inferencing having an impact on their plans And I guess just generally speaking, any opinion you have on sort of what that ramp over what time period kind of looks like, even if just anecdotally, would be helpful. Appreciate it. Thanks.

Yeah, I think, first of all, we are in the early stages of generative AI. predictive AI is quite mature and has very strong use cases. We have done really well in healthcare and life sciences, in manufacturing, in parts of financial services, lots of use cases, right? And so I think that's mature. It requires good data sets and good data management to make it have the right outcomes. With generative AI, there is obviously a lot of discussion on both regulation as well as judicious use of the technology, everything from fairness to ethics privacy to all kinds, cybersecurity, all of those things. And I think it'll take time. Where we are with most clients today is proof of concepts, right? They are trying to put their data sets together. They are trying to learn what these models will help them do. And there are some use cases which are really easy to see the benefits from. Software development is very easy to see the benefits from. The more advanced ones where some of these concerns exist We're seeing customers move cautiously. So it'll take time. These are multi-year use case developments. And so we feel good about where we are at the moment, and we're just realistic that it'll take time to build momentum.

Yeah, thanks for the context. That's helpful.

Thank you. And our final question today comes from Sydney Hill with Deutsche Bank. Please go ahead.

Great. Thanks for the question. I apologize if you have already addressed this. On the macro level, are you seeing any major differences between demand from large enterprises, small business, and et cetera? Any particular verticals you would point out that shows particular strength or weakness both on the hybrid cloud and the public cloud businesses? Thanks.

The demand picture is still soft and mixed. Overall, you know, we saw some improvements in the U.S., Offset by some weakness in Europe, nothing that is not in the public domain. With regard to the customer types, large enterprise is still soft. Tech, for example, tech and service provider spending has not really come back. It is really a customer by customer situation versus a broad industry situation. With regard to the demand picture in mid-sized enterprise, our mid-sized enterprise business performed more robustly and secularly better than our large enterprise business. Public sector continues to be a work in progress. You know, we saw some of the impacts of the budget negotiations result in softer budgets for certain agencies. Our business performed quite well, particularly in the civilian agencies.

Great. Thank you.

Thank you, Sydney. I'm going to hand it back to George for some final comments.

In closing, I want to thank the entire NetApp team for their strong execution and operational discipline in Q2, which drove revenue above the midpoint of our guidance and record gross margin, operating margin, and EDS. Only NetApp delivers an entire architecture of unified data storage solutions. helping customers operate with seamless flexibility to deploy new applications, unify their data for AI, and simplify data protection in a world of limited IT resources, rapid data growth, and increased cybersecurity threats. Innovation in our all-flash storage portfolio enables us to address a broader TAM, and we continue to innovate and lead in public cloud storage services. Our go-to-market team is laser-focused on these positions of strength, enabling us to deliver strong results in a challenged macro landscape. Looking ahead, I'm confident that the momentum we saw in Q2 will continue through the remainder of fiscal year 24. Thank you.

Thank you. And ladies and gentlemen, this concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day.