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Edited Transcript of NTAP earnings conference call or presentation 13-Nov-19 10:30pm GMT

Q2 2020 NetApp Inc Earnings Call

SUNNYVALE Nov 19, 2019 (Thomson StreetEvents) -- Edited Transcript of NetApp Inc earnings conference call or presentation Wednesday, November 13, 2019 at 10:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* George Kurian

NetApp, Inc. - CEO, President & Director

* Kris Newton

NetApp, Inc. - VP of Corporate Communications & IR

* Ronald J. Pasek

NetApp, Inc. - Executive VP & CFO

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Conference Call Participants

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* Aaron Christopher Rakers

Wells Fargo Securities, LLC, Research Division - MD of IT Hardware & Networking Equipment and Senior Analyst

* Alexander Kurtz

KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst

* Amit Jawaharlaz Daryanani

Evercore ISI Institutional Equities, Research Division - Senior MD & Fundamental Research Analyst

* Ananda Prosad Baruah

Loop Capital Markets LLC, Research Division - MD

* Andrew Teutli-Vadheim

Wolfe Research, LLC - Research Analyst

* George Michael Iwanyc

Oppenheimer & Co. Inc., Research Division - Associate

* Jim Suva

Citigroup Inc, Research Division - Director

* Karl Fredrick Ackerman

Cowen and Company, LLC, Research Division - Director & Senior Research Analyst

* Kathryn Lynn Huberty

Morgan Stanley, Research Division - MD and Research Analyst

* Louis Rocco Miscioscia

Daiwa Securities Co. Ltd., Research Division - Research Analyst

* Matthew John Sheerin

Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Equity Research Analyst

* Matthew Normand Cabral

Crédit Suisse AG, Research Division - Research Analyst

* Mehdi Hosseini

Susquehanna Financial Group, LLLP, Research Division - Senior Analyst

* Nehal Sushil Chokshi

Maxim Group LLC, Research Division - MD

* Nikolay Todorov

Longbow Research LLC - Analyst

* Roderick B. Hall

Goldman Sachs Group Inc., Research Division - MD

* Simon Matthew Leopold

Raymond James & Associates, Inc., Research Division - Research Analyst

* Steven Bryant Fox

Cross Research LLC - MD

* Wamsi Mohan

BofA Merrill Lynch, Research Division - Director

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the NetApp Second Quarter of Fiscal Year 2020 Conference Call. My name is Andrew, and I will be your conference call coordinator for today. (Operator Instructions)

I will now turn the call over to Kris Newton, Vice President, Corporate Communications and Investor Relations. Please proceed, Ms. Newton.

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Kris Newton, NetApp, Inc. - VP of Corporate Communications & IR [2]

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Thank you for joining us.

With me today are our CEO, George Kurian; and CFO, Ron Pasek.

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 the third quarter and full fiscal year 2020, our expectations regarding future revenue, profitability and shareholder returns and our ability to improve execution, gain share, reaccelerate growth and expand our sales capacity without increasing total operating expenses, 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, the IT capital spending environment, and our ability to expand our total available market, acquire new accounts, expand in existing accounts, capitalize on our data fabric strategy, improve the consistency of our sales execution and continue our capital allocation strategy.

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 for fiscal year 2019, including the management's discussion and analysis of financial conditions and results of operations, and risk factors sections and our current reports on Form 8-K.

During the call, all financial measures presented will be non-GAAP unless otherwise indicated. Reconciliations of the GAAP to non-GAAP estimates are posted on our website.

I'll now turn the call over to George.

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George Kurian, NetApp, Inc. - CEO, President & Director [3]

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Thanks, Kris.

Good afternoon, and thank you for joining us.

Our Q2 FY '20 results reflect the strength of our business model and the value of our innovation. We delivered gross margin, operating margin and EPS, all solidly above our guidance ranges. Despite the ongoing macroeconomic uncertainty and the potential for continuing unpredictability in enterprise purchasing behavior, the fundamentals of our business are strong.

I've just come from 2 great events, NetApp Insight and Microsoft Ignite, and the many conversations I had with customers, prospects and partners both underscore the power of our data fabric strategy to differentiate our solutions and highlight our success in reaching new customers and buying centers to expand our market share.

At this year's Insight User Conference, it was clear that we are solving real pain points for customers as they grapple with the complexity of hybrid multi-cloud IT. I witnessed the tangible enthusiasm for how we are helping customers address these challenges by building their own data fabric with NetApp. I'm sure those of you who were able to join us felt that excitement. We saw an increase in overall attendance, and for almost half of the customer attendees, this was their first Insight. The number of executive-level customers was up 80% from last year, and the number of customers with cloud responsibilities doubled.

Hybrid multi-cloud is the reality of customers' IT environment, and NetApp has the strategy, the innovation portfolio and customer experience to help them succeed. At Insight, we announced that we are revolutionizing the customer experience and simplifying the business of hybrid multi-cloud with NetApp Keystone. NetApp Keystone creates a consistent experience from public cloud to the data center, helping customers transform IT to operate with cloud-like ease and flexibility everywhere.

First, for customers who want truly elastic scaling without having to manage infrastructure, they can consume NetApp technology as a cloud service through the world's biggest public cloud. Second, for customers who want a cloud-like experience on-premises, we offer subscription services. And finally, for customers who want to own and operate technology in their own data centers, we've introduced a radically simplified ownership experience for how our customers buy, optimize and grow with NetApp. Customers and partners choose NetApp because of our unique ability to offer a full range of capabilities needed to build their Data Fabric. NetApp Keystone complements this with a consistent cloud-like customer experience across the public cloud and on-premises.

Let me be clear, our approach to cloud is giving us access to new buyers and workloads as well as increasing the relevance of NetApp to companies, both large and small. Cloud gives us both opportunity in the public cloud and makes us more attractive for on-premises deployment. While I'm heartened by the enthusiasm generated by our hybrid cloud data services, the headwinds we identified on last quarter's call persisted through Q2. Both macroeconomic and enterprise spending indicators show continued weakness. While we cannot predict when conditions will improve, we are planning our business assuming no change in these external factors for the foreseeable future.

I'm pleased with our sales discipline and the ability to capture value in this tough market. To that point, our product gross margins demonstrate that we were able to maintain pricing discipline despite the soft environment. Regardless of what is happening in the broader macro environment, I remain confident that we can return to growth because of our ability to deliver real business value to customers' hybrid multi-cloud environment. This increases our strategic relevance and enables us to reach new buyers through new pathways, address new workloads and expand our presence with existing customers.

To better capitalize on our opportunity and replicate our proven areas of success, we laid out a plan for you last quarter that includes increasing sales capacity by approximately 200 primary sales resources by the end of Q1 FY '21 without adding to the total operating expenses for the company. As of the end of Q2, we are well on track to deliver against this goal. The sales headcount will be deployed primarily in our Americas geography. They bring capabilities to acquire new accounts as well as engage new buyers with new sources of funding like cloud architects in existing accounts. As a reminder, we expect it will take roughly 3 to 4 quarters to bring these resources up to full productivity, and the vast majority of the benefit of this additional capacity will be realized next year in fiscal year '21.

We are also sharpening our attack on the key market transition of disk to flash, traditional IT architectures to private cloud and on-premises to public cloud. In Q2, our all-flash array business, inclusive of All Flash FAS, EF and SolidFire products and services, was up 29% sequentially to an annualized net revenue run rate of $2.2 billion. We have industry-leading guaranteed storage efficiency, the highest performance and the most complete cloud integration in the market today.

In the quarter, Gartner published its Magic Quadrant for primary storage, and NetApp took the highest ranking in the leaders quadrant for both our ability to execute and for the completeness of our vision.

Moving to our private cloud solutions. SolidFire, NetApp HCI and StorageGRID are the building blocks for private cloud deployments, enabling customers to bring public cloud-like experience and economics into their data centers. Our private cloud business, inclusive of products and services, attained an annualized net revenue run rate of over $300 million in the second quarter, up almost 30% year-over-year.

Now on to cloud data services. Based on the last month of Q2, our annualized recurring revenue for cloud data services increased to approximately $72 million, up 167% year-over-year. We continue to see a healthy mix of customers new to NetApp in our cloud services and expect that our cloud services will continue to enable us to acquire new customers, reach new buyers and expand the workloads managed at existing customers.

Q2 is the first full quarter that Azure NetApp Files has been generally available, and we're making great progress. At Microsoft Ignite, I spoke to many customers who are planning to move a broad range of enterprise workloads, like Oracle and SAP, into the Azure Cloud with Azure NetApp Files. Customers love that they get the widest choice of file protocols and on-premises class performance and availability with an Azure-consistent experience from procurement to support to billing.

A global energy company that's migrating high-performance workloads into the cloud for flexibility, scalability, global access and collaboration presented at Ignite about their experience with Azure NetApp Files. The performance improvements they achieved are outstanding. Simulation runtimes were reduced from months to days, and in some cases, hours. To quote the customer, "Azure NetApp Files is a lifesaver." And that's just one example of the excitement we're hearing from customers about what we're doing in the cloud.

Our Cloud Volumes service is available in all 3 leading hyperscalers and gives us access to new opportunities from non-enterprise customers, where our traditional solutions do not economically reach, to new strategic buying centers in the world's largest enterprises, where we are only a small part of their infrastructure, we are expanding our addressable market with our cloud data services.

Our many years of work and deep integration with the leading public cloud give us a sustainable competitive advantage in the hybrid multi-cloud. We're delivering an enormous amount of value to a growing number of customers operating and planning to operate in a hybrid multi-cloud world. We're adding new customers each day. We're adding new use cases each week, and we're adding new cloud regions each month to deliver the world's best hybrid cloud data services.

As I've said before, customers and partners are choosing NetApp because of our Data Fabric strategy and our unique relationship with the hyperscale cloud providers. Our cloud data services not only give us access to customers and workloads that were heretofore inaccessible with our traditional solutions, they improve our competitive position for on-premises opportunities. Only NetApp has the strategy, the innovation portfolio and customer experience to help customers succeed in hybrid multi-cloud IT.

We've made a lot of progress in delivering on our Data Fabric strategy. Our on-premises solutions are highly differentiated as evidenced by our strong product gross margin. We are now available in the 3 leading clouds. We have delivered both the technology and the customer experience needed for success in the hybrid multi-cloud, and we are improving our execution and adding demand-generation resources to drive new sales motions. But it is early days, and we have more work to do to communicate the full scope of our capabilities.

As we saw at Insight and Ignite, our story resonates with customers. Because of this, I am confident in our ability to return to growth. We will continue to return capital to shareholders while investing for the long-term health of the business and capitalizing on our unique ability to help customers navigate the complexities of the hybrid multi-cloud.

Before closing, I want to share some news about our organization. Henri Richard, Executive Vice President for Worldwide Customer and Field Operations, has let me know of his intent to retire at the end of the fiscal year. Over the past 3.5 years at NetApp, Henri has done much to transform and modernize our sales force to take advantage of the strength of our Data Fabric strategy and our technology leadership as we pivoted to new buying centers and the growth areas of the market. Henri will participate in the search for his replacement and help in the seamless transition while continuing to lead the field and improving our execution.

At the same time, I'm excited to announce the promotion of James Whitemore to Senior Vice President and Chief Marketing Officer. James came to NetApp in the SolidFire acquisition, where he was CMO, and has since been leading our demand generation and digital strategy in the marketing organization. As acting CMO, James has already made a strong impact, and I'm glad to have him as the CMO of NetApp.

With that, I'll turn it over to Ron for more details on the quarter and our expectations. Ron?

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Ronald J. Pasek, NetApp, Inc. - Executive VP & CFO [4]

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Thanks, George.

Good afternoon, everyone, and thank you for joining us.

As a reminder, I'll be referring to non-GAAP numbers, unless otherwise noted.

As George highlighted, in Q2, we delivered strong margins and operating leverage in the face of continued caution from our customers as a result of the macro environment. Despite the demand uncertainty, we are confident in our product leadership and strategy to reaccelerate growth going forward. We also remain committed to our capital allocation strategy of returning cash to shareholders through share buybacks and our healthy quarterly dividend.

Before discussing our guidance, I'll provide further detail on our Q2 performance. In Q2, net revenues of $1.371 billion were down 10% year-over-year, including 1 point of currency headwind. We had 0 ELA revenue in the quarter compared to roughly $20 million of ELA revenue in Q2 '19. Product revenue of $771 million decreased approximately 16% year-over-year. Adjusting for ELAs, Q2 total revenue would have been down approximately 8% and product revenues would have been down approximately 14%.

Moving down the P&L. Software maintenance and hardware maintenance revenue of $540 million was flat year-over-year. Deferred revenue increased 8% year-over-year in Q2. Gross margin of 68.6% was above the high end of our guidance range. Product gross margin was 57.3%, which is an increase of 3.2 points year-over-year and above our long-term target of 56% outlined at our Analyst Day. The improvement was driven by continued sales force discipline, an increase in all-flash product mix and cost reductions and includes nearly half a point of currency headwinds.

Q2 was the 11th straight quarter we increased product margins year-over-year when adjusting for the benefit of ELAs. The combination of software and hardware maintenance and other services gross margin of 83% increased by over 150 basis points year-over-year driven by continued productivity improvements.

Q2 operating expenses of $631 million were down 3% year-over-year driven primarily by a reduction in variable compensation. Operating margin was 22.5%, solidly above the high end of our guidance range.

Despite the revenue headwinds, EPS of $1.09 was up 3% year-over-year and above the high end of our guidance, demonstrating the operating leverage in our business model. We closed Q2 with $3 billion in cash and short-term investments. Our cash conversion cycle was a negative 4 days, up 15 days year-over-year. DSO of 52 days was up 6 days year-over-year due to linearity in the quarter and, to a lesser extent, customer mix. DIO was 23 days, a 9-day increase year-over-year. We continue to expect our cash conversion cycle to remain negative throughout fiscal 2020.

Cash flow from operations was a negative $53 million, while free cash flow was a negative $89 million. The negative Q2 cash flow metrics are due to timing and do not reflect a change in our underlying business. The timing issues were primarily the accounts receivable. Additionally, there is a shift in the linearity of cash tax payments in FY '20.

We are maintaining our expectations for free cash flow to be in the range of 19% to 21% of revenues in fiscal 2020.

During Q2, we repurchased 9.8 million shares at an average price of $51.19 for a total of $500 million. Weighted average diluted shares outstanding were 236 million, down 28 million shares year-on-year, representing an 11% decrease.

During the quarter, we paid out $111 million in cash dividends. In total, we returned $611 million to shareholders in the quarter. Our fiscal Q3 cash dividend will be $0.48 per share.

Now on to guidance. We expect revenues for fiscal 2020 to be down approximately 8% year-over-year. We continue to expect ELAs to represent approximately 2% of total revenue. For fiscal 2020, we now expect gross margin to be in the range of 67% to 68%, above our previous guidance of 66% to 67%, due primarily to the improvement in product margins. Operating margin for fiscal 2020 is expected to be in the range of 21% to 22%.

Implied in this guidance is our expectation that operating expenses will be down slightly year-over-year in fiscal 2020 due to lower variable compensation. As a result of the updated revenue and margin guidance, we expect EPS to be down between 5% and 8% year-over-year without the benefit of buybacks.

Now on to Q3 guidance. We expect Q3 net revenues to range between $1.39 billion and $1.54 billion, which at the midpoint implies a 6% decline in revenues year-over-year, including a half a point of currency headwind. For Q3, we expect consolidated gross margin to be approximately 67% and operating margin to be approximately 22%. We expect earnings per share for the quarter to range between $1.14 and $1.22 per share.

We are diligently focused on improved execution and addressing the challenges we face. We are committed to returning the company to growth, and we remain confident our business model leverage will enable us to deliver long-term shareholder returns.

With that, I'll hand it back to Kris to open the call for Q&A. Kris?

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Kris Newton, NetApp, Inc. - VP of Corporate Communications & IR [5]

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Thanks, Ron.

We'll now open the call for Q&A. (Operator Instructions) Operator?

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question comes from the line of Wamsi Mohan with Bank of America.

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Wamsi Mohan, BofA Merrill Lynch, Research Division - Director [2]

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Your product gross margins north of 57% have been very strong. We've not seen that in a while actually since 2015. Can you talk about how much of that product gross margin was product mix-driven versus commodity price tailwinds or maybe even federal mix? And do you feel that you can sustain or expand these margins as you go into the back half of the year?

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Ronald J. Pasek, NetApp, Inc. - Executive VP & CFO [3]

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So yes, Wamsi, good question. On a year-over-year basis, most of it was mix, meaning we saw a higher percent this quarter of all-flash than we did, say, last quarter. Some of that was also cost reduction, not just on NAND but other things as well. That was in the face of having no ELAs in the quarter. That goes against you.

I did contemplate the ability to keep this level of gross margin through the rest of the fiscal year, and you saw that in the increase of the total margin guide.

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Wamsi Mohan, BofA Merrill Lynch, Research Division - Director [4]

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Okay. Great. And if I could, really quickly. On CDS, you exited last quarter with $5 million in monthly sales. It seems like you exited this quarter with about $6 million despite Azure GA all quarter. Can you talk about what are some of the challenges not ramping this faster? I know, George, you expressed a lot of enthusiasm in all your discussions both at Insight and Ignite. So where do you expect CDS annualized revenue run rate could be as you exit fiscal '20?

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George Kurian, NetApp, Inc. - CEO, President & Director [5]

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We aren't going to give you guidance on the CDS business. I think as we said, we've taken longer than we originally expected to get to general availability given the technical sophistication of what we are offering to customers. The total addressable market is there. We are seeing a lot of demand and interest from customers, and we're adding customers and growing footprints on a daily basis. We are going to just need to keep doing the work necessary to scale and enable all of the pathways associated with being able to take this solution to market and to replicate the wins that we've got across a broad range of workloads into more customers. So we're focused on execution at this point.

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Operator [6]

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Our next question comes from the line of Rod Hall with Goldman Sachs.

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Roderick B. Hall, Goldman Sachs Group Inc., Research Division - MD [7]

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I wanted to just check and see, Ron, if you could comment on the accounts receivable and -- well, the DSOs, that's the highest we've seen, I think, ever in our model. So just -- I heard you say the tailwind -- it was heavily back-end loaded in the quarter, but any more color on that? And then the ELAs, you're holding this 2% guide, yet there are no ELAs so far. So just anything you can say that would help us all have more confidence that you've got visibility into that. Or are you still having to run on the treadmill to get those deals? Just kind of help us understand why you still have confidence in that ELA guide.

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Ronald J. Pasek, NetApp, Inc. - Executive VP & CFO [8]

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So with respect to AR, it was linearity within the quarter and particularly within the month, and then, to a lesser extent, some of the mix of customers we saw that bought in the last 2 months of the quarter. You saw a similar phenomenon in Q4 where we ended pretty back-end loaded, and of course, collected all of that AR in Q1, which yielded a bunch of cash flow. It happens sometimes.

The other issue with free cash flow and cash flow which I mentioned in my script was larger cash tax payments, but I did reiterate the full year guide of 19% to 21% for free cash flow as a percent of revenue.

With respect to ELAs, I'll make a comment, then let George comment as well. Last year, this quarter we ended up giving you a full year guide of roughly 2% of revenue with the understanding that we can't easily contemplate when those ELAs come in within each quarter, but for the full year, we felt comfortable with that. We did that based on extensive conversations with parts of the sales force, making sure they understood the importance of this and the fact that it has a huge impact on earnings because it's essentially pure profit. So that was a further conversation this quarter and it led to the continued commitment for the second half.

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George Kurian, NetApp, Inc. - CEO, President & Director [9]

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With regard to ELAs, Rod, I think the fundamental thing that we are doing with them is to enable streamlined customer purchasing. It doesn't require them to spend the whole amount of the ELA upfront. It's really to make their overall multiyear procurement agreements with us a lot more streamlined and to enable us to get a broader strategic footprint in the account.

We know these accounts. Some of them have impending events that this would clearly enable things to get more streamlined, and so we're working it, right? It's -- we have visibility into these accounts. We know who these accounts are, and we're working hard to bring these forward.

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Operator [10]

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Our next question comes from the line of Karl Ackerman with Cowen.

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Karl Fredrick Ackerman, Cowen and Company, LLC, Research Division - Director & Senior Research Analyst [11]

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George or Ron, if I may, going back to your outlook for December, it seems you're implying the non all-flash array business will decline about 6% sequentially. That seems to be about in line with the seasonal average use of nearline drives. But at the same time, 2 of your hard drive suppliers have spoken about improved nearline shipments in December and for the first half of 2020, [and you know] you also launch 2 new mid-range hybrid arrays at Insight. So are there competitive forces impeding your ability to do a bit better in hybrid arrays over the next few quarters or is it just conservatism?

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Ronald J. Pasek, NetApp, Inc. - Executive VP & CFO [12]

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So I'm not really sure I understand your question. We're guiding total revenue. We're not guiding even specific product revenue, and within that, not all flash. So I'm not sure I quite understand where you're going with that.

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George Kurian, NetApp, Inc. - CEO, President & Director [13]

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We feel good about our position in the hybrid array market. We are, without question, across a range of customer and analyst surveys, the best hybrid array vendor. We've introduced 2 new models. I think what we are framing up for the next quarter guide is really an overall product number. We're not forecasting it to the level of specific product components at this point.

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Operator [14]

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Our next question comes from the line of Mehdi Hosseini with SIG.

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Mehdi Hosseini, Susquehanna Financial Group, LLLP, Research Division - Senior Analyst [15]

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George, I want to go back to the topic of install base. In the past, you've talked about install base that is only penetrated in the teens. So how do you see, especially in the context of a strong AFA results for the October quarter?

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George Kurian, NetApp, Inc. - CEO, President & Director [16]

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We are up a few percentage points. We're up at 22% of the install base now being on AFA. As we've said before, our install base is growing. And so while we ship a lot of new systems each quarter, the size and scope of the install base and its growth leaves the total AFA penetration at a small number which allows us to have opportunity to continue to refresh over time the rest of the install base.

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Mehdi Hosseini, Susquehanna Financial Group, LLLP, Research Division - Senior Analyst [17]

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Sure. Just one clarification, if I may. Would the end-of-life support for ONTAP 7 actually help expedite or increase the penetration rate?

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George Kurian, NetApp, Inc. - CEO, President & Director [18]

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Some of those customers that have not upgraded so far, this is a small number. But certainly, some of those, if they look at the economics today of a platform like our C190, they would choose to go all flash than go to a 10K disk-based system because the economics are already better with our solutions to replace 10K drives.

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Operator [19]

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Our question comes from the line of Aaron Rakers with Wells Fargo.

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Aaron Christopher Rakers, Wells Fargo Securities, LLC, Research Division - MD of IT Hardware & Networking Equipment and Senior Analyst [20]

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I just kind of want to understand a little bit on the guidance side. It would appear, based on the gross margin guidance in the current quarter, that you're not obviously factoring in an ELA. I think last time, it was like a 400 basis point benefit that you saw in product gross margin.

So if that's true and we kind of think about the set-up going into the April quarter to kind of hit the full year guidance level, number one, are you factoring in a revenue contribution to kind of hit an absolute increase in revenue in the April quarter that includes an ELA, and therefore, we should also be thinking that the gross margin into the April quarter is significantly higher just because that ELA contribution would fall into that if you kind of hit that 2% of total revenue for the full year? Or is that just not factored into your guidance at all? I'm just -- I'm trying to understand how you kind of think about the mechanics of the implied guidance for the April quarter.

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Ronald J. Pasek, NetApp, Inc. - Executive VP & CFO [21]

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Yes. So remember, as we go through the fiscal year, this -- for Q3 and Q4, product revenue becomes a larger part of the total, which overall is dilutive to overall margin, right? So you can't just look at the numbers and say you're holding total margin flat to Q3, therefore, you don't have an ELA in it because the mix of product versus services is higher in Q3, obviously. So there is some ELA in Q3, and there absolutely is some in Q4.

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Aaron Christopher Rakers, Wells Fargo Securities, LLC, Research Division - MD of IT Hardware & Networking Equipment and Senior Analyst [22]

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Okay. And on an absolute basis, April quarter versus what you've done over the past few years -- I think early '18, the storage market was fairly healthy, so I'm just trying to -- do you have a line of sight that says, look, on an absolute sequential basis you can kind of see that kind of jump that you saw back in 2018? Or is there something else that I'm just not thinking about in the model?

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Ronald J. Pasek, NetApp, Inc. - Executive VP & CFO [23]

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Well, again, you've got the benefit of ELAs in Q3 and Q4 which you didn't have essentially last year, Q3, Q4, to a great extent. That helps things, all things being equal.

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Operator [24]

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Our next question comes from the line of Katy Huberty with Morgan Stanley.

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Kathryn Lynn Huberty, Morgan Stanley, Research Division - MD and Research Analyst [25]

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EMEA was stronger than other segments. Can you talk about whether that was your own execution or did you see some improvement in the market? And then just generally speaking, can you comment on the spending environment relative to the caution that you highlighted in the first quarter in the major segment?

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George Kurian, NetApp, Inc. - CEO, President & Director [26]

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We saw Q2 relatively unchanged from Q1. And as we said at the start of the year, Q1 was a step-down from calendar Q1 which was our fiscal Q4 of last year, but Q2 was not -- there were no major changes overall in terms of the trajectory from Q1 in terms of spending.

Customers continue to be cautious. They are scrutinizing transactions. They're buying for what they need today. And the differentiation of our offerings is clearly visible in the fact that our gross margins were really, really strong.

With regard to EMEA, our teams have done a really good job, and I want to salute our sales teams. There's a lot of execution that has been a big part of our strength in EMEA.

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Operator [27]

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Our next question comes from the line of Matt Cabral with Crédit Suisse.

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Matthew Normand Cabral, Crédit Suisse AG, Research Division - Research Analyst [28]

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The services business was down a touch if you put together both hardware and software. Just wondering if you could talk a little bit about where you are in addressing some of the renewal issues that you've highlighted on prior calls and just how we should think about a return to growth for services going forward.

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Ronald J. Pasek, NetApp, Inc. - Executive VP & CFO [29]

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So we've made some progress. You can see that we're essentially flat when you adjust for FX. We still have some work to do. There's some organizational work we're doing. There's some process work we're doing. You can't see that yet manifest itself in growth, but as George indicated, the install base is growing and we believe that eventually that will get back to growth as well. And you can see that in the deferred revenue number. So it's not going backwards, which is good, as it did in Q4 of last year, but we still have some work to do.

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Operator [30]

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Our next question comes from the line of Alex Kurtz with KeyBanc Capital Markets.

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Alexander Kurtz, KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst [31]

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George, on the last call, it seems like the sales force productivity issue was really the main driver to the reset. And I'm sure -- we touched on macro on that call, but it just seemed like that was really the focus from the team. So then fast forward 90 days and you seem very optimistic about the hiring of the new reps. And I just wonder what gives you the confidence 90 days later? Because it seemed like it was a pretty big setback internally as far as how the team was working, but maybe we were overestimating that and maybe things weren't as difficult to kind of fix as far as hiring productive reps and ramping them.

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George Kurian, NetApp, Inc. - CEO, President & Director [32]

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Listen, what we said on the Q1 call was that the quarterly results reflected 2/3 macro, 1/3 sales execution. And so it was a reflection of the macro in the purchasing behavior of our largest customers that drove the majority of the impact in Q1.

We've always believed that our portfolio is really strong. And given our position in the market, we have ample room to capture more accounts and to invest some of the really strong gross margin leverage that we're seeing into investment in field sales coverage. We've always believed our story is differentiated in the market. We're doing exciting things, and we are an attractive place to work. So we've been pleasantly surprised with our ability to hire good quality salespeople, and we're focused on getting them productive and ramping them. I think I would just say we are heads down and focused on execution.

Q2 saw an improvement relative to Q1 in terms of our ability to execute and capture the deals in front of us. We've got to keep doing that, and I expect us to continue to do that through the course of the year.

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Operator [33]

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Our next question comes from the line of Amit Daryanani with Evercore.

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Amit Jawaharlaz Daryanani, Evercore ISI Institutional Equities, Research Division - Senior MD & Fundamental Research Analyst [34]

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I guess, Ron, you're taking up gross margins fairly notably for fiscal '20. Structurally, I'm wondering, do you think 67%-plus gross margin is something that's sustainable long term? Or were there some specific benefits that were maybe more onetime in nature in fiscal '20 versus longer term? How do we just think about the levers that are enabling this upside? And then, George, how do you think about Dell's upcoming mid-range solution and what that could do from a pricing or competitive basis to you guys?

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Ronald J. Pasek, NetApp, Inc. - Executive VP & CFO [35]

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So Amit, I think if you look at where we are in the quarter and then implied in some of the guidance for the rest of the year, we are at the model we articulated at our Analyst Day for product margins 1.5 years ago. So we said 55 at that point. After the 606 change, I said 56 to 57. And so yes, I believe it's completely sustainable. It's a good 10 points below. One of our competitors is an all-flash competitor. It's 10 points above where we were 2 years ago. So it's a really good place to be, and they have -- it gives us a lot of flexibility to still be aggressive but not under-earn.

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George Kurian, NetApp, Inc. - CEO, President & Director [36]

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With regard to your comment about Dell EMC, we feel very good about our solution set. We are seen by Gartner and customers as the leader for primary storage, and we are the only vendor in the market with a comprehensive cloud strategy. And so we feel good about our position in the market, and we're going to capitalize on it, which is why we're investing in sales capacity to go capture net new accounts and expand wallet share within existing accounts.

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Operator [37]

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Our next question comes from the line of Andrew Vadheim with Wolfe Research.

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Andrew Teutli-Vadheim, Wolfe Research, LLC - Research Analyst [38]

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I wanted to follow up on a prior question and how it relates to guidance. So you mentioned the weakness you're seeing and sort of deteriorating macroeconomic environment, but just wondering why you decided then to tighten the full year guide, especially on revenue, kind of taking it from a 5-point range to a point estimate.

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Ronald J. Pasek, NetApp, Inc. - Executive VP & CFO [39]

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I think when you think about the guide, we have 2 quarters of actuals. I'm guiding Q3 discretely, so you essentially have 3 of the 4 quarters. I think it would be strange to give -- keep the same 5% to 10% down when, in fact, we kind of know where we think we'll be in Q4.

Remember, Q4 last year is a relatively easy compare. We were down 3%. So getting to that number should not be that difficult, whereas the first half of this year was much more difficult compare. Couple that with the fact that we have ELAs in the second half. We didn't have them in the first half. I just felt like it was a better thing to do.

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Andrew Teutli-Vadheim, Wolfe Research, LLC - Research Analyst [40]

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Okay. And then separately, public sector was kind of down sequentially. Just was wondering to what extent that was expected. And should we think of public sector sort of being in line with the rest of the company on a year-over-year growth basis in sort of Q3 and 4Q?

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George Kurian, NetApp, Inc. - CEO, President & Director [41]

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Over the last year or 2, we started to shift the mix of our public sector business to be more program-related and broadened the book of business beyond just the Fed to state, local and higher education and other parts of the market. As a result, you will see the business trend towards more of a standard pattern as opposed to a big step-up in Q2.

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Operator [42]

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Our next question comes from the line of Simon Leopold with Raymond James.

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Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [43]

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I wanted to see if we could touch a little bit on what you're seeing in the macro environment given what we've heard from others reporting tonight. It sounds to me that maybe you saw some of the deterioration of enterprise demand a little bit earlier and so this is more of an issue of timing. And what I'm really looking for from you is how the demand has maybe evolved or changed over the course of the quarter versus what you talked about in August. Is the weakness shifting among verticals, steady, how's it changed?

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George Kurian, NetApp, Inc. - CEO, President & Director [44]

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I think in aggregate, we did not see a material change in Q2 from what we saw in Q1. With regard to the exposure of specific verticals and so on, we have a broad book of business. We wouldn't say that we are exposed to any particular vertical to be able to comment specifically about it. I would say it's reflective of the news that you see in the market, right?

And there are teams in countries like Germany where the spending pattern is tight who are executing really, really well for us. And we did see some slowdowns in other parts of the world, but nothing that's unique to NetApp.

And it's -- our view is Q2 is reflective of a more stable long-term pattern that we see in the market, and it hasn't materially changed from Q1. And that's what we're planning our business around to capture the value from our differentiated offerings by being disciplined on price and extracting the value that we feel we deserve and then investing some of that benefit from gross margin and operating margin leverage into the quota-bearing sales capacity that we talked about last time. And we feel that the combination of the 2 should allow us to get our business back to growth over time and continue to deliver the earnings model and returns to shareholders that we've committed to.

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Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [45]

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Just to clarify one thing. Did you see seasonal strength in the federal vertical in the most recent quarter that sets up a tougher sequential comp in the January quarter? Is that material for you?

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George Kurian, NetApp, Inc. - CEO, President & Director [46]

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Our book of business in the public sector market is increasingly broad. We have diversified our book of business to be deployable in program spending which is not driven by any specific seasonality pattern. We are growing our footprint in state and local governments. So the public sector business had its normal year-end pattern, but it's a smaller component of our -- the Fed business is a smaller component of our overall public sector business.

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Operator [47]

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Our next question comes from the line of George Iwanyc with Oppenheimer.

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George Michael Iwanyc, Oppenheimer & Co. Inc., Research Division - Associate [48]

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George, you continue to be pretty bullish on adding new customers especially with your cloud offerings. Can you give us a sense of whether that's just share displacement there, primarily new workloads? And is that transitioning over to some traditional storage sales as well?

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George Kurian, NetApp, Inc. - CEO, President & Director [49]

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We are certainly seeing a broad range of workloads being deployed on our cloud solutions, e-commerce, databases like Oracle and SAP HANA, which are high-performance transactional workloads, we see generics and bioscience applications, vertical applications for oil and gas and health care. So a really broad set of application that require consistent performance and high availability. And I think that's what we are uniquely positioned in the cloud for.

There are customers and many that are saying that, listen, we're going to -- if we're going to use you in the cloud, we want to harmonize our on-premises environment so that we can move workloads between the 2 landscapes. And with our announcement of Keystone, a subscription service for on-premises environments, they can now have not only the technology that allows them to standardize workload models between on-prem and public cloud, but the customer experience and the consumption offering that allows them to do that.

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George Michael Iwanyc, Oppenheimer & Co. Inc., Research Division - Associate [50]

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All right. And just expanding on your Keystone comment, how long do you think the selling motion will take to get that up and running?

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George Kurian, NetApp, Inc. - CEO, President & Director [51]

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I think that, listen, we don't believe that Keystone subscription services will replace CapEx purchasing, right? We think it will be a part of what customers want for their IT landscape. We are doing the work to enable our sales teams to be able to position that offering in the right way into customers, and we think it'll take time. We'll give you updates as we go.

With regard to our business model, we hold the assets on our books. You'll see depreciation similar to what -- where in the P&L we have -- we report cloud data services depreciation, right? So it's not going to be material this year.

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Operator [52]

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Our next question comes from the line of Jim Suva with Citigroup.

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Jim Suva, Citigroup Inc, Research Division - Director [53]

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And George, you've been very vocal about hiring [into more] sales, and can you just remind us of the cadence? Is it kind of higher during 6 months train, get relationships growing 6 months after, so we're kind of looking at fiscal kind of '21 or kind of summer of next year, and all of a sudden the fruit really starts to bear from these efforts? Is that the right time line or I might be off on that?

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George Kurian, NetApp, Inc. - CEO, President & Director [54]

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We said that -- just to go back to what we said, we said that we were going to hire 200 incremental demand-generation headcount over 4 quarters, with the last quarter being Q1 of fiscal '21. And we're on track. It takes 3 to 4 quarters to train a rep and to get them to full productivity. So we think that the predominant benefit of this additional capacity will be in fiscal '21.

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Jim Suva, Citigroup Inc, Research Division - Director [55]

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Great. Thank you so much for the clarification. It's greatly appreciated.

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Operator [56]

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Our next question comes from the line of Lou Miscioscia with Daiwa Capital.

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Louis Rocco Miscioscia, Daiwa Securities Co. Ltd., Research Division - Research Analyst [57]

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Okay. So 2 questions sort of combined together. One of the things about the sales force, you said a good portion of the sales force wasn't selling the entire product line. Given obviously the relationships they have there, I assume this is just more of a reeducation and maybe some adjusting to the sales plan. So I'm just wondering how is that actually happening, how is it going? And then combined with that, maybe this is a part of it, obviously, flash improved significantly on a quarter-to-quarter basis. Just -- you went through some of the impacts last quarter, but how did you get flash bouncing back so quickly this quarter?

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George Kurian, NetApp, Inc. - CEO, President & Director [58]

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I want to credit the field organization for focus and execution, right? I think we said that what we were going to do was to focus on the big market transitions, disk to flash, traditional IT to public/private cloud, and the deployment of enterprise workloads in public clouds as sort of the key areas where we would attack the market. And I think credit to the sales leadership and the sales force for the progress in all flash.

With regard to the comments you made earlier about our ability to sell the full portfolio, what we observe is that there are different buyers for some of our portfolio than the traditional storage buyer, cloud architects, DevOps, staff and workload owners like application owners. We have been focused on reaching them and bringing them to our user conference. We saw a substantial uplift in the number of people from those pedigrees coming to our user conference, reflecting both the success of our field and marketing teams in reaching them over time as well as the interest that they have in our portfolio, right?

So we need specific competency to go after those types of sales motions, and we're bringing that into the company as part of our 200 headcount. And of course, we're focused on training the storage-focused sales force on expanding their relevance to some of these new audiences.

So work's underway, as I said. We're heads down in executing against these 3 imperatives. We saw the benefit of that focus in Q2, and we're going to continue to stay laser-focused on that through the rest of the year.

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Operator [59]

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Our next question comes from the line of Ananda Baruah with Loop Capital.

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Ananda Prosad Baruah, Loop Capital Markets LLC, Research Division - MD [60]

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George, at your last Analyst Day, you guys talked about mid-single-digit revenue growth. Now that you're getting the sales force sort of call it reoptimized, I mean maybe even reoptimized is distinct from the adding. Does the optimization process put you in the position longer term to do stronger revenue growth if you are marketplace optimized? And just real quick, Ron. I believe you had some ELA expectation in the results for the quarter. So did you -- and you basically did in line revenue. So did you outperform your internal product revenue targets for the quarter?

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George Kurian, NetApp, Inc. - CEO, President & Director [61]

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So I think that we have many avenues to grow our business. We have a leading position in primary storage on-premises. We have a growing private cloud business, and we are the only storage vendor who can support enterprise workloads in all of the major public clouds. And so I feel like we have plenty of total addressable market.

We're focused on getting the company back on track to growth, right? And we'll tell you more about our long-term earnings model the next time we hold an Analyst Day.

I will just tell you that we have delivered on all of the elements or commitments we made in terms of gross margins and operating margins and so on. And barring the slowdown in enterprise spending this year, we were on track to meet even the top line numbers that we had committed.

So we feel strongly about delivering on our commitments. Right now, we are entirely focused on executing against the opportunities in front of us and getting the company back to growth. Additional sales headcount funded by the strong margin profile of our business is the first step. Getting them on board productive and all of that is the focus of the company right now. Ron?

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Ronald J. Pasek, NetApp, Inc. - Executive VP & CFO [62]

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And Ananda, you're right. I did mention in the Q2 guide we had factored in some amount of ELA, which of course, did not come through. And it was essentially the entire miss to the midpoint. It simply flops into Q3. So yes, we basically came in exactly where we thought, with the exception of that 1 ELA.

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Operator [63]

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Our next question comes from the line of Nehal Chokshi with Maxim Group.

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Nehal Sushil Chokshi, Maxim Group LLC, Research Division - MD [64]

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So really nice net new cloud ARR within the quarter of $11 million, which compares to $7 million in the year ago quarter. So that's a very strong net new ARR growth. Is that all Azure Files-driven or sales capacity-driven or something else?

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George Kurian, NetApp, Inc. - CEO, President & Director [65]

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The majority of our growth in cloud data services is from Microsoft Azure NetApp Files. We saw -- and the majority of that revenue is from net new customers, right? So we don't have a single large customer that's a big percentage of the total number. We're seeing good momentum across a broad range of use cases and a broad range of customers trying things out and deploying their first workload.

So as we go forward, we are focused both on continuing to acquire new customers, but additionally, to expand our footprint now that we've got success in some of these customers to broader sets of workloads. So thank you for that.

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Nehal Sushil Chokshi, Maxim Group LLC, Research Division - MD [66]

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And if I may, my understanding is that you do have some specialists trying to sell cloud data services, although I believe also the broader sales force is also capable of selling the cloud data services. What's the sourcing of this new cloud ARR between these 2 sales forces?

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George Kurian, NetApp, Inc. - CEO, President & Director [67]

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It's hard for me to comment on that. I think we've got multiple pathways into the market. We've got both specialists and generalists within our field who are focused on selling cloud data services as part of their remits. And we have the Microsoft pathway into market, which we are continuing to work to enable around the use cases and the expanding number of use cases of our technology.

So it takes time, but we're heads down and focused on it. And we're really excited about how successful the technology is in serving the customers that have come onboard, right? So things like databases and e-commerce and content management and media and life sciences and an incredibly wide range of applications, frankly, more than I had expected. We have compelling business advantage that we offer customers.

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Operator [68]

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Our next question comes from the line of Nik Todorov with Longbow Research.

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Nikolay Todorov, Longbow Research LLC - Analyst [69]

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Service margins continue to tick up despite, I think, you guys are still investing a lot in the CDS business which is a headwind which should abate at some point. Ron, can you comment about the runway? Or how do you see the opportunity to continue to grow services margins over time?

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Ronald J. Pasek, NetApp, Inc. - Executive VP & CFO [70]

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It's something that we are focused on in the sense that we're trying to get more efficient. Having said that, I don't want to be too much more -- higher than where we are today. It's not something I contemplated in our long-term guide at our Analyst Day, much [like] what you saw this quarter. So I think there's good work being done. There's some more work we can do, but we don't think that there's a ton of upside to that number.

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Nikolay Todorov, Longbow Research LLC - Analyst [71]

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Okay. And if I could just follow-up. At some point, in order to hit the fiscal year '21 guide for CDS, there needs to be a step function increase, I guess, on a quarter-over-quarter basis. I guess what are the -- what needs to -- what work needs to be done? Do you guys need Google also to go general availability to kind of start seeing really that inflection so we can -- so investors can get more confident around that target exiting fiscal year '21?

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George Kurian, NetApp, Inc. - CEO, President & Director [72]

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No, we started -- we got to general availability later than we expected given the complexity of integrating a really high-performance service so deeply into the hyperscale of cloud.

We are at GA with Microsoft. We have a clear line of sight into GA with Google, and we think that there is a broad -- the total addressable market's there. As I said earlier, the number of use cases that are being deployed on our platform is broader than we originally anticipated. And so we've got work to do to execute to train the sales force, to train the Microsoft channel, get our message out to market and bringing the customers to be able to deploy them on our platform.

We saw good start to that with the attendance at Microsoft Insight -- Microsoft Ignite and at NetApp Insight, where the number of people coming to talk to us and start to do proof of concepts with us were really good. So we've got our heads down. We've got to deliver on getting these customers successful. But we feel like we've got a really, really good platform, and the early results have been really good.

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Operator [73]

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Our next question comes from the line of Steven Fox with Cross Research.

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Steven Bryant Fox, Cross Research LLC - MD [74]

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Just one question from me. George, obviously, you're not making any grand ambitions about the macro. So when you mentioned the return of growth, I assume for next fiscal year, is it mainly driven by the sales force execution? Or how would you sort of rank and characterize what's most important in terms of getting back to top line growth?

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George Kurian, NetApp, Inc. - CEO, President & Director [75]

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I think it's really making sure that we can capture the full range of opportunities that are available in front of us. As I said, we have leadership positions in a broad range of categories of primary storage. We are the only vendor with a cloud strategy and really compelling technology available in the big public clouds, all of the big public clouds, and we need to be able to go and access the customers that are making those decisions, which is where the sales headcount focus is really a critical part of the go-forward plan.

The differentiation of our technology is evident in product gross margins, right? And the leverage of our business model is evident in the results we just showed and the guidance we gave. And I think for us, it's -- the macro is going to be the macro. We're going to go take share and to go after the addressable market. We're doing that prudently within the guidance of -- that we gave you and by prioritizing our resources against the biggest opportunities.

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Operator [76]

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Our last question comes from the line of Matt Sheerin with Stifel.

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Matthew John Sheerin, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Equity Research Analyst [77]

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Could you talk about the contribution you saw in the quarter from your big distribution channel partners? Several distributors and resellers have called out relative strength in storage following a very weak June quarter. Is that a reflection of the middle markets being a little bit more stable or bouncing? Or any changes in your channel partner programs?

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George Kurian, NetApp, Inc. - CEO, President & Director [78]

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The contribution of indirect channels to our business was relatively unchanged in terms of the overall mix of our business. It's approximately 80% each quarter. And we feel that, that's reflective of our overall book of business. Nothing unusual there.

Our -- you are correct that the mid-market is relatively less concerned about the impact of the global economic slowdown and some of the uncertainty there. And we have more opportunities to capture share because our share in the mid-market is a bit smaller than it is in the enterprise.

Our channel partners -- we're focused on enabling a focused set of channel partners so that they get the full impact of NetApp's enablement resources. And so we've got a narrow group that we work with, and we're pleased with the progress so far.

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Kris Newton, NetApp, Inc. - VP of Corporate Communications & IR [79]

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All right. Thanks, Matt.

I'll pass it back to George for some final comments.

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George Kurian, NetApp, Inc. - CEO, President & Director [80]

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Before we close, I want to underscore a few key points.

NetApp is helping customers deliver enormous business value in both traditional IT-led and, increasingly, in cloud-led use cases. Only NetApp has the strategy, the broad innovation portfolio and customer experience to help customers succeed in hybrid multi-cloud IT. We believe we can return to growth over time by selling the value of our differentiated portfolio and investing in additional sales capacity to reach new buyers.

As I saw at Insight and Ignite, we are making real progress here. We continue to be disciplined in our spending and have a strong financial model with growing gross margins and operating margins that enable us to return cash to shareholders and invest in the long-term health of our business.

Thank you, and I look forward to speaking with you again next quarter.

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Operator [81]

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Ladies and gentlemen, this concludes today's conference call. Thank you for participating, and you may now disconnect.

Everyone, have a wonderful day.