Q2 2024 NetApp Inc Earnings Call
Good day and welcome to the second quarter of fiscal year 2024 earnings call.
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After todays presentation, there will be an opportunity to ask questions.
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I would now like to turn the conference over to Kris 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 <unk> Dot 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 strategy.
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.
Now I'll turn the call over to George.
Thanks, Chris Good afternoon, everyone. Thank you for joining us today.
Due to improved on our solid start to FY 'twenty four in what continues to be a challenging macroeconomic environment. We.
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 remain 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.
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 outcome net app delivers for our customers.
Net up is at the forefront of the evolution of the storage industry, helping our customers turn disruption to opportunity with intelligent data infrastructure.
Today's organizations need storage infrastructure that harnesses the power of <unk>.
Public and hybrid cloud, while keeping data secure and protected from ransomware attacks.
They need infrastructure that supports dynamic workloads like AI cloud need them and open source applications.
And they need infrastructure that helps to create more sustainable data centers.
Only net app delivers an entire architecture of unified data storage solutions.
Based on one operating system on tap that supports any application.
Any data type and spans one premises and multiple cloud environments.
This comprehensive architecture delivers unparalleled simplicity of management.
Simplicity of deployment and consistency of automation.
All unified by common API and a single control plane.
We further elevate the customer experience with our blue XD sustainability dashboard and Netapp advance a common set of programs and guarantees that include storage lifecycle program, which removes the burden of upgrade cycle as well as storage efficiency ransomware.
Covering and data availability guarantees.
Intelligent data infrastructure combined 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 simplified data protection in a world of limited resources rapid data growth.
And increased cyber security threats.
Looking at the results of the quarter momentum from new products and the go to market changes. We made it started the year drove 10% quarter over quarter growth in hybrid cloud segment revenue to $1.4 billion.
Our all flash array business benefited from the growth of the E. F. F. C series, increasing 14% from Q1 to an annualized revenue run rate of $3.2 billion.
The F F. C series, all flash array continues to exceed our expectations delivering new to netapp customers and numerous wins over the competition.
In the quarter. We successfully competed against in all flash competitor would see theories do we need 16 million dollar deal and an infrastructure as a service company there.
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 of our storage systems.
And the right price performance ratio secured a win there.
Despite the competitors attempt to use price once they realize the value proposition was insufficient.
On tap one or 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 the optimized and AI ready versions.
U S. H C. C V family is a solution.
<unk> 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 airports E series to the on tap AI architecture lowering the overall cost of entry is 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 in 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 priorities growing first party cloud storage services.
We aligned our cloud sales specialists to our Hyperscale 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 ear or.
During the quarter, we engaged in a strategic review to sharpen the focus of our cloud portfolio as.
As a result, we will continue to prioritize cloud storage offering delivered through the hyper scaler, while refocusing some services such as cloud insights and into cluster to complement and extend our hybrid cloud storage offerings, creating greater differentiation and additional value.
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 aligned to customer preference for consumption offerings.
And we have decided to exit the fast backup and virtual desktop services.
We anticipate E R R headwinds of approximately $55 million.
Exited services and and renewed subscriptions in the second half of fiscal year 'twenty four.
Growth in first party and marketplace services are expected to partially offset this decline positioning us to enter FY 'twenty five 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 they are 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 services in the public cloud.
But we are natively integrated into all three of the leading hyperscale vendors and we're not standing still but disadvantage.
Just two months after introducing the G. C N B 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 vertex the eye with Google Cloud Netapp volumes as well as.
Cross protocol hybrid cloud AI pipeline on Amazon Epic X four net up on tap with support for stage maker studio notebooks.
Our position with the hyper scaler also enables us to displace legacy on premise competitors as customers migrate workloads to the cloud.
Our U S based medical equipment company chose FSX for net up on tap to replace a competitor's sand systems when they move their database workloads to the cloud.
This is the customers first engagement that net out.
Following a successful initial deployment they are evaluating FSX, then 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 FY 'twenty four despite continued softness in the demand environment due to the challenging macro.
Customers value a modern approach to hybrid multi cloud infrastructure and data management, which enables.
<unk> 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 Q.
Q2 was a very solid quarter in what continues to be a challenging macro environment with soft it spend.
Our relentless focus on consistent execution delivered results that met and exceeded our guidance ranges and drove record setting non-GAAP 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%.
So 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 'twenty three.
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 'twenty four.
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 I T budgets remain constrained in a challenging macro environment.
Adjusting for the FX tailwind of 160 basis points billings and revenue would have decreased 11% and 8% year over year, respectively.
Hybrid cloud revenue of $1.4 billion decreased 7% year over year and product revenue of $706 million decreased 16% year over year.
As discussed last quarter, the first half of fiscal year 'twenty, three revenue and most notably product revenue benefited from elevated levels of backlog entering fiscal year 'twenty three for.
For the second half of fiscal year 'twenty for year over year comparisons should be more apples to apples.
Support revenue and attached to our installed 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 'twenty four.
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 Hyperscale or 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% and product gross margin increased 1080 basis points year over year to 61% product gross margin benefited from three main factors.
Number one our mix 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 NAND pricing and mitigate margin pressure from rising prices in the future.
As NAND 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% FX tailwind.
These record results demonstrate the strength of our business model.
Correct 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 due.
DSO was 46 and inventory turns were 15 <unk>.
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 multiyear 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 'twenty for guidance.
Still a soft.
Spending environment.
We now expect fiscal year 'twenty for revenues to be down approximately 2% year over year, an improvement from our previous guidance.
We expect to see continued strength in product in Hyperscale or first party and marketplace services and as we worked 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 mix 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 net app.
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 investments and we are committed to delivering sustainable.
<unk> 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.
To ask a question. Please press Star then one on your telephone keypad.
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The majority of your question. Please press Star then two.
Today's first question comes from Mehdi Hosseini with <unk>. Please go ahead.
Yes.
Thanks for taking my question two quick follow up given the updated fiscal year 'twenty four revenue guide should we assume that.
The July product revenue 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 the momentum with some of these.
Higher margin higher capacity to product to what extent should we assume thesis.
Market share has enabled you to ride out the tough 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 workloads and use cases, particularly as time off soft.
Pending wherever we are aligned to the value that we bring.
And the software value of on tap.
Particularly useful in these all flash configurations. We are also expanding the total addressable market with the salary configuration of the C series and the high performance Flash products. So I'm excited about what the future holds for our flash.
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, Barry on your question on product revenue certainly for fiscal 'twenty four implied in the guidance is continued growth.
Growth in the second half for the product line total revenue growth averages about 4% for the second half we have now guidance for fiscal 'twenty five yet, but we certainly would we feel good about going into 'twenty five as it relates to our product portfolio and our operational improvements.
Thank you.
Thank you.
Yes, Ma'am. Our next question comes from meta Marshall with Morgan Stanley. Please go ahead.
Great. Thanks.
A couple of questions just one.
Realizing that you're saying, there's no kind of major contributor to the gross margin upside, but just how do you see them.
And NAND 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.
You know do you attribute kind of the more confidence and the year to the early success that you're having with C series do you kind of attribute it to science, you're kind of seen coming out of and so I just kind of what gives you more confidence on the year just given the dampened environment. Thanks.
Hey, Peter It's Mike I'll take the first one and then George I'll take the second one.
The comment in the script was specifically related to no one time transaction.
They drove the over achievement in product margins as we look forward.
Through the RASK in fiscal 'twenty born in 'twenty, five and he loves.
Let's start with the second half of 'twenty four we're currently guiding product gross margins between 50% and 60% as we all know we continue to benefit from the lowest component costs, we've seen in many years.
I've included some room in our guidance to be flexible and pricing as well as the mix of capacity and.
All seen from the industry analysts reports, we do expect the component pricing has bottomed out in our Q2.
So as we go throughout the rest of 'twenty four we do feel very good about our position for the rest of the fiscal year as it relates to purchase agreements that we have historically as well is pretty bad.
Similar to 'twenty four we are looking to extend that in the 25 and we will continue to work with our suppliers as we go through the rest of the year. I'd also note that historically you all know storage industry pricing evolved as component pricing changes and we expect that trend to continue so all that being said we feel good about the second half of 'twenty four.
We've included in our outlook.
Heading into 'twenty five we'll see how.
All things progressed as it relates to mix pricing and component cost and will guide 25, when we get to our Q4 call.
With that I'll hand, it to George.
With regard to your question on the.
The underlying factors that support our optimism in the guide first of all from a macro perspective, it's still a challenged macro with the 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.
We continue to see a more robust product business in the commercial or mid market.
Customer base, so no real fundamental change in the in the demand environment with regard to the two underlying factors support confidence. One is we are a much more focused go to market organization and we are seeing the second consecutive quarter of pipe.
<unk>.
Comments 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. So far all flash portfolio, we talked in the prepared remarks.
About a large competitive win against a purely flash competitor and we see that 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 Krish Shankar with kidney Carlin. Please go ahead, yes.
Yeah, Hi, Thanks for taking my question actually I have two question for George George first one kind of like what are the lead time for the storage products today, and what does that imply for your visibility when you look into calendar 'twenty four and the second question is I'm.
Curious whether on the on our storage content per customer does it have 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 timelines around it.
With regards 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.
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 cold and robust business. There we are starting to see early signs of trials that use case.
We generate of AI generated AI is particularly well suited for net apps capabilities because they operate on unstructured data files documents video audio and so on and so we have large repository of those 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 generation of AI document summarization analysis, and so on and we are the.
Structure foundation to that so it will take time for generate of AI to become a demand driver. We are seeing early positive signs.
Thanks, Josh.
Thank you and our next question.
It comes from Steven Fox with Fox Advisors. Please go ahead.
Hi, Good afternoon, I had two questions on the product business. So first of all I'm not sure.
Fully understanding what you were saying about the pricing environment. 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.
You know, how how challenging or not challenging it is to.
The whole pricing and in these gross margins in the second one is related to that 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 chain.
Changes in NAND pricing thanks.
So 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 at any particular transaction or other depending on their own strategic reasons overall, we don't see fundamental changes.
In the pricing environment.
In the room with lower component cost gives you an opportunity to do more in terms of.
Pricing flexibility, but I think that our past quarters gross margin results are demonstration of the fact that we do.
Able to maintain pricing discipline at a time, where demand is soft and it starts 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 I'll refer to George's comments, David when I talk about the sustainability. So.
So we finished at 61% product margins in Q2, we guided a range of 50 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 'twenty for the reason why we guided slightly lower than Q2 from a margin perspective is exact.
What George talked about.
We feel really good about our pricing discipline in 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 costs. So hopefully that helps.
We're not a guide in 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.
A little bit on the macro yeah, clearly, you're executing really well and should we.
Should we expect.
Across the customer base in general as people start to appreciate maybe more pricing being more attractive.
Or is this something that was specific to net up just given the success that you're seeing in your C series.
Yeah.
I'll take the second let Michael cover the first Cynthia. Thank you for the question listen I think that with regard to customer adoption of flash based technologies.
They are you know we.
We saw the highest performance landscape move to flash several years ago, and there has 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 or more.
More in the general purpose.
Application footprint B.
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 10-K hard drive market that is.
About a.
30% to 40% of the hard drive market, so you'll see that move over time, and so I'll, let Mike talk.
So the first question Brad sure.
If you look at the midpoint of guidance for the year, we do expect it to be relatively consistent with the numbers, we like to talk about which is the 48% in the first half and 52 in the second again keep in mind that.
Good bit of our revenue actually 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.
Our next question today comes from Romsey Mohan It was 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 'twenty four 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 the railroad.
Basically I think before you were thinking 40% of total public cloud wondering where you're thinking that that might shake out in all of the long term.
So let me provide some baseline before I jump into the.
The strategy review takeaways on the implications.
Cloud is around 10% of total revenue.
Subscription is 23% of cloud revenue Dow.
One 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.
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 hyper scaler marketplace storage services.
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.
Our consumption offerings as we rollout one key services.
Summers that used to buy storage subscription referred to now go towards the <unk> 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 will refocus other services like cloud insights, which are subscription services and into cluster and differentiate net app in the cloud storage workloads motions that we are focused on.
Decided to exit some standalone services like virtual desktop and fast backup services.
This will lead to about a 55 million headwind from these actions in the second half of fiscal year 2004.
The reduction in public.
Public cloud subscription services will be partially offset by the growth of our consumption cloud storage services in particular, and so our plans for the second half of the year assume 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 'twenty for 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, sure and if I could Mike your your margins were really really strong both sequentially and on an absolute basis.
I'm wondering as we think about free cash flow margins, what would all the EBIT margin improvement flow through.
And the free cash flow margins and secondarily just wanted the EBIT margins.
Is there a way to dimension out of the three things that you noted.
Yeah, well, maybe rank order order of magnitude so that we can get some sense around the confidence of the sustainability, especially as it relates to commodity pricing, which you seem to indicate won't won't really matter too much sequentially, but just wondering what was the biggest sequential driver off that margin improvement. Thank you.
Sure. So 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 moved.
Moving with operating cash flow and then on the second question 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.
A significant impact.
Received some benefit.
Cost as those older inventory.
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 yes.
Yes, that's correct my sector.
Uh huh.
Thank you and our next question comes from the whole chalk she wears Muslim capital markets. Please go ahead.
Great. Thanks for taking my question.
You guys mentioned, 30% growth in first party store services, what's the and our our underlying that.
We don't break those out I think.
Azure and Google and we have brought higher price points for Amazon and so I feel really really good about the momentum in our first party cloud storage services.
Maybe frame it a different way the driver of that growth is expansion or lands.
Okay, Great and then a follow up quick question George you talked about how you had a $16 million win with the C series and he mentioned for drivers behind that which of those four drivers was really probably the biggest element of that.
<unk>.
So and I think we have a real.
Really strong operating system capability for performance and simplification at scale. Many of the other vendors that stock simple run into real trouble when you're trying 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 a reason and the number two reason is now that we have the C series, we have a price point to deliver to.
Two 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.
Just wanted to confirm that that's the case and then really the big element I'm trying to sort of tease out here is you've taken out $55 million of a R. R. So roughly $15 million.
Of revenue yet your your outlook is higher.
What is informing the higher outlook, what's been the biggest surprise.
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 small.
One two build out off we believe that these actions should allow us just to.
Get back to growth in fiscal year, 'twenty five off a healthier business.
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 listened and we said that when we guided the second half of the year.
Here, we took up the overall guide by close to $100 million.
That is mostly based on the momentum of our all flash and 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 'twenty four in our cloud subscription business, which will only be partially offset by growth.
And our cloud consumption business.
Yes.
Thank you. Thank you.
And our next question today comes from Aaron Rakers with Wells Fargo. Please go ahead.
Yeah, Hey, 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 we hear a lot about like AI, you know large language models, becoming smaller and implemented more maybe pervasive way over time.
Traditional enterprise environments, we've even 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 polling either discussions are early signs of demand.
And if so is it is it a prerequisite that that has to pull flash.
All flash storage with that that kind of footprint.
And the reason I ask is theres a lot of discussion about it 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.
Yes, 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.
The term is distillation, we do see that going on and customers, whereas the kind of run the different model. They begin to realize that you can get as effective and outcome with much faster results.
Then you know.
And a smaller number of parameters for example, the demonstration the live demonstration that we showed at Netapp insight actually bought the distillation, we started with a much larger LLM NB brought it to much smaller range of parameters because you get the same benefit so that's going on the second.
With regard to training environments, which is the part of the data lifecycle and AI. When you aggregate dataset and you train the algorithms or the language model for better answers to be able to predict a good outcome or generate a relevant outcome.
You do need very high performance storage, because the Gpus that drive those algorithms need very very fast and a lot of access to data and with our you know unstructured data scale out file system, we feel very well positioned for that and then the star.
David with regard to infancy interesting is the part of the data lifecycle, where you've taken a motto and now you want to put it into production on our data that could be on a factory floor could be in a distributed office there. It really depends on the data set and the use case what type of storage.
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.
Yeah, that's very helpful and as a quick follow up real quickly it.
Who is your predominant competitor that you see on the on the block optimize fee level, all flash arrays or theories of race.
It's all the block market is a crowded market, we feel very good about our offerings in the mid range, especially in the ability to offer a single solution with common automation common administration comment lifecycle management for both.
File and block and no other vendor in the market can do that.
And so feel very good I think.
The large competitors are clearly Dell and HP in.
In the mid range and then you occasionally see some pure.
Yep. Thank you.
Thank you and our next question today comes from Sami Chatterji with J P. Morgan. Please go ahead.
Oh, hi, thanks for taking my questions.
Yes, if I start with the public cloud strategic review that you disclosed just wanted to clarify based on the changes you're making there.
Any cost implications other changes.
Assuming that allows you to focus your go to market a bit more but is any sort of cost implications.
Nibbling, some caustic out there and secondly, Mike you mentioned sort of the 58% to 60% gross 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 'twenty five.
How should we think about the trajectory of the gross margin into fiscal 'twenty five.
Levels did you have to offset some of the flow back to the operating margin.
Really reporting annuity 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.
Ever cost opportunities. They are it's been factored into the second half guidance that we gave you.
Okay and then thanks for the questions for me.
No question, especially going into fiscal 'twenty five from the product margin I'll go over a little bit.
The answer to me that when she asked the same question so.
We've all seen from the analyst reports, we have we do expect that NAND is largely bought them. All 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 or purchase agreements for 24, well certainly look at those and continue to look at those and twenty-five but it has to make sense for both net app and our suppliers. So as we go into end of 'twenty five there are certainly some levers the big question there to meet that.
I don't have an answer to is what does the market do in pricing due over the next six months. That's why we're gonna wait we will guide the margin number when we guide for the full year, because we really want to get through the next couple of quarters see how component pricing goes well, we expect the mix to be and then what happens from a pricing environment.
Okay. Thank you.
Thank you.
Thank you and our next question comes from Ananda Baruah with loop capital. Please go ahead.
Yeah. Good afternoon, guys. Thanks for taking the question I guess, yeah, GA and in French related question, yes.
Maybe two quick part are you hearing any of your customers talk about.
Legislation around and putting having an impact on their plan and I guess, just generally speaking any any 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.
Generate of AI.
Predictive AI is quite mature and has very strong use cases, we have done really well in health care and life science.
In manufacturing and parts of financial services.
Lots of use cases, right and so I think thats mature it requires good data set.
And good data management to make it.
We have the right outcome, we can generate of AI. There is obviously a lot of discussion on both regulation as well as.
Judicious use of the technology everything from fairness to ethics to privacy too you know.
Al-qaeda cyber security all of those things that I think it will take time.
We are with most clients today is proof of concepts right. They are trying to put their datasets together. They are trying to learn on what these models will often do and there are some use cases, which are really easy just eat the benefits from software development, it's very easy to see the benefits from the more advanced ones.
Some of these concerns exist.
Seeing customers move cautiously so it'll take time. These are multiyear you know multi.
Multi year.
Year to transition use case developments and so we feel good about where we are at the moment and we're just realistic but it'll take time to build momentum.
Yeah. Thanks for the context that's helpful.
Thank you and our final question today comes from Sidney Ho with Deutsche Bank. Please go ahead.
Oh, 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 watch enterprises small medium business insurance and federal any particular verticals you would point out that shows particular strength or weakness both on the hybrid cloud and the other competition. 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.
For example tech and service provider spending has not really come back.
It's really a customer by customer situation.
Versus the broad industry situation with regard to the demand picture in midsized enterprise, our mid sized enterprise business performed more robustly and particularly better than our large enterprise business.
<unk> sector continues to be a work in progress you know we saw some of the impacts of the budget negotiations resulted 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 EPS all.
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 simplified data protection in a world of limited it resources.
Data growth and increased cyber security 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.
They are pushing us to deliver strong results in a challenged macro landscape looking ahead I'm confident that the momentum we saw in Q2, well continue through the remainder of fiscal year 'twenty four 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 will have a wonderful day.