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NetApp (NASDAQ:NTAP)

Q3 2013 Earnings Call

February 13, 2013 5:30 pm ET

Executives

Kris Newton

Nicholas R. Noviello - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Thomas Georgens - Chief Executive Officer, President, Principal Operating Officer and Director

Analysts

Kulbinder Garcha - Crédit Suisse AG, Research Division

Shebly Seyrafi - FBN Securities, Inc., Research Division

Andrew J. Nowinski - Piper Jaffray Companies, Research Division

Brian Marshall - ISI Group Inc., Research Division

Amit Daryanani - RBC Capital Markets, LLC, Research Division

Keith F. Bachman - BMO Capital Markets U.S.

Ananda Baruah - Brean Capital LLC, Research Division

Brian G. Alexander - Raymond James & Associates, Inc., Research Division

Kathryn L. Huberty - Morgan Stanley, Research Division

Maynard Joseph Um - Wells Fargo Securities, LLC, Research Division

Rajesh Ghai - Craig-Hallum Capital Group LLC, Research Division

Benjamin A. Reitzes - Barclays Capital, Research Division

Steven Milunovich - UBS Investment Bank, Research Division

Peter Misek - Jefferies & Company, Inc., Research Division

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Louis R. Miscioscia - Credit Agricole Securities (NYSE:USA) Inc., Research Division

Glenn Hanus - Needham & Company, LLC, Research Division

Mark A. Moskowitz - JP Morgan Chase & Co, Research Division

Operator

Welcome to the NetApp Third Quarter Fiscal Year 2013 Earnings Call. My name is Adrianne, and I'll be your operator for today's call. [Operator Instructions] Please note, this conference is being recorded. I'll now turn the call over to Kris Newton. Kris Newton, you may begin.

Kris Newton

Good afternoon, everyone. Thank you for joining us. With me on today's call are our CEO, Tom Georgens; and our CFO, Nick Noviello. This call is being webcast live and will be available for replay on our website at netapp.com, along with the earnings release, the supplemental commentary, our financial tables and the non-GAAP to GAAP reconciliation.

As a reminder, during today's call, we will make forward-looking statements and projections, including our financial outlook for Q4 and expected dilution from our convertible notes, as well as the benefits to us and our customers of our products, our expectations regarding future competitive position and expected benefits of partnerships, alliances and acquisitions, all of which involve risk and uncertainty.

Actual results may differ materially from our statements and projections for a variety of reasons, including among other things, general economic and market conditions and matters specific to the company's business such as customer demand for and acceptance of our products and services. We describe some of these factors in our accompanying press release, which we have furnished to the SEC on an 8-K. A detailed discussion of risk factors which may cause our actual results to differ from our forward-looking statements and projections is contained in our most recent 10-K and subsequent 10-Q reports also on file with the SEC and available on our website, all of which are incorporated by reference in today's discussion.

All numbers discussed today are GAAP unless stated otherwise. To see the reconciling items between the non-GAAP and GAAP, you may refer to the table in our press release or supplemental commentary or on our website.

In a moment, Nick will walk you through some additional color on our financial results, and then Tom will walk you through his perspective on the business this quarter.

I'll now turn the call over to Nick.

Nicholas R. Noviello

Thank you, Kris. Good afternoon, everyone. NetApp delivered solid financial results in fiscal Q3. Revenue of $1.63 billion was slightly above the midpoint of our prior guidance. We achieved non-GAAP gross margins of 60.4% and operating margins of 17.1%. Non-GAAP EPS of $0.67 exceeded the high end of our Q3 guidance range, and we generated $254 million in free cash flow in the quarter, just under 16% of revenue.

Revenue increased 6% sequentially and 4% year-over-year. Revenue from our Americas commercial, EMEA and APAC geographies all grew, both sequentially and year-over-year. Revenue from our U.S. public sector geography was down sequentially as expected but was up 14% from Q3 a year ago. Branded revenue of $1.43 billion was up both sequentially and year-over-year. Branded revenue grew 7% from Q2 and 8% from Q3 last year, while OEM revenue declined 3% sequentially and 17% from Q3 a year ago. Product revenue was flat from last year but up 7% from Q2.

Non-GAAP gross margins of 60.4% were in line with prior guidance and our targeted financial model. Product gross margins of 53.1% were down slightly from Q2 related to customer mix. Service gross margins of 58.7% were up just over 1 point from Q2 due to lower costs and the more favorable mix of revenues related to service contracts versus professional services.

Non-GAAP operating margins of 17.1% were just inside the range of our targeted financial model and exceeded prior guidance for the quarter. Non-GAAP operating expenses were down slightly from Q2, reflecting lower variable compensation and conservatism in spending, given the overall business environment. Non-GAAP other income net was down from prior quarters, reflecting interest expense related to our senior notes offering in December.

Our Q3 effective tax rate was 13.6%, lower than prior guidance and reflected a prior year discrete item and current year cumulative benefit related to the R&D tax credit approved by Congress in early January. For Q4 and the fiscal year 2013, we now expect a non-GAAP effective tax rate just below 16%.

Non-GAAP EPS exceeded the high end of our guidance range by $0.09, $0.03 of which was due to the lower effective tax rate and the remainder due to improved operating margins.

Our balance sheet remains strong with approximately $6.7 billion in cash and investments. The increase of approximately $1.2 billion in cash and investments from Q2 reflects the $1 billion in 5- and 10-year senior unsecured notes we issued in December. Total deferred revenue increased by $106 million from Q2, and accounts receivable day sales outstanding decreased slightly from 36 to 35 days. Inventory improved to 14.9 turns, with inventory levels down and normalizing to more historical levels.

Cash from operations was $365 million, and free cash flow was $254 million. Free cash flow was reduced by approximately $70 million related to the buyout of our remaining off-balance-sheet synthetic leases. Overall cash also reflects the repurchase of approximately $62 million of stock in the quarter and the completion of the acquisition of Cache IQ. We expect to repurchase 2x to 3x more shares in Q4 than we did in Q3.

Diluted share count decreased in Q3 by approximately 3 million shares. The accounting for the shares associated with our $1.265 billion of convertible notes had minimal impact on diluted share count in the quarter. The notes become fully convertible in March and will mature at the beginning of June. At that time, we will settle them with $1.265 billion of U.S. cash paid to noteholders and to the extent the average share price is over the strike price of $31.85, shares of common stock associated with the conversion feature of the notes. This dilution will be partially offset by note hedges at that time. As you may recall, 80% of our convertible notes are hedged.

Separately, our related warrants will come due beginning in September 2013 and may also create dilution if our share price is over $41.28 at maturity. We expect to repurchase shares to offset any remaining dilution associated with the maturity of our convertible notes, as well as our warrants.

Our target revenue range for Q4 is $1.7 billion to $1.8 billion, which at the midpoint implies just over 7% sequential growth and just under 3% year-over-year growth. We expect the growth of Branded revenue to exceed that of the total revenue and to be offset by flat to reduced OEM revenue. We expect consolidated non-GAAP gross margins of approximately 60% to 61% and non-GAAP operating margins of approximately 17%. We expect our blended consolidated non-GAAP effective tax rate to be just below 16%, bringing our non-GAAP EPS estimate to approximately $0.65 to $0.70 per share. Diluted share count is projected to increase to about 372 million shares in Q4 based on our average stock price of $36.02 for the first 10 days of the quarter. This will include about 5 million shares from the convertible notes. Recall that the impact of the note hedges is not included as an offset.

At this point, I'll turn the call over to Tom for his thoughts. Tom?

Thomas Georgens

Thanks, Nick, and good afternoon, everyone. In what remains a challenging macro environment, NetApp again performed well, with revenue coming in just above the midpoint of our prior guidance and EPS above the top of our range. The NetApp team remains focused on things that we can control: delivering innovation, expanding our partnerships and strengthening our go-to-market position. Our ability to execute in all of these areas by delivering innovative best-of-breed solutions creates a compelling reason for customers to choose our technology for the foundation of their shared and dedicated storage infrastructures and enables NetApp to deliver strong financial performance.

Our Branded business was strong again this quarter, growing at twice the rate of the total business year-over-year. Driven by the strong value proposition of Data ONTAP, the Branded business grew 8% from Q3 a year ago, its strongest growth in fiscal year '13. Data ONTAP is the #1 storage operating system and serves the needs of the shared storage infrastructure, which represents the vast majority of today's opportunity.

We are pleased to see strong customer adoption of ONTAP 8. Almost 50% of installed base has moved to ONTAP 8, and half of that has moved to the rapidly expanding 8.1 release introduced less than a year ago.

The adoption of clustered ONTAP is also seeing strong growth. The acceleration of clustered nodes continues, with units shipped up 70% from last quarter. We now have cumulatively shipped well over 2,000 clustered nodes. While some customers are still in the learning or early adopter stage, others have made it a standard for their data center. For example, in the course of 1 year, a new financial services customer has grown to 38 clustered nodes and roughly 12 petabytes of storage. In addition to the benefits of a limited scale performance and nondisruptive operations, customers value the reduction of complexity that clustered ONTAP brings to their environment.

NetApp has the most comprehensive Flash portfolio in the storage industry, offering solutions for both shared infrastructure and workload-specific requirements. As with clustered ONTAP, the value delivered by these solution is generating robust customer demand. Since the introduction of our first Flash solutions 3 years ago, we have shipped 36 petabytes of Flash, and more than 20,000 systems have been deployed with at least 1 NetApp Flash solution. By offering Flash solutions at the array, controller and server level, we enable our customers to get the performance they require at an optimum price. To date, NetApp customers have accelerated 3 exabytes of disk storage using Flash Cache. Bookings of systems with Flash Pools, our hybrid disk and SSD solution introduced in Q1, have increased 67% sequentially. Flash Accel, which enables customers to utilize server-based Flash to accelerate application performance without sacrificing any of the NetApp management capabilities, will begin shipping this quarter.

On last quarter's call, we talked about a highly competitive all-Flash array bake-off, in which we competed in one using the high-performance characteristics of E-Series and SSDs. In Q3, we booked more than 100 of these systems. You can expect NetApp to be much more aggressive on the all-Flash array front. Look for more news in the near future.

In Q3, we refreshed the FAS3000 family. The newly introduced FAS3220 and 3250 target enterprises and midsized businesses that are consolidating operations onto a shared storage platform. The new systems improved performance by up to 80% and increased storage capacity up to 100% over our existing products in this space. These new platforms already comprise 32% of the FAS3000 units shipped in the quarter. Overall, the units of the 3000 family were up 16% sequentially but down 24% year-over-year as there continues to be some migration between the FAS2000 and the older lower-end 3000 platforms. The FAS2000 product line continues to grow rapidly, with units up 10% from last quarter and up 55% from Q3 a year ago. The FAS6000 family was up 19% sequentially and flat from last year. In Q3, over 20% of our FAS6000 system shipped in clustered deployments and 19% shipped as hybrid arrays were Flash Pools.

Finally, over the course of fiscal year '13, we have seen a marked improvement in activity and pipeline for the Branded E-Series products. In Q3, we enhanced the E-Series Platform with improved performance, increased connectivity and greater data protection. Unit shipments of the E-series have grown 43% sequentially.

Partnering remains key to our strategy. Both our alliance partners and our reselling channel partners are core to our ability to globally deliver a complete innovation stack to our customers. There is no better example in the power of this strategy than FlexPod, a converged solution based on NetApp and Cisco technology sold by our joint channel partners for shared storage infrastructures. This solution has strong momentum, with over 2,100 customers in 35 countries and over 700 partners enabled to deliver the stack. During the quarter, we saw record new customer adoption of FlexPod.

In Q3, we expanded the Cisco partnership through deeper and broader solution integration and announced FlexPod for cloud service providers, FlexPod for branch offices and expanded application validation to include Oracle, SAP business objects, SAP HANA, Microsoft private cloud and the Citrix cloud platform. We also announced clustered ONTAP support for Citrix ShareFile, enabling customers who are storing their data on premise to leverage ONTAP software to access data, scale performance and capacity, reduce data center footprint and reduce costs.

Customers not only have a requirement for shared storage and dedicated storage infrastructures, they are also looking for new means of IT delivery utilizing the cloud. NetApp has long been focused on servicing the needs of the cloud service providers and customers looking for IT as a Service.

In Q3, we introduced NetApp private storage for Amazon Web Services, an enterprise storage solution that balances internal data center resources along with AWS cloud resources to best meet customer needs. The volume of activity around this solution is very promising.

Our indirect and OEM businesses represented 81% of revenue in Q3 and grew 7% from Q3 a year ago. Arrow and Avnet were 33% of total revenue, up from 27% of revenue last year. OEM business was 12% of revenue, down both sequentially and year-over-year. While we have always said that the OEM business will have a different growth profile than the Branded side, the 3% sequential decline was greater than we anticipated at the outset of the quarter. We continue to aggressively position our solutions with the OEM partners, some looking to do less business with us and others looking to grow.

We are pleased that we continue to make progress on our key initiatives: the adoption of clustered ONTAP, leadership in the Flash space and leverage through our channel and alliance partners. While there are some pockets of optimism, the global macro environment remains uncertain with renewed concerns in Europe and uncertainty in the U.S. federal spending due to looming sequestration. In every geography, we continue to see lengthening of sales cycles and large deals being drawn out. However, I am confident in our ability to execute and realize the payoff investments we have made in innovation and partnerships.

Finally, I would like to extend my congratulations to the entire NetApp team for being ranked #6 on FORTUNE's list of Great Places to Work. NetApp's culture is a competitive advantage and a key to our continued success. We are proud when our customers and partners say that it just plain feels different to work with NetApp. This recognition, our fifth year in the top 10, is evidence of our commitment to creating a model company.

At this point, I will open up the call for Q&A. [Operator Instructions] Thank you.

Question-and-Answer Session

Operator

[Operator Instructions] And we have Kulbinder Garcha from Crédit Suisse on line with a question.

Kulbinder Garcha - Crédit Suisse AG, Research Division

It's Kulbinder from Crédit Suisse. For Tom, I have a question, I guess. If I look at your full year, if I look at your guidance for the next quarter and even at the high end of the range, it looks like full year product revenue growth would still be down, maybe as much as 2%. I'm just trying to think, how do you think about that with respect to competitive environment, market share for the full fiscal year? How do you feel about that? And then kind of linked to that, your capacity growth only at 9%, which is much lower than any trend level we've seen historically. Do you have any insight as to why you're so low, Tom? Anything on that would be useful as well.

Thomas Georgens

So, obviously, a few questions there. I think in terms of our guidance for next quarter, clearly, it's a factor in the macro as we see it, the factors that I talked about in the prepared text around certainly concerned about sequestration, certainly concerned about Europe, negative GDP growth last quarter. I know we need to balance that against what we see, what our customers are telling us, what we see in our own business and what we see in the pipeline. That's what ultimately leads to the number. I think, certainly, it's a difficult environment to be aggressive in, but the guidance we gave is a combination of all those factors, probably a tough macro and perhaps a little bit more focused on our own customer base, where, clearly, we've had some momentum in the past 2 quarters. I think it's part of the product revenue. The key component there is to, ultimately, tease apart a couple of issues. Number one is the OEM business versus the Branded business. The OEM business is almost exclusively product revenue. So to the extent that there's a slowdown in that part of the business, it hits product revenue pretty hard. The Branded business is spread out a little bit more than that. But if I look at this particular quarter, our Branded business was actually up 8% year-over-year. That's the strongest performance of our Branded business all year long. So if anything, that business is probably stronger now than it's been all along. To kind of glean the market share out of all of that is what is the product revenue growth of the Branded business because that's the only part that counts in the market share number, and I don't think we reported that. But the growth of the Branded product revenue, which would be correlated with the market share, is greater than our overall year-over-year growth. So that would put it in certainly single digits but mid single digits. And from a market share perspective, there might be somebody else at that level, but I don't see anybody doing better than that. So I got to believe that this number from a market share perspective has to be an increase in terms of our performance year-over-year. The broader question around the drive capacity, that's a function of a few things. Part of that is also the OEM business is a factor in that as well. The OEM business was bigger last year. The other thing is -- also has to do with product mix. We certainly saw a big push of the low-end platforms, which are good upgradable platforms and new footprints for us for the future, a new customer acquisition. But they're not as capacity laden as some of the other ones. So I think at the end of the day, it's not something that we're alarmed about. I think it's a function of the product mix, both OEM versus Branded and, likewise, high end versus low end.

Operator

And we have Shebly Seyrafi from FBN Securities on line with a question.

Shebly Seyrafi - FBN Securities, Inc., Research Division

So your OEM business was actually getting worse. Growth-wise, I think it was down 17% last quarter versus down 9% in the prior quarter. It seems that's a big headwind, and I think you said in the prepared remarks that you expect flat to reduced growth in fiscal Q4. So are you thinking about this is it, basically, it's not going to be a headwind going forward and perhaps the product revenue growth can now accelerate to high single digits over the next year? And just your thoughts on that.

Thomas Georgens

What I think specifically about the OEM business is a few things. I think first and foremost, the OEM business is going to be dated by the sell-through with the OEM partners. And most of the partners in that portfolio have storage businesses that are actually down year-over-year and some by a substantial amount. But I think that's case #1. The other part of it, frankly, is that it was down lower than we would have thought. So clearly, there's the behavior of the OEMs itself. And I think the OEM business will be different than our Branded business in that it will be a combination -- it will tend to be a little bit more volatile over time as make-buy decisions on their part shift back and forth. Likewise, we add new OEMs, that tends to be lumpy. So I think in the long run, it's absolutely our aspiration to continue to grow this business. I expect it to be a little bit lumpy and a little bit volatile certainly compared to our Branded business. So certainly, it's not something that we're backing off on. I don't know if I'm necessarily going to call a bottom on it yet because that's going to be a function of the performance of our OEM partners. But that said, it's still an investment area, it's still an opportunity for us, and we're still looking to add new partners, which we did last quarter.

Nicholas R. Noviello

And the other point that I should add on top of that is that the E-Series OEM side of it, the E-Series Branded side of it, is actually picking up the pace quite a bit, and we actually saw some good momentum, particularly around the Flash products.

Operator

And we have Andrew Nowinski from Piper Jaffray on line with a question.

Andrew J. Nowinski - Piper Jaffray Companies, Research Division

I just want to touch base on the telco side. I think last quarter, you called out revenue doubled from the prior year. Did you mention anything on how that vertical performed this quarter? And then could you just provide any color in terms of what's driving that demand?

Thomas Georgens

Well, I think first of all, it's robust again. I don't think we put a number on it this quarter, not wanting to mix bookings and revenues, but it was still very, very strong. In certain areas of the world, we actually have a go-to-market channel that's around telco and service providers, which isn't the entire service provider opportunity. It does include SaaS vendors and stuff like that. And that was the strongest performing sector in the U.S. by far. So overall, that business remains robust. We made a bet a couple of years ago that this was going to be a big element of growth for us and a big segment as customers think about IT as a Service and they think about service providers. And if I look at where we are with the service providers, where we are with the various different cloud providers, I think that those investments are paying off, and I think we're seeing that in the growth. Certainly, other people have talked about the growth of that segment. But I think the role of the service providers, the role of IT as a Service, is increasing over time and necessitated a focus. But part of that business tends to look like an OEM business, and that is, you kind of work with them, you get design wins, you get design into their practices and their services and then they need to sell through. And I think we're clearly seeing that. So from a service provider perspective, although there isn't a really great number out there, but I would eventually guess that our market share there is higher than our aggregate market share in the entire industry. And I feel good about the payoff we're getting from those investments we made a couple of years ago.

Operator

And we have Brian Marshall from ISI on line with a question.

Brian Marshall - ISI Group Inc., Research Division

Yes, if you look at my entire covered universe, you have the highest percent of your market cap and net cash. And I was curious if you could give us a quick update on your thoughts with respect to M&A and pursuing innovation through external measures as opposed to internal. And then also from a capital allocation perspective, love to get an updated thought there as well.

Nicholas R. Noviello

Brian, this is Nick. Let me start that, and I'm sure if Tom has some comments, he'll add on to it. If you look at the cash and investments balance at the end of the quarter here, this is reflective of the notes and the $1 billion of notes that we issued in December. The other thing to think about is 50% of the cash is in the U.S. So a couple of things going on, let me kind of work through the pieces here. We have $1.265 billion of convertible notes coming due in June. Those are cash-settled convertible notes. So that is a $1.265 billion of U.S. cash due in June. So you have to really take that off of the 50% of cash and investments balance. Now let me kind of work the other side for a second, which is what are we doing with cash. If I look at cash from operations year-to-date, I pick that off the cash flow statement, 80% of that has been reinvested in the business. It's been reinvested in the business or returned to shareholders. The reinvestment from the business CapEx side, on the acquisition side, we've now got a set of technology tuck-ins that we've done. In terms of returns to shareholders, we've got a set of returns, 410 million so far this year. We're going to do some additional in the fourth quarter. All of those pieces will come through this year and show up in these numbers. So if I roll back to what I indicated at our Financial Analyst Day last June, it was really balanced in the use of cash, balanced in the use of cash in terms of investing in the business, balanced in terms of investing in M&A, balanced in terms of return to shareholders. We're doing all of those things. We expect to continue to do all of those things. We're in a period here where we've got a convertible note coming due in June. We've got senior debt that we issued in December. We've got a set of synthetic leases which were the remaining off-balance-sheet synthetic leases that are now done and taken care of in Q3. All of those things are kind of coming together and are part of clearing up and making obvious the capital allocation philosophy.

Thomas Georgens

Yes. I think another way to solve the cash as a percentage of market cap, obviously, is to make the stock price go up. And so we're working on that, too. But I think in general to your question on acquisitions, I've said in the past that as far as tuck-ins go, I think you should expect, just as we get bigger, we're looking for technologies, probably the rate of that will increase modestly. We did one last quarter. We just announced one today. So I think you should expect that kind of cadence going forward in terms of small tuck-in-type acquisitions. In terms of larger transactions, those are going to be very asynchronous. They're going to be a function of the opportunity, the price, the executability, obviously, the strategic fit. So I wouldn't forecast any trend on larger deals. Those are going to be entirely opportunistic. But as far as tuck-in activity, I think you should expect to see us, just as we get bigger and get more focused on this area, that probably, our historical rate will increase a bit. And like I said, you've just seen 2 in the last 2 quarters.

Operator

And we have Amit Daryanani from RBC Capital Markets on line with a question.

Amit Daryanani - RBC Capital Markets, LLC, Research Division

Just a question on your gross margin, especially on the product side. Can you talk about your -- despite the sequential growth you saw in Jan quarter, which you're expecting in April as well, it looks like gross margins are all kind of stuck in that 60.5% range at the midpoint. Could you just talk maybe what are the headwinds you see that's negating maybe the better revenue growth and then the better mix you're getting from stronger Branded revenues all year?

Nicholas R. Noviello

Yes. So I think there's a couple of things there, Amit. Let me start -- this is, again, Nick. Let me just start with quarter in Q3. And there was a set of questions going from Q to Q -- from Q2 to Q3 guidance and really a set of questions on what's going on, on the product side of the fence. Because if you looked at the guidance, it would suggest that the gross margins on the product side would be down a little bit. What's going on, on the service side of the fence? There's some different things going on in both areas. Okay? First of all, on the product of the fence, we suggested that -- and I think there was a specific question last quarter. "Hey, are product gross margins going to go higher?" We said, "Hold on a second, there's a couple of things going on." First of all, we have an OEM business. We've got a little bit of calendar year-end drag that's going to happen in product gross margins from an OEM business. As we close the quarter, there's probably less of that drag than we expected. There's probably some other elements that offset that in a few other areas in product gross margin. But at the end of the day, the 53.1% we did was probably pretty close to what we expected. There's been a noise over the last year on disk drives and the drag associated with disk drives. That's all behind us now. Q2 is generally a higher configuration mix quarter. That obviously is not going to happen in Q3. So all of the things, they're never going to be exactly as you'd expect, but all of those things came together and overall product gross margin kind of in the range of what we'd expect. If I look back 16 quarters, or if I look at Q3 to Q4 for the last 4 years, product gross margin is flattish to up. That's what we're expecting in the guidance here. It's flattish to up. It's a combination of what's going on in the Branded business, and it's a combination of the OEM side of the fence. If OEM revenue is flat to down, there's less drag because OEM revenue carries a lower product gross margin than the rest of the business. On the service side of the fence, we have inside Q3 a little bit better gross margin than we originally anticipated associated with mix of business. On the service side of the fence, we also manage and make investments from time-to-time. And many times because those investments are made to service the growing installed base, you make the investments in front of the installed base growth, okay, which means you are making them in advance of the revenue growth. So sometimes, that will mean that you've got a service growth -- gross margin decline in front of the revenue that occurs. We build all of those factors together and look at those in combination from Q3 to Q4. So in terms of the guidance range of 60% to 61%, again, I think that's based upon the bottom-up roll-up that I just took you through in some respects here. It's based upon the revenue side of the fence and that flat to down on the OEM and the up on the Branded side, on the product revenue side, and it's based upon the continued growth of installed base and the investments we need to make on the service side of our business from time to time.

Operator

And we have Keith Bachman from Bank of Montréal on line with a question.

Keith F. Bachman - BMO Capital Markets U.S.

I'd like to ask about your free cash flow targets. This quarter, I think it came in about 16% of revenues. In the past, you've talked about targets more in the 18-plus percent or 18% to 20%. And yet over the past few quarters, this has been tracking a little bit below that in kind of the 16% to 17%. Could you just talk a little bit about what you expect in the near term, in the April quarter, but more importantly, just talk about your longer-term targets for free cash flow yield, please?

Nicholas R. Noviello

Yes. So Keith, one of the impacts, and we talked about this last quarter, to free cash flow in Q3, was the buyout of those synthetic leases, right? [indiscernible] CapEx, that's going to drag free cash flow performance as a percentage of revenue. Our expectation is to be able to get back to that range we talked about at our Analyst Day. Our expectation would be for continued performance on the cash flow side of the fence in Q4. And so I think if I take it to the overall model, the expectation is to continue to move towards the ranges we've put out there, and you see that on the gross margin side. We're inside the range on that model we put out there, which was 60% to 62% for Q3. We hit the low end of the range of the operating margin, 17% to 19%. And we'll continue to work on the free cash flow side.

Thomas Georgens

Yes, I believe the impact of the synthetic lease buyout was $70 million.

Nicholas R. Noviello

$70 million.

Thomas Georgens

So that's a real number in the context of our overall free cash flow generation. In fact, you back that number out, we're pretty much in the range.

Operator

And we have Mr. Ananda Baruah from Brean Capital on line with a question.

Ananda Baruah - Brean Capital LLC, Research Division

Just a question on OpEx, if I could. All 3 OpEx lines are down from the October quarter. And I went back -- I just took a look back to the history. It's the first time, with the exception of the recession going back to the early 2000s, that, that was the case. So there was some anecdotal comments, I guess, in the prepared remarks about just being prudent. But could you -- it seems like for Jan quarter and the April quarter, there's a little bit more prudency than typical. And I'm just wondering if there's a sort of any kind of conscious shift in strategy and how long we might expect that to continue.

Thomas Georgens

Certainly, there's been no shift in strategy other than, clearly, it's a challenging environment. We need to be careful, whether it be in the guidance that we give or the targets we give it internally. But we still have a very, very broad agenda of expanding our partnerships, ongoing innovation, the introduction of clustered ONTAP. And you'll see some other announcements from us very, very shortly around some new technologies that we spent some time working on. So the investment profile is still pretty robust. And so we certainly haven't backed off on the innovation agenda, but we're being careful about how we spend on other types of things and trying to keep this well within the envelope of reasonableness. Clearly, until there's a high-growth environment, then we need to be very, very careful on the OpEx in order to continue to drive the operating margin improvement. And as Nick indicated, we're now in the range of our long-term model in terms of gross margin. We're in the range of our long-term model in terms of operating margin this quarter. And our guidance for next quarter would imply similarly. But clearly, we need to be generating growth in this business. So we certainly aren't going to cut off R&D and preclude future growth.

Operator

And we have Brian Alexander from Raymond James on line with a question.

Brian G. Alexander - Raymond James & Associates, Inc., Research Division

Yes, just a follow-up on E-Series. Tom, given some of the enhancement you've made for the platform, do you see E-Series competing more with some of your OEM customers' Branded offerings? And/or are the lines blurring at all with your core FAS offerings that you have these features and that, that may be contributing to the accelerated OEM declines we saw this quarter? Or do you still see this is an entirely separate use case?

Thomas Georgens

I think it's substantially a separate use case. I'd say in the specific case of IBM, clearly, they've got their own portfolio. And the positioning of the product within their portfolio, there's unquestionably overlap, and that's got clearly a factor. And I think that's certainly true now. It's certainly true even before Ingenio, where we have the E-Series. So I think the IBM is probably the one where there's competing factions within the portfolio. I think the other partners range from totally committed to this technology to having a clear defendable spot for this that doesn't have as much overlap. So I'd say partially in your question, yes, it's certainly true of IBM. In terms of competing with FAS, that's a lot less likely. Clearly, the price performance profile of this product really aimed at optimizing price performance and capacity is a segment that we've not gone after with FAS, per se. And if you look at where it's been successful, the vertical markets around high-performance computing, around media management, around video, around full Flash arrays, those are things where the price performance value proposition shows through, and I don't really think that, that's bleeding off any material FAS business. And that business, it's growth, plus the FAS business has generated the 8% Branded revenue growth that we saw this quarter. And we're quite pleased about that. That's certainly the best number we've seen in the year.

Operator

And we have Katy Huberty from Morgan Stanley on line with a question.

Kathryn L. Huberty - Morgan Stanley, Research Division

Can you just talk a little bit about linearity in the quarter? And specifically, what did you see demand-wise in the month of January after all the noise around the fiscal cliff in December?

Thomas Georgens

Well, for us, this is somewhat of an unusual quarter for us because we've got the calendar year in the middle of our quarter. And I would say the fiscal cliff and the looming sequestration and impact on federal spending, certainly, while the federal and U.S. public sector number growth were actually quite good, I wouldn't say that we were immune from those dynamics in any way. We certainly saw big deals being stretched out. We saw greater approval cycles necessary to make business happen. And I think the key to that is we just need to have more things in the hopper that are going to come out the other side. So I wouldn't say that our business wasn't subject to all the dynamics that you're hearing from everybody else. I just think we're in more deals, so we've got more partners engaged. And as far as linearity in the quarter, I would say that it wasn't that much different than other quarters that we've seen. I'd say that the budget flush at the end of the year was within range, although certainly not robust. And as far as January goes, since we're trying close the quarter when other people are starting to begin a quarter, I think our January dynamics are a little bit different than other people. So I wouldn't want to generalize on January. There's a lot of budgets that are being created, a lot of uncertainty in our customer base. So we'll see how it plays out. But like I said, I don't think that given our guidance and given the numbers that we put up in the EPS, I wouldn't say that we are immune to the dynamics. I just think we're in more deals, we're more engaged and we have our partners more engaged. And it's allowing us to have many irons in the fire now, and they came through for us this quarter.

Operator

And we have Maynard Um from Wells Fargo on line with a question.

Maynard Joseph Um - Wells Fargo Securities, LLC, Research Division

I'm curious if you can share your philosophy on market share versus margin preservation. Were there deals you walked away from? Or would you walk away from deals that are low product margin structure? Or would you manage the business more to a product margin? If you can just kind of share the philosophy there, I'd appreciate it.

Thomas Georgens

Well, clearly, as a company, we have to preserve the business model. So we're not going to chase business at any price. We have a field organization, particularly at the senior levels, that are very, very heavily compensated on margin on deals. But it's a portfolio. And would we take low margin business? Yes, we do. I don't think -- I'm not ashamed to say that. But it's a function of a number of factors. It's a function and a territory of what their portfolio looks like, or they basically have a good mix of good solid deals that they can absorb some low margin deals. And it's a function of where the opportunity leads. Sometimes, breaking into some big accounts takes some sacrifice on our part if we believe that there's big opportunity for us going forward, and those are strategic decisions we make every day. So absolutely, we walk away from ugly deals that we believe are not leverageable in the future or are not strategic to us, or a poor fit for our technology. Clearly, that happens. On the other hand, we also take some very ugly deals as long as they fit within the broader portfolio and where we are in the quarter, and we think that there's longevity and long-term opportunity in those accounts.

Operator

And we have Rajesh Ghai from Craig-Hallum on line with a question.

Rajesh Ghai - Craig-Hallum Capital Group LLC, Research Division

You've seen several announcements over the past few months which indicate that Cisco and NetApp are coming closer, at least as it relates to FlexPod. I was wondering if you could share any data, any quantitative information as to how this Cisco leadership has benefited you for the past few quarters, either in terms of the trajectory of revenue or for FlexPods or new customer wins.

Thomas Georgens

Well, we certainly share the FlexPod numbers on the call. And that number, I believe, is 2,100 new customers. In fact, we had the biggest acquisition of new customers around FlexPod this quarter. So I don't really see any slowing down of that momentum. And I think the key independent of any specific product component is I think that there's good alignment between NetApp and Cisco. I think our long-term view of the market and the role of Ethernet-based storage, I think we're very much aligned on that. I think if we think about how we go to market and very partner-centric, I think we're very much aligned on that. And I think the other component that we can underestimate is in terms of our aspiration and opportunity in the business. I think the opportunity for strategic overlap and strategic conflict is a lot less with NetApp than, potentially, some other partners. And as a result, I think we've got some good, clear momentum with a lot of runway ahead of us. So FlexPod is certainly something that's worked out very, very well. I think it's certainly been material to our business. I believe it's been material for Cisco as well. And some of the recent announcements that we did around some future joint development is actually expanding that not only in the FlexPod domain but around other use cases as well. So I think we're very, very pleased with the Cisco relationship. I think there's great alignment between the 2 companies. And I think that there's a clear runway of not a lot of strategic overlap and not a lot of conflict. And I think, frankly, that has helped us as well.

Operator

And we have Ben Reitzes from Barclays on line with a question.

Benjamin A. Reitzes - Barclays Capital, Research Division

Yes. I wanted to go back to the OEM business. Without the decline year-over-year in the high teens would have been quite a product quarter if that could have been a lot flatter. I guess the question is, looking in the next couple of quarters, Tom, how do you manage that decline? Should it -- do you feel it's possible to say that can actually maybe flatten out at some point? Or is it just something that we should model declining and a drag on the business like it was in the last quarter?

Thomas Georgens

Well, I think to answer that question, you'd have to predict the business trajectory of our partners, which, in many cases, look like the overall market. And I think that's probably a good first path approximation about where this is going. I think for us, in terms of the E-Series OEM, and the NetApp FAS OEM is in there as well, clearly, this isn't something that we're anywhere close to surrendering on. In fact, I see growth opportunity there. We're certainly pursuing other OEM partners. But I think that we need to be careful on the OEM business that we also bear in mind that within the OEM context and that technology set is also coming E-Series Branded, which is becoming more and more important to our business and we're seeing good bookings growth there. So E-Series in the aggregate last quarter -- last year had OEM business well ahead of our forecast and a little bit of slow ramp on the Branded side. This year, we're seeing the OEM business coming down a bit and certainly disappointing relative to that. But we are seeing the pickup on the other side. So in the aggregate, the E-Series is probably moving closer to where we originally anticipated this business to be, but we need some more Branded pickup to really get there. But as far as the OEM business, clearly, it's something that we want to see. It's very, very prone to the dynamics of the OEMs themselves. Their own make-buy decisions, and that's a business that will be volatile because those make-buy decisions can change. And when they do change, you can go one way or the other. But we're looking to add more partners. We have added more partners, and we clearly want to see growth out of that. But if we can see growth out of that business and continue the acceleration of the E-Series, I think that's a big amount of impending growth in that category that we've not yet realized, not really seeing on our P&L yet.

Operator

And we have Steve Milunovich from UBS on line with a question.

Steven Milunovich - UBS Investment Bank, Research Division

Yes, could you dig a little bit deeper in your government exposure, which, as you pointed out, was very strong, up 14% year-over-year? Yet you indicated some caution going forward. Maybe talk about some of the components of that. And do you still expect maybe single-digit growth going forward or it could be worse?

Thomas Georgens

Well, I think as we put together the guidance, we look at a number of factors and then weight those. So, I mean, clearly, we can all make our bet on how sequestration is going to play out. Is it going to play out as currently stated? Are they going to kick the can down the road? Is there going to be some type of compromise? And those are the things that we factor in. The other thing about the sequestration is it's not the entire federal business, and there are other areas of that, that we've actually had a pretty good quarter. And as you know, we've been trying to diversify our federal business over the last couple of years, and we've done that. And the other component of our public sector business is actually state local, and that actually has been a very, very high-growth business for us. And now, it's not a trivial part of our business anymore. Two years ago, when we started that, it was relatively small, and that's continuing to grow. The health care segment part of that is also healthy. So in terms of the U.S. public sector, I think it would be hard for us to claim that sequestration will be good for our business. But I think we're a bit more diversified than we used to be. But nonetheless, I think we need to be careful, and that's factored into the guidance we gave.

Operator

And we have Peter Misek from Jefferies on line with a question.

Peter Misek - Jefferies & Company, Inc., Research Division

I just wanted to get some color on penetration and pipeline for ONTAP upgrades and how it's looking for the rest of the year. Can you give us any data on how many people have upgraded or what kind of upgrade activity you have, trials, projects, et cetera, and how the pipeline looks for the rest of the year?

Thomas Georgens

Well, I think first and foremost, the sequential growth now has been very, very strong sequential growth, 3 quarters in a row. And the actual number of systems out there was over 2,000. So it's not a trivial number anymore. When we look at the 6,000 family, which is our largest systems, over 20% of those are being shipped with clustered ONTAP now. Now, in general, most of the clustered ONTAP nodes are coming with new equipment as opposed to being upgrading old equipment in the field. That's a general trend. So for us, it appears to be the momentum is very, very high. We did our training sessions at the end of last year for our technical people and our partner technical people. We did that in Europe, United States and Asia, and it was very, very well-received. So this is clearly a technology that we're pushing with very, very high energy. And I think that right now, the ramp is probably steeper than we anticipated. And if I had to summarize, I'd say they were probably a little bit slower starting, but the ramp is actually steeper than we thought. So I think that with the latest releases of the software, perhaps the last hesitancy both on the part of our sales force and on the part of customers may have been cleared away. And certainly, post-8.1, the acceleration has been quite severe.

Operator

And we have Jayson Noland from Robert Baird on line with a question.

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Tom, I wanted to ask about Amazon. Any more color you can offer on the partnership? What does the economics look like to NetApp? And, I guess, how do you think about cannibalization here longer-term?

Thomas Georgens

Well, in some ways, I kind of consider this similar to -- in the questions we got 4 or 5 years ago around de-duplication, and the question is, is that good for our business or bad for our business? And if we have 99% market share, then it might be a concern. But as far as Amazon, I think the simple fact of the matter is, is that they're spending billions of dollars building an infrastructure. There are certain use cases that are going to be interesting to customers. And customers have to manage the hybrid nature of it, that they'll have some data on-prem and some data off-prem. And it's an opportunity for ONTAP to basically manage that for them. So we can look at Amazon as purely a competitor, or we can look at it as somebody we can sell product to, but I think that there's a lot of value in us thinking about Amazon as an alliance partner that's going to build an infrastructure that will be integral to the environment and how do we enable customers to use that and use that effectively. It's a way for us to partner with Amazon. It's a way for us to help solve a problem for end users. And the way I see it is data will be in a lot of places. It will be on-prem. It will be in service providers. It will be on Flash arrays. It will be on FAS arrays. It will be in hyperscale providers like Amazon. And as far as we're concerned that what we want to do is we want to be in a position to manage all of that data no matter where it lives. And the other thing about the offering that we provide is an opportunity to have access to the customer could use the server farms that Amazon has, they could use the storage as well, or they could use NetApp storage all at the same time. And I think that's what's unique about it. So for us, what's innovative and what's really interesting is the customer response to this. We just got briefed on this yesterday and very, very strong customer response that's interesting in this technology. And maybe in a simple way of putting this, we don't make disk drives, but we do software to manage them. And I think we want to bring the AWS environment into our management domain. So I think there's an opportunity to innovate here, there's an opportunity to create value. And yes, will some storage go in that direction? Absolutely. I'm not in denial about that. But if we can manage that process and use data ONTAP as the central control point, then I think there's a big opportunity for us because customers clearly want to go that way with a certain set of their workloads.

Operator

And we have Louis Miscioscia from CLSA on line with a question.

Louis R. Miscioscia - Credit Agricole Securities (USA) Inc., Research Division

Tom, a question pretty much in line with that one that was just asked. When you look at some of the startups like Nirvanix and Cleversafe, they're not exactly like AWS even though some of the technology under their coverage is the same thing. But obviously, they're looking to manage the data themselves. So has that taken away any of your business, I guess, either in the last calendar year or looking forward? And maybe if you could talk about your own product mix-based storage grid. And it's sort of been buried within NetApp, is it starting to emerge at some point?

Thomas Georgens

Well, I think the whole cloud space is -- we can probably spend the whole call on that. And there's a bunch of definitions that we want to go through. But first of all, on-premise computing, really driving the private cloud enabled by virtualization, that's a big opportunity. It's an area we've been successful and something that I see still as a huge opportunity for NetApp, particularly on our clustered ONTAP, and that will continue to grow. Out of that, some of that business, customers are looking at SaaS models or IT as a Service. And in the process of doing that, that's been a big part of our service provider for us, is understanding that customers want to move in that direction. It creates a concentrated set of customers but ones that have massive scale and massive performance requirements and nondisruptive operation and multi-tenancy. And once again, that's a good match for clustered ONTAP. So some of that business will move to other types of cloud providers. And clearly, that's a target for us and something that we've invested in and actually one of the areas of our business that's growing the fastest. And then there's this broader category for hyperscalers, and that's what we're talking about here. I think that there are a set of workloads where those are not appropriate, and there's a set of workloads where those are, which means that end users are going to have some amount of their data on-premise, some data in service providers and some data at the hyperscalers. And I think somebody to broker all of that, I think, is really important. I think a single-point solution around any one of those is going to be an island of storage, and I think it's NetApp's opportunity to integrate those. So rather than doing Google or Azure or Amazon as purely a competitor, the question is, what about them as an alliance partner as part of the overall hierarchy of storage and the infrastructure of a data center? And that's our play, and it's really interesting to see what the response has been to this announcement that we did with Amazon.

Louis R. Miscioscia - Credit Agricole Securities (USA) Inc., Research Division

And your storage grid?

Thomas Georgens

Well, storage grid is clearly a different type of opportunity. What Amazon and some of these other technologies are driving is really object-based storage at scale. And whether people want to build that capability in-house, or we want to enable people to build a capability that can compete with Amazon or particularly around vertical markets like health care, clearly, we see storage grid in that particular domain. So there's no doubt that the role of object-based storage is becoming a bigger and bigger talking point with customers, and that's where we see storage grid playing.

Operator

And we have Glenn Hanus from Needham on line with a question.

Glenn Hanus - Needham & Company, LLC, Research Division

Could you contrast -- you made a lot of comments about big deal sales cycles, deferrals. Could you sort of contrast where you see all that stuff today versus 3 months ago?

Thomas Georgens

Three months is kind of a narrow point of view.

Glenn Hanus - Needham & Company, LLC, Research Division

Well, however you want to characterize it. Just trying to get kind of more color about the trend of that. Is it kind of getting better, worse? How do you see that now going forward as you look at your pipelines and stuff?

Thomas Georgens

Well, it's clearly anecdotal. It's company-by-company. It's industry-by-industry. Financial services is still an area where we see elongated cycles and, obviously, concern economically. On the other hand, there are certain geographies that are very, very robust for us. Japan has been remarkably strong. China remains strong. But it's very, very mixed and it's very, very case-by-case specific, certainly, that there are overhangs. I think sequestration, the impact on DoD, I think, is pretty clear, and I don't think we have escaped that. Overall, GDP growth being negative in the U.S., but some industries, like financial services, are struggling. Other ones, oil and gas or our consumer, have actually been a little bit stronger on the IT side. So I think it's very, very mixed. I don't think there's one geography that's successful across the board. And even within the more active vertical markets, it's really a story around successful players are less successful players. If I had to generalize, I would say certainly no improvement is probably the best I can say at this point.

Operator

And we have Mark Moscowitz with JPMorgan on line with a question.

Mark A. Moskowitz - JP Morgan Chase & Co, Research Division

Tom, the question is really around consistency. Clearly, you put together now a string of quarters where your operating metrics have been more consistent. There still seem to be, though, if we look at it from a stock perspective since we're all stock analysts here on the call, there seems to be skepticism still, your stock is still below where it was trading a year ago despite your revenue and operating model now getting back to similar levels. And you seem to be projecting a little more optimism around your book of business. And also, you got new products coming, more new products coming down the pipe. Can you just kind of talk more about what has changed to allow NetApp to get back to this point, this consistency? And how should we think about the next step function up, is it really just driven by new products? Or have you done anything internally around either your sales force infrastructure or global support to be a little more direct in line of sight in terms of working with your customers better?

Thomas Georgens

Well, I think that as far as the stock price, that's going to be derived from our performance. And so our focus is executing on the performance and delivering the results every day. The other message, to the extent that there's a dramatic message to the team is that the macro is the macro, it's everybody's problem and there's nothing we're going to do about that. We need to focus on the things that we can control. We need to focus on innovation. We need to focus on expanding our partnerships and our alliances. And if I look at the hard work that we've done around that, it's great to see the clustered ONTAP adoption. That's the biggest innovation in our history. It's great to see the momentum around that because it's a big differentiator. And when that's fully deployed and people really see the value of it, and now that we've gotten a substantial amount of the functionality there that people can derive tremendous value on that today, we like that. And likewise, we've got other things on the way. You'll see a Flash announcement from us very, very soon, the use of E-Series as an all-Flash array and shipped 100 units last quarter, pending growth of Branded E-Series. So if I look at where we are today, I think there's a lot of nascent growth opportunities. Clearly, we need to ultimately execute. But I'd say that clustered ONTAP is in the early days of impacting NetApp's business. E-Series is in the early days of impacting NetApp business. We're going to ship Flash Accel this quarter. We're going to make a Flash announcement in the near future. So I think there's some pending growth things. So for us, focus on that innovation piece. You've seen publicly what we've done around alliances, around recent announcements with Cisco, around Citrix, around SAP. Clearly broadening the appeal of our products integrates highly with other solutions. And then internally, we talked about the OpEx story, is that how do we be very, very, very focused on execution across every aspect of the business? So it's a time for focus, it's a time for intensity. It's not a time when there's a big investment envelope, and just focus on the things that we can control. And the message to the team is, is that independent of the macro, if we execute on things that we can do on all of these fronts, then NetApp can drive consistency, do what we say we're going to do and drive out performance in this industry whether the macro rebounds or not. And that's really our focus.

Operator

We have no further questions at this time. I would now like to turn the call over to Tom Georgens for final remarks.

Thomas Georgens

Okay. Well, first of all, thank you very much for your time today. We appreciate your interest in NetApp, and we look forward to seeing you in, roughly, 90 days. So thanks again.

Operator

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating, and you may now disconnect.

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