NetApp Inc. (NASDAQ:NTAP)
Q1 2017 Earnings Conference Call
August 17, 2016 05:00 PM ET
Kris Newton - VP, IR
George Kurian - President and CEO
Ron Pasek - EVP and CFO
Rod Hall - JPMorgan
Simona Jankowski - Goldman Sachs
Katy Huberty - Morgan Stanley
Jim Suva - Citigroup
Eric Martinuzzi - Lake Street Capital
Aaron Rakers - Stifel
James Kisner - Jefferies
Bob Hahn - Raymond James
Joe Wittine - Longbow Research
Srini Nandury - Summit Redstone
Sean Ryan - UBS
Mark Kelleher - D. A. Davidson
George Iwanyc - Oppenheimer
David Ryzhik - Susquehanna
Alex Kurtz - Pacific Crest
Steven Fox - Cross Research
John Lucia - JMP Securities
Nehal Chokshi - Maxim Group
Ananda Baruah - Brean Capital
Good day, ladies and gentlemen and thank you for your patience. You joined the NetApp First Quarter Fiscal Year 2017 Financial Results Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions]. As a reminder, this conference maybe recorded.
I would now like to turn the call over to your host Vice President of Investor Relations Ms. Kris Newton. Ma’am, you may begin.
Hello, and thank you for joining us on our Q1 fiscal year 2017 earnings call. With me today are our CEO, George Kurian and CFO, Ron Pasek. This call is being webcast live and will be available for replay on our website at netapp.com along with the earnings release, our financial tables and guidance, a historical supplemental data table and a non-GAAP to GAAP reconciliation.
As a reminder, during today’s call, we will make forward-looking statements and projections with respect to our financial outlook and future prospects, such as our guidance for the second quarter, our expectations regarding future revenue growth, improved profitability, including cash flow and shareholder returns, our expectations about our ability to drive operational and financial performance, all of which involve risk and uncertainty.
Such statements reflect our best judgment based on factors currently known to us and are being made as of today. We disclaim any obligation to update our forward-looking statements and projections. Actual results may differ materially from our statements and projections for a variety of reasons, including the macroeconomic and IT spending environment, our ability to successfully pivot to the growth areas of the market and enable customer migrations to our strategic solutions, our ability to expand our operating margin, our ability to reduce our cost structure, streamline the business and improve efficiency within the planned timeframe, and our ability to continue our capital allocation strategy and invest in strategic opportunities.
Please refer to the documents we file from time-to-time with the SEC, specifically our most recent Forms 10-Q, our Form 10-K for fiscal year 2016 and our current reports on Form 8-K, all of which can also be found on our website. During the call, all financial measures presented will be non-GAAP unless otherwise indicated.
I’ll now turn the call over to George.
Thanks, Kris. Good afternoon, everyone. Thank you for joining us today. In Q1 fiscal year 2017, our focus on the disciplined execution of our strategy yielded solid results on both the top and bottom-line. We delivered revenue of above the midpoint of our prior guidance range with both operating margin and EPS above our previous guidance. Over the course of the quarter, we strengthened our position in flash and hybrid cloud, while continuing to transform our business to operate more efficiently and to lower costs.
We’re clearly making progress, but still have work to do as we operate in the low growth macroeconomic and IT spending environment. We are controlling what we can and are increasingly confident in our ability to execute as we streamline the business and pivot to the growth areas of the market. We believe these actions will return the company to revenue growth with improved profitability, cash flow and shareholder returns.
Let me remind you of our key priorities in delivering on this commitment. First, we are executing on our data fabric strategy and the strategic solutions that form the foundation of how we enable customer success in the data powered digital era. Second, we are substantially reducing cost and systematically streamlining our operations while maintaining our ability to deliver innovation and lead the market. And third, we’re committed to a robust capital allocation program, which includes a combination of share repurchases, dividends and investment for the long-term growth of the business.
I'll start with an update on the first priority. Ron will update you on the other two. Our strategic solutions aligned to customer's top IT priorities. This alignment drives our confidence in our ability to lead in the fastest growing segments of the market. In the first quarter, strategic solutions represented 61% of net product revenue and grew 24% year-over-year. Conversely, net product revenue from our mature solutions declined at 24% from Q1 a year ago. As expected, the impact of the declines in mature solutions are lessening which will allow the growth of our strategic solutions to reaccelerate the business and return NetApp to moderated revenue growth in fiscal year '18.
Our customers are transforming their IT organizations for success in the data powered digital era. They are prioritizing investments to modernize their data centers to lower costs, increase simplicity and agility, extract more value from their data and integrate cloud resources with on-premises environments. Clustered Data ONTAP replaces legacy frame array environments to deliver next generation enterprise storage for efficient management of data growth and service provider like flexibility across flash, disk and cloud footprint. We continue to gain new customers and migrate existing customers to Clustered ONTAP.
Clustered ONTAP was deployed on 82% of fast systems shipped in Q1, up from 65% a year ago. We saw continued strong customer demand with unit shipments of Clustered ONTAP systems growing 35% year-over-year. The installed base of Clustered ONTAP in 7-Mode systems continues to grow in total and Clustered ONTAP is now running on 32% of that growing install base.
We're building on this strength with the newest generation of ONTAP which further simplifies customer's ability to deploy modern enterprise data center and hybrid cloud environments. Introduced in Q1, ONTAP 9 builds the foundation for a data fabric, bridging new and traditional data center architectures, making it easy to manage and move data where it's needed across flash, disk and cloud resources. Customers can choose the architecture of their choice, engineered and converged systems, software defined storage or cloud, all with industry leading efficiency, performance and density for flash environments. No other storage solution offers customers this range of capability, flexibility and investment protection.
Also introduced in Q1, ONTAP Select, a scalable software defined storage solution helps customers achieve their business objectives by bringing together the ability to deploy storage with cloud like agility and granular capacity scaling, with the proven features of the industry's number one storage operating system. ONTAP Select offers the flexibility to deploy ONTAP on commodity servers with the customer's choice of Hypervisors. It simplifies operations and lowers training requirements by providing consistent management across all ONTAP data storage, whether on-premises or on the cloud.
Flash plays an important role in IT transformations as customers seek to gain a competitive edge through greater speed, responsiveness and value from key business applications as well as efficiencies through consolidation and lower power requirements. Customers are replacing hard disk installations with flash, making flash the de facto standard for new on premises deployments. In this transition from disk to flash, customers cannot forego enterprise data management and data protection capabilities. With our highly differentiated portfolio of All-Flash-Array offerings, NetApp is uniquely positioned to enable customers to consolidate on to flash and create All-Flash data centers.
IDC ranked NetApp number two in the All-Flash-Array market with a significantly higher share than we hold in the overall storage market. Last week we won the flash memory summit best of show for most innovative flash memory customer implementation and swept all six brand leadership categories for all flash NAS and unified NAS SAN arrays in the 2016 brand leader survey. Our advantages in this market are reflected in the continued strong growth of our All-Flash-Array business, which grew approximately 385% year-over-year to an annualized net revenue run rate of almost $775 million, inclusive of All-Flash FAS, EF and SolidFire product and services. The majority of this growth was again driven by high demand for the All-Flash FAS.
In Q1 we further enhanced the All-Flash FAS with increased speed and data efficiency capabilities, guaranteeing 3X performance improvement over hard disk arrays and four to one data reduction. NetApp was first to market with 15 terabyte flash drives, which in combination with storage efficiency features in ONTAP 9 delivers a flash optimized enterprise class storage platform that is the best in the industry for mixed workload consolidation. We are displacing our competitors' legacy SAN frame array architectures with the All-Flash FAS. It enabled us to break into a large U.S. based healthcare company, which had been a decade long competitor stronghold. We replaced the competitor's SAN infrastructure for the customer's mission critical SAP environment. The All-Flash FAS beat out the incumbent and a newer All-Flash competitor on performance, features and resiliency. Not only we'll be able to reduce the data center floor space required for this workload by 95%, we were also able to provide the customer a path to the hybrid cloud.
The All-Flash FAS addresses requirements for next generation enterprise storage for customers who want to improve existing infrastructure and processes. For enterprises and service providers who are building multi-channel public and private clouds, SolidFire delivers a storage solution that is operationally simple, able to deliver predictable services and scale as services need to grow. It's unique web scale style architecture enables customers to easily build best in class service environments. In Q1 we delivered new SolidFire innovations across software, hardware and systems along with the new model for purchasing storage, FlashForward capacity licensing. The latest version of the SolidFire element OS software offers a more intuitive user interface and a robust implantation of VMware Virtual Volumes for VMware operations, including native per virtual machine quality of service. The latest SolidFire platform, which doubles performance and capacity can be easily added to existing clusters, allowing customers to rapidly deploy the newest flash technology without forklift upgrades or controller swaps.
FlashForward Capacity Licensing unbundled storage software from hardware in an efficient software purchasing model with perpetual transferable and pulled enterprise-wide licensing. IT transformations are also enabling customers to accelerate time to market, improve customer satisfaction, drive innovation and gain a competitive edge by getting more out of their data. NetApp data management solutions accelerate third platform analytic solutions by delivering an open, scalable enterprise grade platform for building customers critical data legs. To enable the real-time enterprise, customers can run analytics in place on existing data stores without copying or having to ensure data consistency across silos.
For customers who want to leverage the nearly endless compute on demand capabilities of the cloud to accomplish cost effective data analysis, NetApp data fabric cloud sync service provides a simple automated way to get data into Amazon Web Services, run the desired cloud analytic service and the data back to where it is needed, whether on premises or in the cloud. We showcased cloud sink at AWS Summit last week and you can expect to hear more about how we empower customers to leverage cloud resources and integrate them with their existing IT investments over the course of this fiscal year.
Our data fabric strategy enables data management that seamlessly connects disparate systems, software stacks, clouds and data centers. We give our customers the ability to manage, secure and protect their data across flash, disk, public and private cloud resources, all at the scale needed to accommodate the exponential data growth of the digital world. More and more customers are telling us that they choose NetApp because we enable their cloud strategies by providing data portability and cloud integration. Coupled with our industry leading next generation enterprise and web scale storage solutions, we're helping our customers transform for success in the data powered digital era. We accomplished a lot in Q1, our focus on disciplined execution and pivot to the growth segments of the market is yielding results and starting to change the trajectory of our business.
We introduced substantial innovation across our portfolio that helps our customers as they transform to modernize their data centers to lower costs, increase simplicity, extract more value from their data and integrate cloud resources with their own premises environments, and we will introduce more exciting innovations at our Insight User Conference in Las Vegas next month. We're making progress, but we still have more work ahead of us to return the Company to long-term growth and to our target operating margin. We are streamlining the business and reducing our cost base to position us for future success by allowing investments in strategic opportunities, while accelerating our ability to deliver shareholder value in the form of improved profitability and cash flow. Our first quarter results provide early indicators that our strategy is working and I am very confident in the NetApp team’s ability to successfully evolve the company.
I’ll now turn the call over to Ron to walk through our Q1 financial performance and expectations for the second quarter.
Thanks George. Good afternoon everyone and thank you for joining us today. Before we get started, I’d like to remind you that we will be referring to non-GAAP numbers today. Also please note that year-over-year compares are against a 14-week quarter we had in Q1 of fiscal 2016. With that let’s get started. We executed well in the first quarter and overall are pleased with our results. Q1 net revenues of $1.29 billion declined approximately 3% year-over-year and were within our guidance range. Excluding the approximate $40 million benefit to software maintenance and hardware maintenance and other services revenue from the 14th week we had in Q1 of last year, net revenues were roughly flat year-over-year.
Product revenue was $660 million and for the first time in several quarters was essentially flat on a year-over-year basis. As we’ve discussed, we expect the growth of our strategic solutions to improve our overall product revenue growth trajectory over the course of fiscal 2017. Though we still have a lot of work to do, the product revenue results are good indication of the progress we’re making here. The combination of software maintenance and hardware maintenance and other services revenue of $634 million, were down approximately 6% year-over-year due to the extra week in Q1 fiscal 2016.
Gross margin was 62.4% and within our guidance range. Product gross margin of 46.7% was flat sequentially. Although product gross margin remains below where we'd ultimately like it to be, we feel good about the stabilization. On a year-over-year basis, product gross margin was down about 4.5 points. Software maintenance gross margin was relatively flat year-over-year, while hardware maintenance and other services gross margin increased just under 4 points year-over-year.
Operating expenses of $652 million decreased 13% year-over-year. This decline reflects the early results of our transformation efforts, as well as the benefit of the return to a typical 13-week quarter, partially offset by SolidFire. Operating margin of 12.1% was above our previous guidance range. As I discussed on our last earnings call, aligning our cost structure with the opportunities in front of us is my top priority and completely within our control. Although, we have made progress on this front, we will continue to take additional steps throughout the year to permanently lower our cost structure including, but not limited to headcount reductions and continue to drive greater efficiencies across the business. We will continue to communicate specifics as these savings are realized.
Our effective tax rate for the quarter was 16.6%. Weighted average diluted shares outstanding were 282 million. EPS of $0.46 was $0.07 over the high-end of our prior guidance range, reflecting lower operating expenses, higher revenue and a benefit of our share repurchases. Our cash and balance sheet metrics remain healthy. We closed Q1 with $4.4 billion in cash in short-term investments with approximately 13% held by our domestic entities. We repaid the SolidFire loan in the first quarter of global profits. We remain deeply committed to completing by the end of May 2018, the remaining balance of our share repurchase program that we announced in February 2015.
In Q1 we repurchased $175 million of our stock, and paid approximately $53 million in cash dividends. Today we also announced our next cash dividend of $0.19 per share, which will be paid on October 26, 2016 to shareholders of record as of the close of business October 7, 2016. Deferred and finance unearned services revenue was up 8% year-over-year. Inventory turns increased to 24 and DSO was 35 days. Q1 cash flow from operations was approximately $228 million versus $129 million in Q1 a year ago. We generated strong free cash flow of $192 million in the quarter. Representing about 15% of net revenues, free cash flow grew over 100% year-over-year.
Now to guidance, as George discussed we are aggressively pivoting to the growth areas of the market while at the same time transforming the Company in order to streamline the business, drive greater efficiency and rapidly address the changing market. As we've outlined today, we executed well against our plans in Q1 and are encouraged by the early signs of progress that we're seeing. While we still have a lot of work to do, we remain confident in our ability to continue to execute against the plans we outlined for fiscal 2017 on our prior earnings call.
For Q2, we expect net revenues to range between $1.265 billion and $1.415 billion, which at the mid-point implies a sequential increase of 4% and 7% decrease year-over-year and a difficult compare. We expect Q2 consolidated gross margins of approximately 62% to 63% and operating margins of approximately 13% to 14%. And finally we expect earnings per share for the second quarter to range from approximately $0.51 to $0.56 per share.
With that I'll hand it back to Kris to open the call for Q&A.
We'll now open the call for Q&A. [Operator Instructions] Operator?
Thank you, Ma'am. [Operator Instructions] Our first question comes from the line of Rod Hall of JPMorgan. Your question please.
I just wanted to ask about the cDOT conversion, because I ask about it every quarter and it seems like you made good progress this quarter at 32% of the install base. At what point do you -- do you think this just continues to grow linearly towards or how do you see this progressing? Should we just assume it continues to grow kind of at the rate it has been the last few quarters? And then I also wanted to ask about gross margins. By your comments there I assume that you're seeing pricing relatively stable. You don't see any issues as you move to cDOT or anything like that with pricing. So if could just kind of comment on that as well, it would be helpful?
First of all, I'd just say that we're pleased with the progress on cDOT penetration of our install base and new customers. I think when you think about our install base, it's a very large install base that we've built up over 20 years and its growing and so the percentage of systems that we represent is a very large number. The cDOT conversions are lumpy. They go up and down. The pace at which they move are tied to customers' IT spending and their readiness for conversion. In aggregate you're seeing us continue to progress the conversion of the install base. I would just say that I would not -- we're planning the business around any particular quarter-on-quarter model. I think in aggregate we're pleased with the progress and we continue to want to get our customers over the clustered ONTAP and you're seeing that.
In terms of gross margins, I think a couple of things. The first is the value proposition of All Flash FAS clustered ONTAP are showing up in the differentiation and customer acquisition and the shipments that we are delivering to customers. The gross margin model that we showed last quarter to this quarter has stayed stable and the market remains competitive, but we differentiated technology in the market as well as we outlined in our cost focus, we continue to do work in the supply chain on both of cost of goods sold as well the operating structure of the Company to support that model.
I think I'd remind you what I last quarter as well. Discounting is a function of what we're seeing in the marketplace plus product promotions we're running and so we're still doing some of those but deemphasizing certain ones and emphasizing others.
Thank you. Our next question comes from the line of Simona Jankowski of Goldman Sachs. Your question please.
I just wanted to confirm that I heard you correctly, that the installed base is still growing and related to that, would you expect your services business to return to growth in future quarters?
The install base is growing. That's correct Simona. It's a very large number and it's growing. I think in terms of the services business, the first thing I'd just tell you is the year-over-year compare was from a 14-week quarter last year to a 13-week quarter this year, and if you adjust for that, the services business is essentially flat. If you look at our deferred revenue, it shows strength reflecting the nature of the long-term contracts that we have with customers, as well as the strategic value and the business criticality of our solutions.
And so you expect that to be -- just clarifying -- you expect that to grow in future quarters versus being flat or plus or minus?
Yes, as the install base grows, that services revenue will grow as well.
Thank you. Our next question comes from the line of Jason Nolan of Robert Baird. Your question please.
I wanted to ask, the mix that's in there, I assume a lot of that is All-Flash FAS versus SolidFire and E Series. If you could confirm that first. And then ask about competitive dynamic. It seems pretty intense right now and I guess my question is why is AFA so much more intense than the traditional storage business?
First of all, the progress we've seen this quarter reflects -- the biggest part of it reflects continued success with All-Flash FAS. We've been encouraged by the progress with SolidFire as well, with new customer acquisitions led by the NetApp sales team. But as we had outlined in prior statements, SolidFire today is immaterial to the revenue. It's consistent with the plan that we've laid out for you, and we're encouraged by the early signs of progress. In terms of the All-Flash Array market, I think what we see is that the larger system vendors who have now integrated All-Flash offerings as part of their enterprise grade storage and models continue to get the lion's share of enterprise storage footprints. I think the progress we've made with our All-Flash arrays reflects the differentiation of our clustering technology, the storage efficiency, the performance and reliability of our offerings. And so we feel very, very good about where we are.
Thank you. Our next question comes from Katy Huberty of Morgan Stanley. Your line is open.
U.S. public sector revenue grew this quarter. Are you starting to see larger deals and do you expect that to continue as we go into the fiscal year end for that segment? Thanks.
Thanks Katy. We are encouraged by the progress with U.S. public sector. I'll just tell you there was no specific pattern that we noticed. We also continue to monitor the U.S. public sector spending patterns as we head into the November election season. So we feel good about our position in the market, the competitiveness for offerings as well as progress we're making with some of the agencies, but we'll continue to monitor the sector as we head into the November season.
Our next question comes from Jim Suva of Citigroup. Your question please.
I have a housekeeping question for Ron and then may be a strategy or market insight for George. Ron, on the OpEx, specifically the general administrative side, it looks it was kind of at very low levels or multi low levels. Is that level sustainable or is there even more room to get more efficient there or were there some type of benefit that happened this quarter, just for modeling for kind of long term run rate for that why [indiscernible] came down a lot both sequentially and year-over-year, even though year-over-year understand the week, but sequentially it came down a lot too, and compared to history it's really low. And then George, on the insight for the market, any impact to Brexit? Your company had a full month of sales and revenues through the month of July. Did you see any order delays? Did those come back in August or is it creating a little more uncertainty in the UK and how should we think about any impact there that you are seeing.
Sure Jim. So yeah, with respect to G&A, this is early part of the work we've talked to you about relating to transformation, both in really all the support functions and then some of the line organizations as well. So it is -- some of it did happen a little quicker than we thought and will continue throughout Q2, maybe at not the same levels, but it is a permanent reduction to the levels of G&A and part of our strategy.
With regard to Brexit, I think both in terms of the commercial impact as well as the FX impact to our business, they were immaterial this past quarter. It's too early to tell. And so we monitor in discussions with our large customers but we didn't see anything material to our business.
Thank you. And just as reminder, if everyone could keep it to one question, so we can get to as many of you as possible. We'd appreciate it.
Thank you. Our next question comes from Amit Daryanani of RBC Capital Markets. Your line is open.
Hi guys. This is [indiscernible] calling in for Amit. I wanted to go back on the product gross margin question. It's been below 50% for the second consecutive quarter. There has been discounting and promotional activity. But can you just talk about how the margin profiles of strategic and material product businesses might differ, essentially as a mix of strategic increases?
There is no material difference between strategic and mature in terms of product gross margin. In terms of our overall gross margin, as we said, as part of our focus on cost management, we continue to take a hard look at every category cost of goods sold, as well as the cost of goods on the services side. And so we continue to work to maintain our gross margins in aggregate in the ranges that we've guided to.
Our next question comes from Eric Martinuzzi of Lake Street Capital. Your question please.
Yes. As I look at the strategic product growth area, you exited FY 2016, I think it was a 21% rate and you put up Q1 here at about a 26% rate. So that acceleration, obviously terrific execution. As we look out for the remainder of the year, is this something that is sustainable? You talked about a difficult comp in Q2, but I don’t know that I have the level of detail in between the two segments between strategic and mature. But is that acceleration in FY 2017 sustainable?
So question as strategic revenue grew 24% in Q1 and we feel that we are encouraged by that growth rate year-on-year. It was 14% in Q4 year-on-year. So we feel good about the process in the strategic solutions. As I said, we think that as the mature solutions become a smaller percentage of our business, they become less of a headwind in terms of overall revenue growth. And our plan is to get product revenue back to growth at some point this year.
Thank you. Our next question comes from Aaron Rakers of Stifel. Your line is open.
I wanted to take a longer term view and understand some of the things that you’ve done here recently for the quarter. How should we think about your ONTAP select, as well as the purchasing model of FlashForward for your SolidFire solutions? Or put another way, how you guys thinking about the model implications from software defined storage, or rather that de-bundling between software and hardware going forward?
Let me take that from a customer perspective, and then Ron can comment on the financial implications. First of all, from a customer perspective, we think that the value of differentiated storage and data management capabilities as we’ve always said is software and we have among the best storage and data management platforms in the industry without question for traditional enterprise with Clustered ONTAP and for web scale enterprise with SolidFire. So we feel very good about our position in those markets. The software value of those products protect and differentiate gross margin.
ONTAP select is an offering that we’ve made available to customers, who have the engineering capability to integrate software with systems for specific deployments. I think the range of customers who have that level of engineering capability is small. And so we think that the preponderant majority of our business will continue to say integrated systems. With regard to SolidFire's FlashForward licensing model, it essentially allows customers to simply procurement of software so that they can build the pool of storage that is enterprise wide and then buy hardware as they need it and integrate it under that software umbrella. Typically, what we have seen with that type of model is that it allows us to get larger footprint sooner in customers as they standardize on SolidFire for a broad range of use cases.
I'll just add that what you're describing is a way that our customers can't consume our products and we're well aware of the change. It is a very small piece of our business, not material at this point but it's something we do want to accommodate.
Thank you. Our next question comes from James Kisner of Jefferies. Your line is open.
So, let’s talk a little bit about working capital. It looks to me like your cash [indiscernible] cycle was hitting a multi-year low. This year you had very strong collection. Just wondering how we should think about DSOs and cash conversion cycle going forward and do you expect free cash flow being in mid-teens as a percent of revenue for the year?
So, yes, we benefitted from a huge improvement quarter-to-quarter which is seasonal in DSO. We had a relatively back end loaded quarter in Q4, which had an artificially high effect on DSO. That came back into the norm. It's still -- at 35 it's still five days higher than it was at Q1 a year ago. The other huge benefit to cash conversion was a really low inventory, probably historically low inventory. That's a little bit of an anomaly. It's probably too low. You shouldn't expect that level going forward but it should be an improvement from the prior year. We continue to focus on working capital. It's one of the parts of our transformation efforts. Keenly aware of it. So it is not an accident that these things happen, and we're going to continue to drive it.
Next question comes from Brian Alexander of Raymond James. Your line is open.
Hi, this is Bob Hahn for Brian. Just a follow-up question for Ron, when you mentioned promotional activity, and mentioned reducing some programs and growing others. Could you be more specific in where you're driving more or less promotional activity, and to what extent you think gross margin pressure is within your control in temporary?
What I described last quarter were two promotions which are still running. One was on flash and one was on cDOT. Some of those are running at a course, not needed as much anymore. We're looking at additional promotions that I don't want to talk discreetly, they tend to be really important to us at a given time. That's really a function of what's going on in the marketplace.
And broad breaststrokes, as we accelerate certain accelerates certain strategic technologies to market, we pivot our focus there with promotions and other things for a period of time, and we brought down on the pieces that are more mature or well penetrated. And I would just continue to think about that as part of our ongoing portfolio management.
The next question comes from Joe Wittine of Longbow Research. Your line is open.
Maybe just a clarification on the buckets that you're breaking out, appreciate you doing that. What exactly is in the mature bucket at this point? Are customers still adding to legacy ONTAP 7 environments? And then within strategic also, does that -- what chunk of strategic is still -- would someone consider legacy on-prem arrays that are running clustered cDOT?
So, mature is essentially the OEM products that include E-Series and are legacy FAS OEM products, 7-Mode systems and add-on hardware. Add-on hardware is equipment that is purchased after an initial configured system sale, for example add-on storage. The strategic solutions include our clustered data ONTAP operating systems, All Flash Arrays the branded E series OnCommand Insight, SolidFire and some of our hybrid cloud solutions.
There are customers who are adding on to some of their 7-Mode environments for purposes of business continuity, for purposes of this is an application that I don’t want to migrate to clustered ONTAP, because it's an IT area that they're no longer investing or they feel that their current environment is good and so you see people continuing to add-on in small numbers systems and add-on storage to their 7-Mode footprint. The majority of customers that are deploying new configurations as represented by the percentage of shipments out the door are deploying clustered ONTAP configuration.
Thank you. Our next question comes from Srini Nandury of Summit Redstone. Your question please.
George, can you talk about the relative growth rates of your All Flash FAS versus the growth rate of EF All Flash series as you currently see?
The EF series is focused on a much smaller range of used cases, primarily the performance oriented segment of the market where customers want industry leading performance for specific dedicated environments like databases. All Flash FAS represents the focus for the broadest range of customers who are looking at replacing disk based solutions for general purpose storage environments with All Flash configurations. And SolidFire uses flash based technology to build web scale cloud designs for customers, people that want to replicate what Amazon or Google or Facebook have deployed in their datacenters in their own environments. And so those are three pieces. We think that All Flash FAS and SolidFire will be the majority of the business going forward.
Thank you. Our next question comes from Steve Milunovich of UBS. Your line is open.
It's Sean Ryan for Steve. So real quick, looking out the back half of the year on a competitive landscape, what do you kind of see happening with Del EMC? Are you seeing them get more aggrieve, as they combined and what do you think there might happen with HP [indiscernible] services. Are any of these going to change the competitive landscape?
Well, first of all, let me say that from a technology perspective, we feel very, very good, we have taken flagship customers from both EMC and HP this past quarter as with our All Flash technology, and we feel that as customers look to build All Flash data centers, we've got a technological lead that is very strong and the road map of both All Flash and hybrid cloud solutions from us is resonating with customers. Every transaction is competitive. And so to the extent that we are displacing competitors in large accounts, these are highly competitive transactions. We think that that nature of competitive dynamic will continue. And so what we're doing on our side is both building differentiated capacities in software as well as dealing with the cost structure of the company, both in COGS and OpEx to allow us to compete effectively in the market.
The next question comes from Mark Kelleher of D. A. Davidson. Your line is open.
Just want to talk about your go to market strategy. I noticed your indirect revenue ticked up a few percentage points sequentially. Where is your focus there? Do you have enough -- is there any seasonality to that and do you have enough direct salesforce? Where is your investment being made right now?
We have a new leader of our go to market organization, Henri Richard, who is focused on accelerating our penetration and returning product revenue to growth, but the indirect channel is an important strategic asset to NetApp. We work closely with our channel to help them accelerate capabilities into the market for our All-Flash Arrays for cluster data ONTAP as well as for SolidFire. We also had a strong quarter on the OEM side, which is reflected in both the mix of mature as well as the mix of indirect channel. And so we're going to continue to focus on the right mix of direct and indirect and the channels are really important part of our go to market model.
Thank you. Our next question comes from George Iwanyc of Oppenheimer. Your line is open.
Thank you for taking my question. So just following up on the OEM strength, is that part of the business stabilizing at this point? Do you expect any growth there?
OEM is down substantially from years past; it is still dependent on the business of our end customers. But to the extent that there is material seasonality to that business, it's a smaller percentage of our business this year than it was in the past. I'll just leave it there.
And just following up. With the incremental improvement that you've seen on the mature product side, do you expect that to continue to be the case as we go through the fiscal year and quarter-over-quarter, the year-over-year pressure eases?
Yes, you should continue to see that decline throughout the remainder of this year and probably into next year. It won't go to zero, but the decline will slow as the year progresses and we go into FY 2018.
Next question comes from Mehdi Hosseini of Susquehanna. Your line is open.
This is David Ryzhik for Mehdi. What percent of the growth in cDOT unit shipments is due to All-Flash FAS? And also if you can characterize the adoption rate of cDOT in U.S. public sector as well as by geography?
We don't break out the adoption rates by geography. I think in general, we are pleased with the progress of cluster data ONTAP across all our geographies. The largest footprint of our installed base is clearly in North America. And so if you look at the remaining footprint, just because of the size of the footprint, we still have a large number of systems to convert, which we see as opportunity for us to do so over the next few quarters. In terms of the mix of all flash and hybrid, our guidance to our field is to sell the best value solution under the clustered ONTAP umbrella, whether -- a customer wants flash, we sell them flash. If they say I want to continue to do hybrid, we'll sell them hybrid. Our overall goal is to sell our clustered operating system and clustered systems to the broadest range of customers. The all flash systems are growing at a faster rate than hybrid. I’ll just leave it there.
The next question comes from Alex Kurtz of Pacific Crest. Your line is open.
Just want to go back to the product, the medium to longer term outlook on product margin. Should we just expect, where you’ve been the last few quarters is where the business is going to be trending, just like more competitive environment, lower volume and that’s really where you guys are going to be tracking over the next, I don’t want to put a specific timeframe on it, but over the maybe next year to year and half, or is there something in the product mix that's coming up, that could really drive that back to near historical levels?
Yes. What I tried intimate on my prepared remarks was that we’re not happy with where it. I'd like to see it grow. But to some extent, we can do certain things on the cost side, the offering side, the mix side. But to some extent, it’s a function of the competitive environment. So although, I'd like to have it grow, I can’t tell you for sure that it’s going to happen. You’re right. It's historically at a very low level. It puts pressure on the business model. I’d like to see it’s higher, but I also want to be competitive.
And just to clarify one thing. I'd imagine the All-Flash Arrays carry a higher product margin. So how should we interpret that as far as reflecting your overall product margin? Does that mean the other products are being discounted more and that’s the results we’re seeing here?
No, I really don’t think you should assume that there is a huge difference in product margin Pre flash and traditional storage. So that’s not what’s going here at all. This is really just a function of the competitive environment.
Our next question comes from Sherri Scribner of Deutsche Bank. Your line is open.
This is [indiscernible] for Sherri Scribner. I was wondering with the progress you’ve made in the SolidFire integration, is M&A a priority? Can you update us on your capital allocation priorities?
Yes. So the priorities are very, very clear. We’re prioritizing the share repurchase. We’re on track to make the commitment to be done by May of 2018 on the $2 billion that we outlined. Also the dividend, continue to pay and hopefully we’ll see the dividend. To a far lesser extent, you’ll see us being inquisitive. There are some things out there that we might be interested and they’re not pretty big. There tend to be small IP based acquisitions, but that’s how we think of the capital allocation strategy.
We’re focused on bringing SolidFire to the broadest range of our customers through our broadest set of go-to-market partners. We’re pleased with the initial progress. But we have a lot of work to do and so we’re going to see focused on it.
Next question comes from Steven Fox of Cross Research. Your question please.
Just on the operating margin targets that you’ve laid out getting back to the high-teens, hopefully exiting this year and then doing that for the full year next year, if we just think about the controllables around that versus the growth prospects and mix, can you sort of outline the big three, two or three things that would drive margins higher from here?
Yes. It's mainly -- as you said the cost structure, certainly operating expenses. You should expect to see us make the commitment of, essentially on a run rate basis of being $130 million net lower as we exit at Q4 ’17 from Q3 ’16. That is a combination of OpEx mostly and to some extent, COGS. Those are the big efforts we’re making to improve the bottom line to your point, assuming maybe we don’t see top line growth. So the assumption is we'll [indiscernible] margin for the year is 15% to 17% and that's with SolidFire in there. And then what I said was we expect to be around 18% in FY '18 with SolidFire.
And just to clarify one point on mix, it sounds like from everything I've heard on the call that there's not a major mix assumption that has to happen obviously. The strategic business wants to grow but, is there anything we should think of that would be a major swing factor around gross margins going forward?
No, not at all.
Next question comes from John Lucia of JMP Securities. Your question please.
Last quarter you talked about customers acting with caution due to an uncertain macro. I didn't really hear you touch on that much this quarter. I was just wondering if you've seen any improvement in terms of purchasing patterns in the storage market in general? Would just like to get your take on that.
The quarter came in line with expectations, and in line with historical linearity. I would say that the macro continues to be uncertain. I don't think that we've seen a fundamental shift in the macro environment. I would say that solid-state storage is clearly seeing interest because of the really quick return on investment, the substantially better total cost of ownership and so people are prioritizing that potentially within their spend envelope. But I think overall from a macro perspective, it's still relatively choppy.
Thank you. Our next question comes from Nehal Chokshi of Maxim Group. Your question please.
Between the stabilizing product revenue on the year-over-year growth basis, as well as the product gross margins, stabilizing plus 50% of your market value and net cash position, I think you guys are effectively trading at five X fiscal year of free cash flow. So my concern here is that you guys become a prime private equity target, and will you look to return cash to shareholders at an accelerated rate in order to make sure that the long term oriented shareholders are protected from private equity firms basically cherry picking off what is a very attractive asset?
I think first of all, we've laid out our plan for the Company, which include driving the strategic solutions to growth. We've said that the mature solutions will become less of a headwind and that is playing out and the quarter is the representation of that playing out. We've optimized the cost structure to continue to deliver favorable set of both free cash flow and operating cash flow metrics that in turn gives us increased confidence that we can support the capital allocation program that we've laid out. We've laid out a capital allocation program that includes dividends, share buybacks and the investment of capitals for strategic activities and we remain committed to that.
Next question comes from Ananda Baruah of Brean Capital. Your line is open.
So for probably George and Ron, just staying on the capital allocation topic, if the model plays out guys, sort of 2017 and '18, as you believed that it can and hope that it does, why actually -- I'd love to hear the thinking behind staying committed to the buyback part that you guys have, as the stock would seemingly work higher. So kind of still get it lower levels, but why not pivot some of that capital maybe towards the dividend, as the dividend yield gets lower and stock moves higher. Is that based into your thinking? Then I'd love to hear about it. Because it sounded like Ron, you guys feel pretty committed to the turn of dollar target. And then if you could just sort of -- if there was any -- just a thought process behind hedging yourself to that target, what was sort of the statement alleged to that in the context of the question?
Yes, sure, it was a comment made certainly before I got here. It's the type of thing our long-term investors want to see. I think of the dividend as something we give people regardless of what's going on. And some investors really to see pay only dividend some months as to only do repurchase. So we do a combination of both and keep both happy. I think your question is good, but at the same time we made the commitment. We're going to follow through on the commitment.
Thank you. And our final question for the session comes from Maynard Um of Wells Fargo. Your line is open.
This is Manjar [ph] on behalf of Maynard. Just wanted to clarify, your guidance implies that OpEx will increase sequentially in Q2. So could please confirm that? And how we should think about OpEx in second half and as we exit the fiscal year?
Yes, you are right. We came in lower than I thought we would in Q1 and so there is a very slight increase to OpEx in Q2 if you the midpoint. As I try to intimate, the cost reductions always come very smoothly. There are other things we spend money on that cause little blips through the quarters. However, in general I think as we exist the rest of the year, you should see the OpEx continue to come down through Q3 and into Q4.
Thank you. I'll turn it back to George for some final remarks.
We are pleased with our Q1 results and the clear progress we're making with our strategic solutions, but we still have more work ahead of us, and we remain focused on disciplined execution of our strategy. We're committed to the fundamental change that we outlined with the three key priorities. Let me remind you of them once again.
The first one is to pivot to the faster growing parts of a market and align ourselves closely with our customers, business and IT transformation priorities with our focus on the strategic solutions portfolio. The second is to reduce cost by streamlining and improving the efficiency for our business. The third is to support and continue with the robust capital allocation plan that we have, that includes shareholder returns and investment for the long-term growth of the business. We brought a lot of innovation to the market in Q1. You can expect to see even more exciting innovations this year, some of which we'll showcase at our Insight User Conference next month. I look forward to speaking with you all again next quarter. Thank you.
And thank you sir. And thank you ladies and gentlemen for your participation. That does conclude your program. You may disconnect your lines at this time. Have a wonderful day.
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