Kris Newton - Vice President-Investor Relations Thomas Georgens - Chairman & Chief Executive Officer Nicholas R. Noviello - Chief Financial Officer & Executive VP-Operations.

Kulbinder S. Garcha - Credit Suisse Securities (USA) LLC (Broker) Brian G. Alexander - Raymond James & Associates, Inc. Sherri A. Scribner - Deutsche Bank Securities, Inc. Jayson A. Noland - Robert W. Baird & Co., Inc. (Broker) Maynard J. Um - Wells Fargo Securities LLC Louis R. Miscioscia - CLSA Americas LLC Keith F.

Bachman - BMO Capital Markets (United States) Amit Daryanani - RBC Capital Markets LLC.

Good day, ladies and gentlemen, and welcome to NetApp's Fourth Quarter and Fiscal Year 2015 Financial Earnings Conference Call. At this time all participants are in a listen-only mode. Later we'll conduct a question-and-answer session and instructions will be given at that time. And as a reminder, this conference call may be recorded.

At this time, I would like to hand the conference over to Kris Newton, Vice President of Investor Relations. Ma'am, you may begin..

Hello, and thank you for joining us on our Q4 fiscal year 2015 earnings call. With me today are CEO, Tom Georgens; and 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, our financial tables and guidance, a historical supplemental data table and the 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 first quarter and full fiscal year 2016, our expectations regarding areas for investment, expectations regarding market acceptance of clustered Data ONTAP, our ability to drive growth and operational and financial performance, our expectations for our evolving business transition and our expectations regarding our business model and FY 2016, 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.

We describe some of these reasons in our accompanying press release, which we have furnished to the SEC on a Form 8-K.

Please refer to the documents we file from time to time with the SEC, specifically our Form 10-K for fiscal year 2014, subsequent Form 10-Q quarterly reports and our current reports on Form 8-K, all of which can be found on our website. During the call we will discuss non-GAAP financial measures.

These non-GAAP measures are not prepared in accordance with Generally Accepted Accounting Principles. A reconciliation of our GAAP and non-GAAP results is provided in today's press release and on our website. I'll now turn the call over to Tom for his commentary on the quarter..

Thank you, Kris, and thank you all for joining us. We are not pleased with our results in the fourth quarter, and on today's call, I will outline the key reasons for our disappointing performance as well as the steps we are taking to position NetApp for the next phase of our evolution.

I will then turn the call over to Nick to provide additional detail on the quarter and our expectations going into fiscal year 2016. Before we open the call for questions, I will return to summarize the reasons for our continued confidence in the business.

As I've discussed on past calls, the IT industry is undergoing a radical shift as customers rebalance their IT investments to take advantage of the cloud. IT organizations will deploy a mix of on-premises and cloud-based resources, which has slowed the growth rate of the storage market.

Every IT vendor is faced with this transition and the successful ones will involve their business to incorporate this new reality.

We are well positioned for the era of cloud computing and with a robust portfolio of hybrid cloud solutions that enable customers to meet the current and growing demands of their business, while adopting new technologies and delivery options.

NetApp itself is also undergoing a significant transition with the conversion of our customers to clustered Data ONTAP. On our last call, we talked about the execution challenges in our Americas commercial business that materialized late in the third quarter. We also discussed the need to increase our go-to-market capacity.

After a thorough analysis of these challenges, it is clear that we underestimated the disruption that the transition to clustered ONTAP has had on our direct and indirect pipeline. The disruption has been most acutely felt in our Americas commercial geography due to the heavy concentration of large enterprise customers in the U.S.

Clustered ONTAP is a re-architected and modernized version of the ONTAP technology. It is our platform for the next decade of innovation. However, to fully realize the benefits of this technology, customers have to update existing storage management processes and migrate their data.

While the value of clustered ONTAP is driving momentum with new customers and new workloads in existing customers, many of our largest installed base customers have been resistant to upgrades until feature parity with the traditional version of ONTAP was achieved.

This is even true in cases where customers have standardized on clustered ONTAP for new workloads elsewhere in their environment. The inhibitors to upgrade have now been mitigated with the generally available release of clustered ONTAP 8.3.

Our largest customers now see a path to the advanced innovation and functionality of clustered ONTAP and are planning for migration. Since most of the upgrades occur in conjunction with hardware refreshes, we have seen delays in new hardware purchases until planning for process changes and downtime windows can be completed.

This planning can be complex and as a consequence, customers are deferring hardware refreshes and extending the life of existing gear. The financial impact to us is lower product sales and increased short-term service renewals. The complexity and duration of clustered ONTAP transitions have implications on several dimensions.

First, it reduces predictability in some of our largest accounts. We saw that in Q3 and it continued in Q4. Second, our smaller accounts, which are often partner led, are similarly facing this transition. While the installations tend to be less complex, we are often dependent upon our channel partners to guide them through the process.

Those partners that have made an investment in clustered ONTAP training, typically our largest, have had a good year. However, others who are not as well versed in selling clustered ONTAP have seen their customers defer upgrades, which has negatively impacted our channel business.

And third, the effort to drive this conversion has adversely impacted our ability to acquire new footprints and new customers. The net impact of these dynamics has resulted in an insufficient pipeline to meet our bookings objectives. To drive pipeline expansion we are taking concrete actions.

First and foremost, we must accelerate the adoption of clustered ONTAP within our installed base now that the feature inhibitors have been removed. This requires an investment in training and migration services. The objective is to unlock the tech refreshes that are waiting for clustered ONTAP upgrades.

Some of these upgrades at our largest installations are complex and will be driven through direct engagement. But others are far simpler and can be facilitated by our channel partners. Therefore, our second action is to invest in the training and assistance necessary to build the confidence and competence in our broad partner base.

And finally, to offset the diversion of field focus in addressing these issues, we need to be actively engaged in acquiring new customers and new footprints through both direct and indirect channels and we will continue to invest in our sales capacity to create additional bandwidth.

Overall, we remain confident in the value proposition of clustered ONTAP and our customers' commitment to the transition. Certainly, we see some customer consideration of alternative cloud-based models, but we do not see as much risk from on-premise alternatives.

It is unlikely that customers will adopt competitive technologies that have fewer features and require even more complex migrations when compared to clustered ONTAP. Therefore, we are confident that our investment in accelerating clustered ONTAP migrations will unlock business.

Likewise, the need to broaden our reach to address more customers through sales capacity expansion, both direct and indirect, is an investment that we expect to yield positive results.

While our once-in-a-generation re-architecting of ONTAP has created a complexity for our sales channels that we are addressing, the rest of the portfolio has shown excellent progress.

Looking ahead to the next generation of IT, we see the cloud as the biggest transitional force in the industry and for many use cases, it provides flexibility, economics and functionality that cannot be achieved with on-premises solutions.

We are focused on accelerating enterprise ability to realize the full potential of the cloud, while recognizing that they will deploy a hybrid model with both cloud-based and on-premises resources in their IT environments.

Our strategy for the hybrid cloud and our portfolio of solutions provides customers with the only consistent way to manage, secure, and protect their data regardless of where they choose to store it.

NetApp hybrid cloud solutions weave together disparate data elements into a single integrated architecture, giving customers control and choice with the flexibility, elasticity and ubiquity of cloud resources. The customer feedback on our hybrid cloud strategy has been outstanding. It's viewed as relevant, compelling, differentiated and real.

Even for customers who are not ready to go mainstream on the cloud components, the completeness of our story and the enablement of their future direction are proving to be reasons to buy NetApp solutions today.

NetApp private storage for cloud gives customers the flexibility and economic benefits of a multi-cloud solution without the risk and regulatory concerns associated with relinquishing data stewardship or the threat of cloud vendor lock-in.

During the fourth quarter, we further augmented our cloud solutions with new models of SteelStore as an Amazon machine image, giving customers an efficient and secure approach to backing up cloud-based workloads.

Additionally, for customers who want a scalable, durable object storage solution for long-term archives, we have delivered on a major new release of StorageGRID Webscale which adds support for industry-leading storage efficiency, support for Amazon S3 as an integrated object storage tier and introduced the StorageGRID 5660 appliance.

We also released updates to OnCommand Cloud Manager and Cloud ONTAP, giving customers new capabilities to speed business innovation and IT responsiveness. We offer enterprises a choice of cloud providers and the ability to select based on cost, performance and service levels.

Our cloud solutions demonstrate our commitment to enable customers to fully realize the flexibility and economics of hyperscale clouds and to do so as a seamless extension of their on-premise environment. Other new elements of our portfolio have shown excellent progress this past year.

Almost half of our enterprise customers are buying multiple solutions from our portfolio, proving that we are much broader than just ONTAP. Unit shipments of branded E-Series, inclusive of the all-flash EF family grew by 45% from Q4 a year ago and more than doubled in fiscal year 2015.

E-Series augments our storage offerings with a high-performance SAN array for environments that do not require the level of data management provided by clustered ONTAP. Additionally, OnCommand Insight, in use at the largest companies in the world, continues to exhibit strong growth with orders in the fourth quarter nearly doubling from a year ago.

OnCommand Insight allows IT organizations to monitor their heterogeneous storage infrastructure and optimize asset utilization, which is critical as they manage through constrained spending environments.

Much of the acceleration of the growth of these products in fiscal year 2015 resulted from bringing product specialists into a single organization focused on bringing new products to market. We recently added our hybrid cloud products to this organization, and it will continue to be one of the areas of increased investment.

We are excited by the increasing thought leadership of our cloud offerings and the sales momentum of the newer products, but it has been more than offset by the slowdown in the aggregate ONTAP business. New investments in traditional ONTAP deployments have been declining with unit shipments down 30% in fiscal year 2015.

But the story of those customers who have made the transition to clustered ONTAP is a cause for optimism. Clustered ONTAP delivers a software-defined, flash-optimized, cloud-enabled operating environment with a set of enterprise-wide data management capabilities independent of the underlying hardware.

Customers can grow incrementally and non-disruptively with the flexibility of a wide range of deployment options from conversion-integrated systems to third-party arrays as well as software-only and cloud options. We see a growing number of clustered ONTAP customers up 135% in fiscal year 2015 from the prior year.

The bulk of this growth came from new to NetApp customers, which were up roughly 250% in fiscal year 2015. The number of repeat clustered ONTAP customers was also robust, growing more than 140% in the year. Additionally, shipments of clustered nodes grew 138% from Q4 a year ago and for the full year, they grew 163%.

The attach rate of clustered ONTAP continues to increase with roughly 50% of FAS controllers shipped in the fourth quarter going into clustered environments. Once transition to clustered ONTAP we see customer growth above current industry growth rates.

Clustered ONTAP is also a vehicle for our leadership in key emerging segments of the storage industry. In converged infrastructure, FlexPod had another good year with unit shipments up almost 20% this year. More than 70% of our FlexPod systems are shipped with clustered ONTAP.

All-flash FAS with clustered ONTAP is the only unified scale-out all-flash array on the market and gives customers the ability to deploy a high-performance node in their storage pool without having to make compromises.

The clustered ONTAP-based all-flash arrays have demonstrated the ability to match the performance and efficiency claims of the point product all-flash solutions, while uniquely delivering the scalability of clustering and the industry-leading data management of ONTAP.

Rather than creating yet another island of infrastructure, NetApp seamlessly integrates flash into our data management framework that not only extends to discs but to the cloud as well. Shipments of all-flash FAS grew significantly at more than 350% from Q4 a year ago and for the full year, they grew 260%.

In the fourth quarter, 72% of all-flash FAS arrays shipped as clustered configurations. Ultimately, we remain confident in the innovative value proposition that clustered ONTAP offers IT organizations as they build out their hybrid cloud environments.

Customers and partners who have made the transition to clustered ONTAP are growing and this underpins our confidence that now is the time to position investments towards our three priorities of accelerating the migration to clustered ONTAP, regaining traction in the channel, and increasing our sales capacity.

I'll now turn the call over to Nick to provide details on the fourth quarter and our expectations for the first quarter and fiscal year 2016.

Nick?.

Thank you, Tom. Good afternoon, everyone. We are disappointed that our performance in the fourth quarter fell outside of our previous guidance ranges. As Tom discussed, we are experiencing not only a market transition but a transition related to clustered ONTAP.

We achieved our financial targets in the first half of fiscal year 2015, but in the second half a combination of FX headwinds and weakness in our Americas commercial geography negatively impacted results.

While we are confident in our strategy and technology, we need to retool aspects of our business to position NetApp for long-term growth and strong sustainable shareholder returns.

We expect that there will be disruption related to this transition in retooling during the first half of fiscal year 2016 but that by the second half we will return to a growth trajectory and to our business model. I will talk through this further after I review Q4 and fiscal year 2015 results.

Net revenues for Q4 were $1.54 billion, down about 1% sequentially and down about 7% year-over-year. Our results fell short of our previous guidance range due to the impact of continued weakness in our Americas commercial sales geography and unfavorable foreign exchange rates.

FX headwinds reduced sequential growth in Q4 by about two points and year-over-year growth by about three points. For fiscal year 2015, net revenues were $6.12 billion, down 3% from fiscal year 2014, reflecting about a point of foreign exchange headwind.

Our revenues were on plan in the first half of the fiscal year, but lower-than-expected branded revenue negatively impacted the second half. Branded revenue was 93% of net revenues in Q4 and at $1.44 billion was up 1% sequentially and down 7% year over year.

The year-over-year decline reflects four points of foreign exchange impact with the remainder due to weakness in our Americas commercial geography. OEM revenue of $102 million was down 18% sequentially and down 7% year over year, in line with expectation.

For the year, branded revenue was $5.6 billion, down 2% from fiscal year 2014 and flat when adjusted for FX, again reflecting weakness in our Americas commercial geography. OEM revenue was $473 million, down 19% from last year, as expected.

OEM revenue ended the year at less than 10% of fiscal year net revenues and has normalized to a level of revenue that we will no longer be discussing separately. Indirect revenue through the channels and OEMs declined to 79% of Q4 net revenues compared to 81% in Q3 and 83% in Q4 last year.

From a geographic perspective, all geos performed as or better than expected in Q4 when adjusted for FX with the exception of Americas commercial. Americas' commercial revenue declined 8% year over year, primarily driven by the challenges Tom talked about associated with our clustered ONTAP transition and sales coverage.

Product revenue was $913 million in the fourth quarter, down 2% sequentially and 12% year over year. Adjusted for FX, product revenue was down 8% year over year. Over the course of fiscal year 2015, including in the fourth quarter, we saw an increase in the number of short-term support renewals.

We believe these renewals would show up on the balance sheet largely in short-term deferred revenue are an indication that customers remain committed to NetApp, but are not yet ready to do a tech refresh and to upgrade to clustered ONTAP.

The combination of software maintenance and hardware maintenance and other services revenues totaling $626 million in the fourth quarter was up 3% year over year or 5% adjusted for FX. Non-GAAP gross margin of 62% was down 2.6 points from Q3 and below our prior guidance range.

Product gross margin of 53.4% was down 5 points year over year due to FX headwinds, higher discounting, and unfavorable product mix. Software maintenance gross margin was down almost a point year over year but flat to Q3.

Hardware maintenance and other services gross margin of 62.6% was relatively flat year over year, reflecting increased revenue offset by infrastructure investments in people and projects. For fiscal year 2015, gross margin of 64% was almost a point above fiscal year 2014 and at the high end of our previous guidance range.

Non-GAAP operating margin for the fourth quarter was 15.6%, below our previous guidance range due to lower revenue and gross margins. We held operating expense dollars flat from Q4 a year ago, aided in part by favorable foreign exchange.

However, operating expenses rose as a percentage of revenue, as we were not able to reduce costs in the business at the same pace as the revenue declined. Operating margin for the full year was down just over a point from fiscal year 2014 and a point below our previous guidance.

Q4 non-GAAP EPS of $0.65 was below our prior guidance range due to lower revenue and lower gross margin. Our non-GAAP effective tax rate was 16.5% for fiscal year 2015 and 16.7% for the fourth quarter, slightly higher than prior guidance reflecting normal course year-end true-ups.

Q4 weighted average diluted share count of 313 million shares decreased by almost 4 million shares from Q3 due to repurchase activity in the quarter. Over the course of the year, we reduced weighted average fully diluted share count by 8% to 321 million shares. Now, turning to cash and balance sheet metrics.

We closed fiscal 2015 with just over $5.3 billion in cash and short-term investments, approximately 11% of which is on shore. Inventory turns decreased to 16 due to a buildup of finished goods to support a higher anticipated level of demand than was recognized. Days sales outstanding increased to 46, reflecting typical seasonality.

Deferred revenue was up $88 million in Q4 versus Q3 and up $97 million from Q4 last year. Free cash flow of $359 million was about 23% of net revenue in the fourth quarter. Over the course of the year, we generated $1.1 billion in free cash flow, marking the fifth consecutive year of strong performance.

At approximately 18% of revenue, fiscal year 2015 free cash flow was within our previous guidance range. Finally, we repurchased approximately $246 million of stock and paid $51 million in cash dividends during the quarter. We completed the $3 billion share repurchase program we announced in May 2013 a year ahead of our original schedule.

We also commenced purchasing stock related to the $2.5 billion share repurchase program we announced last quarter. As you may recall, our board of directors authorized $2.5 billion of repurchases by the end of May 2018 with the first $1 billion of repurchases expected to be completed by the end of May 2016.

We have enhanced our capital structure, and during the year once again delivered on our commitment to return capital to shareholders while continuing to invest in the business. Through dividends and share repurchases, we have returned approximately $3.5 billion to shareholders since May 2013.

Today, we announced an increase of 9% to our next cash dividend to $0.18 per share of the company's stock that will be paid on July 23, 2015. We have now increased the dividend 20% since announcing the program in May 2013.

At current stock prices, the new dividend rate represents a yield of approximately 2%, which reflects our confidence in the long-term strength of the underlying business and our ongoing commitment to driving shareholder value. Now, I'd like to spend a few minutes discussing our business outlook and guidance.

We remain confident in our business over the long-term. However, consistent with Tom's comments, we are in a period of transition and consequently expect some impact while we retool the business for the future.

The disruption related to this transition will impact the first half of fiscal year 2016, but by the second half, we expect to return to a growth trajectory and to our business model.

Related to this transition, we are focused on balancing disciplined investments with profitability to drive our business priorities and ultimately generate value for shareholders. With respect to our expense structure, we are intent on returning to a level of operating expenses commensurate with our operating model.

We are committed to looking for efficiency, taking cost out of our structure and to redirecting resources and people to highest return activities. We recently executed a set of decisions across our cost structure that will generate savings in fiscal year 2016, including a reduction of our global workforce by approximately 4%.

For fiscal 2016, we expect net revenues to be no better than flat with FX headwinds and limited top-line predictability in the first half and an overall recovery and revenue growth in the second half.

Though ultimately dependent on revenue mix, growth and our continued actions to drive down costs, we expect fiscal 2016 gross margin as a percentage of revenue to be down about one point from fiscal 2015, ultimately related to the clustered ONTAP transition.

We expect operating margin as a percentage of revenue to be down one point to two points for the year but to return to our 18% to 20% target operating margin range by the second half. We expect a year of continued strong cash flow generation as well as deferred revenue growth.

Finally, we expect to continue to repurchase our stock and based on the current prices, reduce share count by another 5%. This equates to a return of over 100% of free cash flow to shareholders again in fiscal 2016.

We expect our Q1 net revenues to range between $1.275 billion and $1.375 billion, which at the midpoint implies a sequential decline of approximately 14% and an 11% decrease year over year. This is despite a 14-week quarter in Q1, an event that occurs every six years.

As we begin the year, we expect to continue to be negatively impacted by FX as well as disruption related to the transition to clustered ONTAP and a one-time increase in lead times due to a factory move.

We expect Q1 consolidated non-GAAP gross margins of approximately 63% to 63.5% and operating expense before the 14th week to be approximately flat to Q4. That said, given the decline in net revenues and gross margins and the increase of operating expenses, we expect Q1 non-GAAP operating margins of approximately 6% to 7%.

Based on our stock repurchases in Q4 and in the first 10 days of Q1, we expect our diluted share count for the quarter to be approximately 315 million shares and non-GAAP earnings per share for Q1 to range from approximately $0.20 to $0.25 per share.

In closing, NetApp is uniquely positioned to help customers as they navigate the transformation of their IT deployments by providing a bridge from the choices of today to their requirements for the future.

We are firmly convinced that the investments we are making today will position NetApp for long-term success and enable us to quickly return to our operating model.

Finally, our capital allocation strategy continues to reflect confidence in our ability to generate significant free cash flow, which will enable us to invest both organically and inorganically in the business as well as continue to return significant capital to our shareholders through share repurchases and dividends.

Now, I would like to turn the call back to Tom for summary comments.

Tom?.

accelerating the migration to clustered ONTAP, regaining traction in the channel and increasing our sales capacity. Our strength of conviction in the benefits of those investments comes from the fact that customers and partners that have moved to clustered ONTAP are growing.

It is our imperative to transition more customers and partners to clustered ONTAP. We believe that these investments will drive long-term revenue growth, although that growth will be somewhat muted and will ramp over time as we work through our transition and shift to the hybrid cloud.

We expect the investments we are making today will be catalysts for growth and drive improvements in the second half of the year, putting us back on our operating model in the second half of fiscal year 2016 and with momentum going into fiscal year 2017.

Before closing, I want to thank the entire NetApp team for their dedication and focus on execution as we work through this transition. At this point, we will open up the call for Q&A. As always, I ask that you be respectful of your peers on the call and limit yourself to one question so we can address as many as possible. Thank you.

Operator?.

Thank you. The first question comes from the Kulbinder Garcha from Credit Suisse. Your line is open. Please go ahead..

Thanks. I have a (33:42) simple question and a follow-up. Tom, a question for you on the transition on clustered ONTAP. I'm just – I was looking at the last transcript and on there you talked about ONTAP meeting the technical requirements of your largest customers and most demanding customers.

But it sounds like it was kind of a release and it didn't? What I'm trying to (34:02) understand what exactly (34:03) what you thought the last three months ago to actually now in terms of this actual release and how the customer feedback has gone? What exactly went wrong and what's causing this transition, frankly? And then just for Nick, I understand the operating margin decline that you spoke about.

I think you said down to about 6% to 7% in the first quarter. What's the gross margin direction? I assume it's going down. I'm trying to (34:27) understand how much is negative OpEx average (34:28) versus gross margin. Thanks..

Yeah. I think – first of all on clustered ONTAP, as we went into the year and even as the year progressed is we got off to a pretty good start and we were ahead of our internal plan at the halfway point and it seems like things were picking up.

And we felt on prior calls like this, we talked about where the optimism in the second half and we certainly knew that we were going to get easier compares on the U.S. public sector and we certainly saw that come to fruition. And the other side is the breadth of the product portfolio.

We had a lot of new products in the portfolio, whether it be E-Series or StorageGRID or OnCommand Insight and that. And the other key thing was that we had the release of 8.3 coming, 8.3 of clustered ONTAP. And it was my full intention that that was going to be a big growth stimulant for us.

In terms of feature gaps relative to prior releases and 7-Mode, in terms of customer inhibitors, those have been substantially closed, in fact, almost entirely closed. The really key one on this one was really around high availability for our most complicated workloads.

And not only closing features, so it's not like we just caught up to where we used to be. We've got a lot of compelling functionality here that doesn't exist at any other – in any of our raw (35:49) products or any of our competitors' products. Also built in this was a set of tools to help with the transition.

We had – around the FAS2000 family, we had efficiency capabilities to make clustered ONTAP the natural target for the FAS2000 as well. And we had a lot of performance enhancements particularly around all-flash FAS and other things around quality of service.

So from a technical perspective, I think the confidence was very, very, very high that this was going to be the release that customers were going to go to. And certainly the new customer wins validated our confidence in the value proposition. And this was the one that customers are going to migrate to.

And all of that, everything that I previously said, remains unchanged. There is no evidence that customers are rejecting this technology or isn't meeting their expectations. That is not the story that we're getting.

I mean clearly the flaw here on our part is that we underestimated the complexity of these transitions, the planning associated with it, and frankly, the dependence on us to help them through that. So I mean at the end of the day, I think these are the most sophisticated customers. These are our largest customers.

These are the ones that are running high availability and the process changes, the getting downtime, downtime windows, all of that is proving to be a lot more complicated and a lot more time-consuming than we originally anticipated. So simply put, that's on us. That's entirely our fault and it's up to us to fix it.

And the good news here is that there isn't a technical impediment. It isn't something that we wish we had or some technical invention that we need to have to complete the vision here. The product is what it is.

It's exactly what we expected it to be, exactly what we wanted it to be, and we need to power through this and get our customers to transition..

Hey, Kulbinder. It's Nick. Let me address your question on the gross margin direction and the operating margin perspective for Q1. So the gross margin for Q1 should be in the 63% to 63.5% range. That includes about a point of foreign exchange pressure in there. I think to get to the operating margin, you have to be, have a couple of things in mind.

One is this 14th week quarter we have, this is the once-in-a-six-year event type of thing. So if you build that in, we've actually taken the revenue down on a sequential basis much more substantially than we've done in prior Q4 to Q1 transition.

So if I normalize out that 14th week, move in manufacturing that we're doing, I'm down about 15% sequentially versus my typical 10%. Right? You take that down at that 63% to 63.5% gross margin, then you have to go through the operating expense side of the fence.

In essence, our operating expenses for the first quarter will be flat to Q4 before the 14th week. If you add in the 14th week, that's an additional about $40 million of expense.

So I'm trying to walk you through the pieces of math here, but suffice it to say that the gross margin percentage range should be about 63% to 63.5%, including about a point – reflecting about a point of FX pressure.

But you really have to think about the implications of the 14th week on operating expenses, which means operating expenses are going up by that, and then the implications of really what we're doing on the revenue side, which is saying, yes, we get some 14th-week benefit, however, we're taking a step down here to be reflective of the transition we're in..

Thank you. Our next question comes from Brian Alexander from Raymond James. Your line is open. Please go ahead..

Nick, you said you'd return to normal growth in the second half of the year. I just wanted you to clarify that, because I think Q1 is going to be down low-double digits year over year.

So are you expecting some well-above seasonal quarters in the back half to get to, to get the market growth, because it's just hard to make the math work on that?.

Well, so first of all, Brian, a couple points. So what I'm saying in terms of revenue for the year is don't expect any more than flat.

Okay? So what I'm saying in terms of the operating margins of the company, I would say that the operating margins in the back half we expect to be back in the range that we've talked about before, so I'm talking about beta (40:21) 18% to 20% range in the back half of the year.

I also expect that from a cash flow perspective that as we get into that back half of the year we're going to be back to the cash flow ranges that we've talked about generating, which is the 17% to 19% on free cash flow. So I'm not talking about market growth here.

What I'm talking about is don't expect more than flat revenues, but expect us from an operating model perspective to get back to those percentages we've talked about as a percentage of revenue for both our profit margin as well as cash, free cash flow as a percentage of revenue.

And then I think the other thing here that I pointed out is that we've taken costs out and you should expect that we will be very focused on costs as we roll through this year..

Thank you. Our next question comes from Sherri Scribner from Deutsche Bank. Your line is open. Please go ahead..

Hi. Thank you. Tom, I was hoping you could give us a couple of metrics on how much your installed base has transitioned to clustered ONTAP, considering that it's taking a bit longer? I think you gave a number of 50% of the nodes are going to clustered ONTAP, so trying to reconcile that with the slow adoption by customers.

I'm just trying to understand what gives you the confidence that customers will start to adopt clustered ONTAP later in the year. Thanks..

Yeah. In terms of shipments, if you look at the various categories of the products, we are well over 50% of the shipments, we're over 70% of the bookings. Our largest machines are in the 80% range. Our mid-range machines are in the 70% range.

And the low end of machines really weren't, because of a bunch of technical reasons, really weren't going to convert over to clustered ONTAP until 8.3, and that's happening now. So 50% of the models, but the models that are targeted for clustered ONTAP are well up in the two-thirds to three-quarters.

But – and that's an important metric and one that we track constantly. It's not the only metric.

The metric that's also important is what percentage of our installed base has converted over? So if customers are in a mode where – the methodology by which they convert to clustered ONTAP typically involves buy new equipment and then basically migrating the data over. So most big ONTAP transitions occur in conjunction with tech refreshes.

So if the customers in the category are saying, okay, 8.3 is the least I'm looking for beginning to start my planning process, but I'm not going to buy hardware today and then move to it and then do another migration in the future. I'm going to do both of those at the same time. And that's where the delay comes in.

So we could ship 100% of the new systems out the door with clustered ONTAP on them, but if old machines aren't being upgraded then those customers aren't buying those new systems.

So that's really the key metric is which – what percentage of our big customers are moving to clustered ONTAP now? Now the question of, well, is there something else at play here? If one of the reasons was if they basically had lost their patience or they weren't going in a different direction, I think they would have gone there by now.

Our issue at this particular point in time isn't that customers are waiting for the next 20 things to come along.

Our issue is okay, this is the release, we've been waiting for these things, it's here now, how do we go about doing this process? And would they consider a competitor products at this point in time? If the reason that they've been delaying is because they've been waiting for new features to come along, they're not going to go to another product with even a more complicated migration that's actually missing even more features.

So I think that the customers that are at this stage are onboard. They're continuing to do service renewals. We certainly see that.

And we saw our deferred revenue actually grow year-over-year, which is an indication that people aren't buying the tech refreshes, which hurts us on the product side, but they are renewing and they are continuing to run this equipment, so it's not like they've made other decisions.

And I think that as the equipment gets older and with 8.3 meeting their needs, there is a lot of pent-up business behind that and we need to power through it. And could we have been more prepared for it? Absolutely. That's the lesson we're learning here today.

But that's the area, the constrained investment environment, that is the place that we are investing our money to get customers through this transition, because the other thing that we see in the data is that those customers that have successfully transitioned to clustered ONTAP, they are doing capacity expansion and software connect rates that are above the industry averages.

So from our point of view is the healthiest thing we could do for our businesses is to gather as much of our installed base as possible to clustered ONTAP..

Thank you. Our next question comes from Jayson Noland from Robert Baird. Your line is open. Please go ahead..

Okay. Great. Thank you. I wanted to ask about direct versus indirect. Tom, I believe you said there was a focus on regaining traction in the channel, but if you go back to the Analyst Day, there was some talk of consolidating to some of your larger partners.

So just wondering how much of changes in the channel, excuse me, have had an impact on your business?.

Yeah, I think certainly as we look at our channel base, we have a very, very, very large number of channel partners and a very, very long tail of active partners that aren't doing a lot of business, and a lot of our business is concentrated at the top. So clearly making our largest partners more successful, has been a focus.

And in fact, our largest partners actually had a pretty good year with us last year in terms of our reseller partners. I think the channel is also seeing the dynamics around clustered ONTAP.

Those that have made the investments, some of our partners were the first to go; in fact that was going to be a differentiator for them and they were going to lead the way. And I think they've done a really good job in terms of getting their customers transitioned, being trained up and actually using this to sell to new accounts.

Other of our partners who are back behind this, they're watching customers not necessarily upgrade and that's impacting not only the NetApp business but it's also impacting our mind share with them around the other elements of the portfolio.

So as I look at the business, clearly, we got to get the channel partners trained up, get them through that transition, and we also need to get them actively engaged with the rest of the portfolio, both things that are ONTAP based like all-flash FAS as well as E-Series and OnCommand Insight and the rest of it.

The one other point that I'd also point out is that it's not only direct and indirect. We look at our customers, we've talked about Storage 5000 in the past, but we have our largest accounts, our big global accounts, and for the first three quarters of this year those were all growing.

And it says that where we've got account intensity, even despite these other issues with clustered ONTAP, we were selling other elements of the portfolio, particularly OnCommand Insight, which had a huge year in our big accounts.

So where we had account intensity we could basically still drive growth despite the ONTAP slowdown, but it's taken a lot of resources to do it. The next generation of accounts will have adopted the next thousand accounts, beyond that we have what we used to call the rest of the Storage 5000, beyond that the mid-size business.

Those bottom two categories which are primarily channel driven actually did reasonably well also. The category where we struggled was that next generation beyond the top global accounts, those are primarily direct led. They may be fulfilled indirect or not, but there is a big NetApp presence in those accounts.

And I think that's where the dilution of resources came in. And as we spend a lot of time on our global accounts, make sure we shored them up, but we've not been nearly as diligent on that next thousand. And my simple observation as I watch the business is yeah, there is kind of a tough macro backdrop, there aren't as many deals as there used to be.

But when there is business and when we show up and when we compete, we're winning more than our fair share. So win rate is not our issue. We need to be in front of more accounts. And that next thousand is an area focus.

That's why we talked about clustered ONTAP transition, we talked about investment in the channel, but we just plain need more sales capacity to be telling this story to more people, and there is just as much conviction about that now as there was 90 days ago, and we're in a situation now where we're back to full strength.

We're continuing to investment beyond that, but we also have to go through the training cycle and get people up to speed, and that's kind of where the state of play is here. But there is no doubt that when we show up in front of our people, or our trained partners are in front of people that NetApp can close and NetApp can win..

Thank you. Our next question comes from Maynard Um from Wells Fargo. Your line is open. Please go ahead..

Hi. Thanks. I just wanted to focus a little bit on the back half and the recovery and the confidence you have.

Are customers indicating they have migration plans? Or is this – how long does a typical migration take? Is this purely a function of having enough people to do the migration? Or are you kind of going under the assumption that the one-year service renewals will convert to product sales at the end of the extensions? And then just directly related to that, understanding customers are unlikely to move to other on-prem solutions, is there any reason why we shouldn't anticipate that customers might use this transition to negotiate price, because it sounds like the gross margins are going to go back to sort of the normalized level, so I'm just curious why you wouldn't anticipate that in a transition like this? Thanks..

Well, I mean, these migrations, I don't want to use the word complete around them per se. Some of these migrations and individual customers include hundreds, if not thousands of machines in dozens of countries. And so there is a planning cycle that they need to get through that they could start a migration.

So they could be doing migrations through that entire estate over an extended period of time, and that's okay. Well, we can't be in a situation where they aren't starting that process because they're in the planning cycle, and we need to help them with that.

So when we talk about investments and helping them through that, in some of those cases we will be directly involved. And in some of those cases where they're very, very strategic and there is a lot of business behind it, we're willing to do that at our own expense because it's in our best interest to do so and the customer's best interest to do so.

But the goal is on these really, really big accounts, once they get this thing rolling, you will have a process and it may take some time.

But while they were in the planning cycle, at least for that use case and that workload that's on that equipment, they're not inclined to basically make big hardware purchases around equipment that they aren't going to use right away.

So from our point of view, it's what can we do to get them over this initial cycle, which is a lot of planning, letting them learn the tools that we have and also in our case, perhaps putting our own professional services resources against this problem and in some cases perhaps even giving them some gear.

That's not going to be the dominant case, we're not going to be able to do that across the board. But for some of the big accounts that we need to get going, that are willing to make that commitment if we're willing to invest and help them, that is already underway and we're doing that now in some very, very large accounts..

Maynard, it's Nick. Why don't I just point out, we talked about a reduction in gross margin by about a point for the fiscal year. Actually, half of that point is going to be related to foreign exchange, obviously, from the first half of the year. We're going to normalize through that.

So yes, there is investment built in, but there is also foreign exchange built in, so you should try to keep that in mind..

Thank you. Our next question comes from Lou Miscioscia from CLSA. Your line is open. Please go ahead..

Okay. Thanks, Tom. I guess you've talked about the cloud, but there is many shifts that are going on in storage.

You've got a product in the converged category doing well there, congratulations, but when you look at hyper-converged, hyperscale, the start-ups like Nimble and Tintri, software-defined, object storage, I know you've got a product there, and then obviously, just the cloud storage vendors or the cloud companies in general, I mean how do you rank these as secular shifts that are hurting you and possibly going back to your comment that you've lost a bit of share this year in conjunction, obviously, with what you've talked about with ONTAP?.

Well, I think a treatise on all those topics could take a long time, but I think – we talked about radical transitions. The radical transition is the cloud, and the cloud dwarfs the impact of any of those other technologies.

And some of these small companies, their incremental revenue year-over-year might be $50 million or $30 million or $100 million, and you look at the kind of money that's being invested in the cloud, and the cloud is not just the hyperscalers, it's also things like Microsoft Office 365 and Exchange and things like that that are moving to the cloud.

So the cloud transition dwarfs all other transitions. Everything else is technology based, and NetApp is a technology company, and the areas that we invest in we are confident in our ability to basically lead that technology and take leadership positions in those areas. So don't minimize the technology stuff.

It's work, it's engineering, it's hard, but that's what we do. The cloud is clearly the much – the thing that's roiling the industry at this point in time. There's no doubt about that.

And our view on the cloud is rather than either deny the cloud or declare it a fad, or fight against it or position them as the competition, our view is to embrace the cloud, find a way to monetize it. And that's the rationale between the evolution of our product offerings.

We talked about NetApp private storage, where the data remains on your network but you have access to the flexible compute of Amazon and SoftLayer and Microsoft. We've got Cloud ONTAP, the ability to actually run ONTAP, build a virtual machine in the cloud, a virtual system in the cloud and buy it by the hour.

And at the end of the day, the story is, is that, the cloud is going to be part of everybody's environment. It won't be everything.

We're a firm believer that everybody is going to have some combination of owned infrastructure and cloud infrastructure, and our job as a company, since our strength is data management, is how do we make that data management experience seamless across all of those domains? So one set of tools, one set of processes, one set of backup, one set of replication, whether data is on our equipment or not, or whether it's on-premise are not.

And that's the value proposition that we're driving. And that's our definition of software defined. In fact, that's the epitome of software-defined. It's not a point solution for certain workloads. It's not some thin veneer of software over some very dissimilar hardware. This is one set of tools across all of these use cases.

So as far as the cloud is concerned, that is the thing that customers are talking about. Everything else, I'm not going to minimize it, we could talk about each one individually if you want, but the cloud is the big change. That's the one that's driving our strategy. And I've been doing a lot of these cloud pitches.

I know some of you have seen the initial version of that at Insight, but it works, and we have a lot of momentum around it. Simply put, ONTAP on-premise is the story and the nut that we need to crack in the near-term.

The rest of it, whether it be our new products, whether it be our cloud strategy, that is clearly working for us and I'm extremely pleased with how that's going..

Our next question comes from Keith Bachman from Bank of Montréal. Your line is open. Please go ahead..

Hi, Tom. Thank you. I wanted to ask about first on competition.

You talked a lot about on the call the transition to 8.3, but if you could speak to in terms of new workloads or jump balls as I think about it, how do you see the level of competition there? And related, do you think your installed base is flat or declining at this point? And then I wanted to ask a follow-up, too.

But let's start with that one, please..

Well, the installed base is measured in units is actually growing and growing quite, quite substantially every year. So that – and that's a function of equipment not taking out of service, plus the thousands of new systems that we put out there every day.

What we are not seeing is a bunch of machines that mysteriously are no longer being operated and dropping out of our order reporting database. So these machines are reporting back, which means that they are live, customers are applying maintenance on them. So that installed base is continuing to grow.

So if there was this big competitive push that was taking us out of all those environments, we would effectively be seeing that go away, and we're not..

Right..

In terms of the broader competitive landscape, certainly EMC and the other server vendors, there is usually one of them in every transaction that we do or every competitive situation that we're in. We certainly see the start-up vendors certainly not underestimating, but they are not ubiquitous like the other guys are..

Right..

In terms of jump ball workloads, I think they fall into a bunch of different categories, whether it be analytic workloads, whether it be virtual desktop workloads, whether it be new apps workloads, webscale-type of things. I think where we're seeing the cloud and new application development is around a lot of these new workloads.

Whether Hadoop is an on-premise solution, or whether we see analytics in the cloud, whether it be some of the customer service, whether it be the mobile apps, those types of things. And I think that those are very, very much a jump ball. I think as far as the other vendors, I'd say certainly the hyper-converge, we see them in those domains.

Flash is a little bit different, I think a lot of the flash battlefield is around some of the new workloads, particularly virtual desktop, but that's not big enough to support everybody's flash investment. The other place where we clearly see flash is basically application acceleration in database, and generically high-performance SAN.

So for NetApp, high-performance SAN has not been a historical strength of ours. Certainly with clustered ONTAP we want to compete more aggressively there, but that's not the installed base. It's not the NetApp installed base that's being fought over in the high-performance SAN market.

So that's an opportunity that with clustered ONTAP and new, now with the all-flash FAS, the latest release and the performance benchmarks that we have that are compelling, it's something that we want to compete on more aggressively. So I'd say it depends on the workload. I think the cloud is more relevant to next-gen workloads.

And then we're starting to see flash around things like VDI, but a lot of it around accelerating traditional workloads, particularly around database acceleration..

Okay. Fair enough. And I just wanted to ask a follow up, Nick. Nick, what happens if your assumptions surrounding your growth potential and transition of 8.3 are incorrect? That is to say we get deeper into the year and NetApp continues to not be able to realize what you believe to be your growth potential.

Nick mentioned you're taking out about 4% of your head count out in the risk.

Do you see more opportunities if need be as you look out over the next number of quarters where NetApp could skinny up meaningfully, reduce its cost structure if that is what the situation warranted?.

Yeah, actually I'm glad you ended the conversation that way. I think the lay of the land now based on kind of what we believe is achievable the rest of the year gets us back to our operating model in the second half.

And the balance that we have clearly is we spend a lot of time on this portfolio, we know there are things that are under our control that if we can overpower it we believe can unlock growth, and at this point in time I don't want to preclude our ability to do that. So we're making the investments to go after that and go after that aggressively.

If it turns out that either the macro substantially deteriorates or our postulate is not correct, although we're pretty convinced that we're on the right track, or any number of other things come in the way and the business doesn't materialize, then clearly our current operating hypothesis will be invalidated and we're going to have to do other things.

So certainly there is an opportunity to take more cost out of the infrastructure. I think to take more cost out of the infrastructure now when we know what big bets that we think we're on the cusp of realizing over the next six months to start to see impacts, then I think we want to make those bets now.

But if they don't materialize, then clearly we need to rethink what we think the long-term growth rate of this business is, what we think the long-term growth rate of this industry is, and we have to look at our cost structure. So we're not wedded to a dollar figure on the cost structure at this point in time. We're going to be practical.

At this point, we took out a certain amount of head count, we took out well more than that and other infrastructure costs in the company, took a couple hundred million dollars out. So we're prepared to do more if the situation warrants, but right now I think we have a structure that enables us to still compete for this business.

And if we're right in our hypothesis, then I think we win. And I think that we will be well served by preserving the investments we're making right now..

Thank you. And our final question comes from Amit Daryanani from RBC Capital Markets. Your line is open. Please go ahead..

Thanks a lot. Nick, I just maybe wanted go through the math for the full-year revenue expectations that are no better than zero percent growth I guess. If I look historically, July quarter fiscal Q1 tends to be about 23%, 23.5% of the full-year revenue contributions. If I play that out this time around, I get your sales to be down 9%, 10%.

So I'm just curious, which of the next three quarters you think will punch in more than their historical weight to get you to a better trend than down 8%, 9%? If you maybe just help understand that math, that would be helpful..

Yeah. Now, remember, what I'd also indicated at the beginning of this call was that we took down the front quarter associated with this transition, and we expect this transition to get its legs under it and get moving as we get to the back half of the year.

So I do expect that the linearity is going to be a little different and that we will be back-end loaded. In addition to that, as you know, we're not going to have an FX compare in the second half of the year, at least at these rates.

So it's really the combination of those two things that you should think about in terms of the revenue and the no better than flat revenue guidance that we gave..

getting clustered ONTAP transition; getting our channel partners up to speed and ready and regaining traction with them; and expanding our sales capacity and telling our story to more customers. So those are the bets. Those are entirely within our control.

I see a direct line to success in those activities to ultimately revenue growth and that's how we can make the comments about the second half of the year. So thank you very much for your time, thank you for your support, and look forward to seeing you all in 90 days..

Ladies and gentlemen, thank you for participating in today's conference. This concludes our program. You may all disconnect, and have a wonderful day..