Good day, ladies and gentlemen, and welcome to NetApp's Second Quarter Fiscal Year 2016 Results Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. [Operator Instructions] As a reminder, this conference is being recorded. I would like to introduce your host for today’s conference, Ms. Kris Newton, Vice President of Investor Relations. Ma’am, please begin.

Hello and thank you for joining us on our Q2 fiscal year 2016 earnings call. With me today are CEO, George Kurian and CFO, Nick Noviello. This call is being webcast live and will be available for replay on our Web site 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 third quarter and full fiscal year 2016, our expectations regarding our ability to respond to changing demands of our customers in an increasing uncertain macroeconomic environment, our ability to manage our cost structure portfolio and processes to drive efficiency, profitability and growth, our expectations regarding market acceptance of Clustered ONTAP, our ability to drive operational and financial performance, and our expectations regarding our business model in FY16 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 with 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 2015, subsequent Form 10-Q quarterly report, and our current reports on Form 8-K, all of which can also be found on our Web site. During the call, all financial measures presented will be non-GAAP unless otherwise noted. 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 Web site. I'll now turn the call over to George.

Thank you, Kris, and good afternoon everyone. Thanks for joining us today. Our Q2 fiscal year ’16 financial results were generally as expected. We’ve continued to make progress as we pivot towards growing parts of the market, scale out software-defined flash, converged and hybrid cloud. Our key investment areas of sales capacity, channel traction and acceleration of the transition of our install base to Clustered Data ONTAP continue to show early results. Our focus remained on enabling our customer success as they navigate their IT transformations to leverage modern architectures and deploy hybrid cloud solutions. Over the course of our second quarter, I’ve continued to rigorously analyze our business, I traveled around the world and participated in our Insight user conference, meeting with thousands of customers and partners. The feedback I heard was overwhelmingly positive and reaffirmed my conviction that our Data Fabric strategy resonates with and is aligned to our customer’s strategic technical direction, underpinning our confidence and the opportunity ahead. We’ve made progress but we still have more work to do to become more efficient and agile, so that we can best take advantage of our long term growth opportunity. An increasing uncertain macroeconomic environment, continued shifts in the market and an aggressive pricing environment, have slightly tempered our fiscal year 2016 outlook. By coupling the strength of our Data Fabric strategy and the benefits we deliver to customers, with a more efficient and agile business, we can generate value for customers, partners, employees, and shareholders over time. I have tremendous confidence in our opportunity for success. That said, parts of our business are working well, some parts need improvement and other parts we must manage through declines. The IT spending environment continues to be constrained and the expectation for growth for the overall storage market has decreased…

Thank you, George, good afternoon everyone. Before we get started as a reminder I will be referring to non-GAAP numbers in today's discussion unless otherwise indicated. Overall, we are pleased with our Q2 financial results and the progress we're making related to our key investments, in sales capacity, in the channel and in accelerating the migration to Clustered ONTAP. Starting with revenues, net revenues for the second quarter were $1.45 billion, up about 8% sequentially and down 6% year-over-year. FX headwinds had an unfavorable impact on the year-over-year comparison by about 4 point. As George indicated, the overall IT spending environment is pressured, this coupled with the uncertain macroeconomic environment has affected us in different ways across our geographies. For example our U.S. public sector business declined 22% year-over-year in Q2 while at the same time excluding impacts from foreign exchange, EMEA and Asia-Pacific were up 8% and 3% year-over-year respectively. Product revenue of $815 million was up 23% sequentially in line with expectations but was down 12% year-over-year. The year-over-year decline reflects favorable Clustered ONTAP momentum which was more than offset by about 5 points of FX headwinds and declines in ONTAP 7-Mode revenue which we expected as well as OEM revenue due to the changing business dynamics of our OEM customers. The combination of software maintenance and hardware maintenance and other services revenues primarily derived from existing new and renewed service contracts was up 3% year-over-year but down 6% sequentially, reflecting the return to a 13 week quarter. As a reminder, we had an extra week in Q1 which resulted in about a $40 million increase to Q1 maintenance revenue. Indirect revenue accounted for 77% of net revenues similar to Q1. Gross margin of 62.5% was down about 2.5 point year-over-year and about a half a point below…

Thanks Nick. We’ll now open the call for Q&A. Please be respectful of your peers, and limit yourself to one question, so that we can get to as many people as possible. Thanks for your cooperation, operator?

Thank you. [Operator Instructions] Our first question is from Jayson Noland of Robert Baird. Your line is open.

I wanted to ask George on the transition program. Could you provide some more detail on the economic incentives that are behind cTAP and then how are the credits accounts for on the P&L?

The credits are essentially discounts related to the product bookings that were registered as part of that program. So every transaction that is qualified for the cTAP incentives goes through a deal registration process that we administer. In terms of the program itself, the incentives and enablement that we have conducted include the availability of temporary swing gear on a loan basis to customers that need temporary capacity, some set of incentives around professional services to help them enumerate the cost of the overall migration effort. A majority of the transitions have being done through the partners and there have been strong update and good feedback from the partners in the second quarter of this year, the number of partners that participated in the Clustered ONTAP acceleration program expanded substantially from Q1 across all of the geographies in the world, as well as the number of customer transactions also expanded substantially from Q1. So we’re pleased with progress. We thank our partners for leading in with us on this important effort.

Our next question is from Jim Suva of Citi. Your line is open.

George can you give us a little bit more color on -- you had mentioned that you’re doing the strategic reviews and a lot of the efficiencies and stuff like that. Is there anything we can judge or put as milestones or look ahead and see how quickly you’re assessing these items? And then for Nick, can you talk a little bit about cash flow, whether it’d be an extra week last quarter, and not the extra week this quarter. If you sum up the two quarters in total, you kind of in my view washes out the extra week factor. And when you look at the two quarters together, the cash flow looks down significantly year-over-year. Is that kind of the new run rate we’re looking at for cash flows as a percent of revenues? Or how should we think about cash flows, because it seems like it’s directionally stepped back a little bit? Thank you.

I’ll take the first question and then hand over to Nick. I’d appreciate the next few callers to just stick with your question. In terms of the overall assessments that we have conducted, it’s really focused on both efficiency as well as velocity. And what I mean by that is efficiency around all aspects of our business, structure, portfolio, business process, so that customers find it easier to do business with us as well as partners. In terms of velocity, we feel that having accomplished the efficiency aspects of the program, we will be able to transition our business more quickly in response to changing market landscapes. We’ll just be a leaner, more efficient Company that can be more agile in response to the changing market environment. You will hear more from me over the second half of this fiscal year and over the next few quarters beyond that as we go through the program. Stay tuned it is a fundamental reassessment of all aspects of our Company.

And Jim just quickly, with respect to the cash flow, I think this is consistent with the slow start up of the year right. The first half was intended to be a rebuild, both of the pipeline and a rebuild of the business condition. You saw that in terms of even the operating margins as we grew up in the first half year. You can see it in net income. Second point would be that as we look at the second half, our view is that we’re going to be in the mid-teens in terms of cash flow as a percentage of revenue in the second half. So, that clearly washes out all of the implications of timing, 13-week versus the 14-week quarter and all of those pieces.

Our next question is from Lou Miscioscia of CLSA. Your line is open.

When you look at your operating franchise, sales, marketing, R&D, G&A, you did a good job year-over-year, and obviously quarter-over-quarter taking out the prior week. Should we expect it to more or less stay flat absolute at this level going forward? And then if you could comment where do you think it could go even more into the future into ’17 and beyond? Because it sounds like you want to continue to take a good cost out, or take cost out?

Hi Lou this is Nick, so a couple of things. I think if you back through the guidance, you will see an implied reduction quarter-over-quarter, so a sequential between Q2 and Q3 reduction in operating expenses overall. Also it’d say that 47% of revenue in Q2 is not the type of level we expect for the business, in the long-term, or in the long-term models. So, more to come, and we’ll talk more about that, George indicated that he’d spend more time talking about the portfolio and all of the things we’re looking at, but suffice it to say for purposes of the Q3 guide you can back through that and see that we expect operating expense to be down sequentially and down even as a percentage of revenue versus Q2.

Our next question is from Kulbinder Garcha of Credit Suisse. Your line is open.

And a question for both of you I guess on gross margins on the product side, and it’s under pressure this year we are seeing currently but they kind of feel almost permanent and the currencies are where they are and then on top of that pricing seems intense. There is always kind of intense in this industry and you're going through a prolonged transition which I assume opens you to more competitive attack. So would I be wise in concluding that this level of gross margin is probably all we’re going to see for some time or are there some of the drivers or initiatives that work to bring them back to historic level? Thanks.

Sure, Kulbinder let me start with that, so certainly if you look at the gross margins and specifically the product gross margins for the quarter on a year-over-year basis we have a 2.5 point impact alone from foreign exchange, we don’t expect that type of thing and in fact that will start to mitigate as we get certainly to Q4. We do have higher discounting, I made that clear. Last quarter and actually in Q4 I talked about higher discounting, it's about two points impact on a year-over-year basis to product gross margin this quarter that we have to work through, that is the aggressive pricing actions going on in the industry right now, we have to look it. That said, overtime we’ve shown that we can move margins here and in fact over a several years we did exactly that. Finally, I would say that on the services side of our business the team has done a really good job in terms of leveraging the cost base and servicing the enormous install base of customers that we have. So I think it's a combination of items certainly the aggressive pricing environment it is something that we have to be reflective of, the portfolio is something we spend a lot of time working on and thinking about and the uptake of Clustered ONTAP with customers and those actions on the hybrid cloud portfolio overtime we expect to see benefits to margins of the Company.

Our next question is from Sherri Scribner of Deutsche Bank. Your line is open.

I was hoping if you can give us a little bit of geographic detail in terms of what you saw across the world, it looks like the Asia business saw some nice uptick in the quarter just curious what that’s about? And looks like maybe the public business was maybe a bit softer, so hoping to get some more detail? Thanks.

Okay Sherri, let me just start on that for a second, so if I take the impact of currency out our EMEA business actually did really well in the quarter and that EMEA business year-over-year without currency was up 8%, Asia was up 3. The challenge obviously was in the U.S. public sector down 22, no foreign currency impact there. I think that to start and I am sure George may have a comment or two as well, I think the EMEA team has done an incredible job really over the course I am going to say no of this last year plus of taking Clustered Data ONTAP and the promise of the portfolio and the data fabric and bringing that to customers, I think it started there. And Asia, we obviously had some very strong areas, we have some that are more challenged and we have some macroeconomic implications in Asia that we’re just going to have to work through and the team there is working through it. In the U.S. public sector, there is a variety of things going on that we just have to be aware of. I would say that we are not anticipating a recovery in the U.S. public sector as we move into Q3.

Just to add some color to that, I think when I look across the geographies our large enterprise customers continue to do good business with us across all the geographies. To add some color to the Asia-Pac and public sector comments, in Asia Pac you certainly saw the impact of the slowdown of China, in the countries that were dependent on China either for investment or as suppliers to the Chinese economy. So it was while the overall business met expectations there was a wide range of different countries. I think in terms of the public sector itself. We do large amount of business through the global system integrators and their business was challenged within the public sector model. We also saw in some cases program delays or prioritization of spend towards priority such as cyber security. We feel confident of our position in the public sector business, we are the number one provider of storage and data management and we continue to win our preponderant majority of new opportunities within the public sector.

Our next question is from Ananda Baruah of Brean Capital. Your line is open.

This could be for either, George or for Nick just what I guess anecdotally is the right way to think about the levers around the R&D it certainly seemed to be just if you take a look at this quarter one of the contributors to the OpEx, the OpEx I would say kind of catalytic performance. But it just seems like this year is going to be a little bit softer than last year and in the context of I may have to give specifics now, but like looking at the overall portfolio is there anything that you can tell us now philosophically how you're looking about the -- looking at the R&D going forward given that we've already seen it come off a little bit? Thanks.

When we look at portfolio management we look at it on both products and product market as well as customer segments, geographies and all aspects of the business. As I said in my prepared remarks we run a very disciplined portfolio management process which means that for capabilities that are mature in the market we continue to reduce our investments in those parts of the business whether they are pathways, whether they are customer segments or on the product portfolio side and reinvest some of that into the faster growing emerging parts of the market. We returned some of that certainly to shareholders and some of that we reinvest to the faster growing parts of the market, so that's our portfolio management approach and we've implemented it, it's certainly part of the model that you're seeing being implemented in the Company going forward and that's what's driving discipline in the operating expense stack.

Our next question is from Amit Daryanani of RBC Capital Market, your line is open.

I guess George I just want to understand this cost containment side you talked expectation last earnings call that we would have more update this time around. So I'm curious what are you seeing and what's driving this announcement of cost optimization to be more further pushed out and then broadly as you think of your business if you have a zero to down 5% revenue trajectory what do you think the right OpEx number is, is it sort of 20% or 40% for you guys? Thank you.

We have done a thorough analysis of the business and identified a number of areas to drive fundamental transformation that fundamental transformation is both to improve the efficiency of the business and also make it easier to do business with NetApp. To do those actions will take time to achieve the full desired outcome, but it is what will help the Company both transform our operating expense stack, as well as make it easier to do business with us so that we can drive top-line velocity. The things that we have done are already showing results in the quarter so we have taken some action in the quarter and we said we will take further actions through the second half of the year and you will see more progress updates as we take those actions on. So we are not saying that we're pushing out any action to next fiscal year. We're going to start and we're going to continue to do it over multiple quarters.

Our next question is from Brian White of Drexel. Your line is open.

I'm wondering if you could give us a little color on how you're thinking about the Dell EMC deal and the opportunities that they open up or the threats that you see from this transaction. Thank you.

First of all I would say that my opening comment is that the Dell EMC transaction is yesterday's solution to tomorrow's customers' problems. It does not fundamentally address the hybrid cloud, it does not fundamentally address the data management opportunity that customers are forced to deal with. It is really about trying to build efficiency in an integrated hardware business rather than the software-defined data center of the future. I think in the near-term based on discussions with multiple customers and partners it is generating a lot of uncertainties for customers and resellers and that is clearly an opportunity for NetApp, which we intend to take advantage of. In the long-term the absence of a compelling story around the ITR section of the future will make their customer value propositions something that we can debate and capitalize on. We are taking action to improve the efficiency of our business to be able to deal with larger scale competitors and be more agile than they are. And I'll summarize at that.

Our next question is from Maynard Um of Wells Fargo. Your line is open.

George you talk about portfolio management but it sounds more like you're looking for areas that de-emphasis in declining products. You obviously have a pretty strong customer install base even in large enterprises, so I'm curious why you wouldn't look to more aggressively broaden out your portfolio to cross sell more products into your existing install base and then across your broad channel. And I know you've done acquisitions like buying Riverbed's SteelStore product but why not have a more aggressive product acquisition strategy maybe even larger to increase your revenue per customer rather than returning the cash to shareholders and I guess the question really boils down to NetApp being either a growth versus value company and which one you think is right for the Company long-term? Thanks.

I would tell you that we are in a changing market landscape where some parts of the market are declining and some parts of the market are growing quickly. I would say that it is important for us from a management perspective to apply discipline and maturely harvest the categories of the market that are declining. We do believe that we can continue to gain share even in those declining markets. At the same time we balance every dollar that we have incremental in terms of investing in new market opportunities or returning it to shareholders and that's a careful balance that we continue to have. In terms of our emerging portfolio of products as I said on the call, we are very pleased with the progress in terms of the growth rates of the emerging portfolio the all-flash arrays, the E series portfolio, the hybrid cloud solutions we're very pleased with the progress both in terms of the growth rates as well as the number of channel partners selling it, as well as the number of customers that are adopting multiple products from NetApp to the point you just made. So we will continue to stay disciplined. We have a disciplined market and strategic evaluation process that looks at our portfolio and compares it to the market trends and it's an ongoing evolution in a changing market, so thanks.

Our next question is from Steve Milunovich of UBS. Your line is open.

You talked about the Company in two pieces standalone storage and on the other side scale out software-defined in cloud, what percentage of the Company is in each bucket today and what do you expect maybe exiting the year in a couple of quarters?

Obviously, when we talked about traditional standalone storage systems we were talking about our 7-Mode operating system and the OEM business. I think when you look at the used cases for the E series through the branded channel there are a large number of third platform used cases that are built around the data center of the future. The Clustered ONTAP operating system is also part of the datacenter of the future combining scale out, software-defined and all-flash architectures to enable customers to operate their environments like cloud service providers. So traditional storage we were referring to were particularly around 7-Mode and OEM.

Our next question is from Andrew Nowinski of Piper Jaffray. Your line is open.

So I just like to ask about linearity in the quarter, I know you said product revenue was down 12% year-over-year, product gross margin was down I think impart due to higher discounting, but then your DSO was also spiked up which seems to imply the quarter maybe have been a little backend loaded and your guidance for the January quarter was a bit lower than street was expecting, so I guess when you look at both your metrics together it seems like you may have pulled in revenue into October quarter, so just wondering if you could provide any color on that dynamic and whether the sales pipeline for the January quarter is up on a year-over-year basis?

Andrew it's Nick. Let me get you started on that part of the first half activity as we talked about it back in May and then again in August on our calls was to rebuild pipeline, and the team has been doing a really important effort around just that, putting sales capacity and rebuilding channel partner relationship et cetera. So I think the work continues to go on there, that's not something that's going end, it's going to be something that continues. In terms of linearity in the quarter, the second quarter is a quarter that encompasses both the federal year-end in September and then our quarter end in October. When I look at our position at the end of the quarter, end of the quarter versus the sort of the end of the quarter a year ago is not much different there. So the linearity, I think is pretty normal in terms of overall what has happened year-on-year, I realize the pieces there is anomalies, I should say there are anomalies in this 14 week quarter from Q1 which we see every six years. So, hopefully, we will not have that type of thing talk about for another six years, but other than that the linearity is really consistent with what we expected and our position going into Q3 consistent with what we had going into Q3 even last year.

Our next question is from Rod Hall of JPMorgan. Your line is open.

George I guess I wanted to ask about the penetration CDOT you said it was 17% I think in this quarter, that's a little bit of a slowdown in penetration rate from the last quarter, so wanted to just get you to comment on that, you're talking about a pretty high transaction rate there so just trying to proposal of two things? And then also on that same line you said 30% of capacity is penetrated, can you guys give us the last two quarters of that number so we can compare that capacity penetration rate? Thanks.

So let me just say that our prior quarter was at 15% and the current quarter is at 17%. So we're not -- we don't see this as a slowdown, we see this as a constant sort of trajectory of customer environments transitioning from 7 to CDOT as well as new shipments getting deployed in our install base. When a new shipment gets sold by NetApp to the customer, it usually takes a little while before it actually shows up in our install based measuring system because of the time it takes for the customer to get it ready and deploy it. So sometimes the quarter boundary is not the perfect answer and so we see this as part of our ongoing trajectory. In terms of capacity deployed and capacity managed, we don't breakout those numbers they are essentially a measurement of the valuable of Clustered Data ONTAP in terms of being able to consolidate multiple systems and provide for large-scale data management in a very efficient fashion for customers, so we are pleased with that statistic as well.

Our next question is from Brian Alexander of Raymond James. Your line is open.

Just going back to the geographic performance why do you suppose Europe has been so strong in the last couple of quarters, I think you said up 8% in constant currency, the macro backdrop at Europe obviously isn’t all that favorable. So what’s different about your business or your competitive position there that’s allowing you to have a pretty strong growth in constant currency versus the performance in the Americas?

I would say there is two or three factors. The first is I want to thank our European sales leadership team. We have a deep experienced, well executing sales leadership team and a group of loyal channel partnerships who we have enabled with our technology sets and that has driven consistency in terms of the execution of the European organization. It is also translating our investments in the channel as well as the capacity investments we have made in the field into results. The second is we have introduced capabilities that were specific to the European market. So for example Clustered Data ONTAP there is a high availability configuration of it called Metro Cluster that is built for European, with European datacenters in mind and that gives us a far superior solution for Europe than any other competitor in the market. So it’s both technology as well as great execution on the ground.

Our next question is from Aaron Rakers of Stifel. Your line is open.

I wanted to go and discuss the free cash flow guidance I believe last quarter you had talked about 15% free cash flow relative to revenue, I know that you’ve tampered slightly your revenue outlook for this fiscal year but now you are talking about 15% for the back half of the year which by my math would adjust a deepened decline in the full year free cash flow contribution. I am just kind of wondering what necessarily has changed so significantly in the free cash flow expectation relative to the slight write-down on the income statement.

Yes, Aaron, actually if you go back to some of the discussion that actually happened in May we are talking about a cash from ops for the year that was going to be coming in, in let’s say the high 100 million range if you backed through the math and then redeploying to shareholders over 1 billion so over 100% redeployed to shareholders. When I look at our forecast today they are moderately south of that but we are not talking about material numbers. So it is mid-teens is the expectation for the second half of the year. There has obviously been some pressure here in the first half, there has been some noise in terms of Q1 versus Q2 but overall for the year we should be generating a cash from ops range in the $800 million to $900 million range and that is not that significantly different from what we even talked about back in May.

Thank you. Our last question is from Joe Wittine of Longbow Research. Your line is open.

George I think I want to appreciate the pragmatic view on market growth splitting out kind of the traditional on prem areas that are shrinking, I think you said 9% of the growth the portions converged all-flash et cetera are growing 20%. Give us a sense of what is NetApp’s current breakdown I think it just helps in believe the story it helps kind of helps us to do the math as far as when top-line growth could return? Thanks.

I would say that first of all it’s hard for us to breakout specific segments because essentially our all-flash arrays are part of our core Clustered Data ONTAP business. I would point you in terms of the places where the business is declining to 7-Mode and our OEM business as we said the 7-Mode business is down to 30% of new shipments down from a much, much larger number a year before, Clustered Data ONTAP is 70% of new shipments and so you can draw your conclusions in terms of when that transition will happen. The majority of our business has already transitioned to the go forward platform. I will leave you with that. The majority of our business has already transitioned to the go forward platforms in the E series branded versus OEM in the ONTAP and FAS business Clustered ONTAP versus 7-Mode.

Thanks Joe. I’ll give it back to George for a couple of summary comments.

Thank you for joining us today. I would like to conclude by saying we continue to make progress as we pivot towards growing parts of the market. Scale out, software-defined, flash, converged and hybrid could. Our key investment areas is sales capacity, channel traction and the acceleration of the transition of our install base to Clustered ONTAP are showing early results. Clustered ONTAP, flash and other emerging pieces of our portfolio are growing strongly although not yet to enough to offset the decline in our ONTAP 7-Mode business. Our customers are transforming themselves using digital technology connected with pervasive broadband networks and cloud computing to improve the efficiency of their business, their global business systems and better serve their customers. Data is at the heart of that transformation and where NetApp has a unique and valuable role to play. Feedback from customers and partners is overwhelmingly positive and reaffirms my strong conviction that our data fabric strategy is aligned to our customers’ strategic technical direction for IT. NetApp is the only Company that can help enterprises manage their data seamlessly across multiple cloud architectures with the scale and modern system architectures needed to accommodate the exponential data growth of the digital era. NetApp is changing to position the Company for long-term growth. We are conducting a fundamental assessment of every aspect of our business, structure, portfolio and process, to reduce complexity and drive efficiency, while improving our overall velocity. We will build a stronger more efficient Company that solves customer challenges, while delivering profitability and earnings growth in a moderated IT spending and storage market. Thanks for joining us and I’ll speak with you again next quarter.