NetApp - Earnings Call - Q2 2020
November 13, 2019
Transcript
Operator (participant)
Good day, ladies and gentlemen, and welcome to the NetApp Second Quarter of Fiscal Year 2020 Conference Call. My name is Andrew, and I will be your conference call coordinator for today. 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. I will now turn the call over to Kris Newton, Vice President, Corporate Communications and Investor Relations. Please proceed, Ms. Newton.
Kris Newton (VP of Corporate Communications and Investor Relations)
Thank you for joining us. With me today are our CEO, George Kurian, and CFO, Ron Pasek. This call is being webcast live and will be available for replay on our website at netapp.com. 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 2020, our expectations regarding future revenue, profitability, and shareholder returns, and our ability to improve execution, gain share, re-accelerate growth, and expand our sales capacity without increasing total operating expenses, all of which involve risk and uncertainty. We disclaim any obligation to update our forward-looking statements and projections.
Actual results may differ materially for a variety of reasons, including macroeconomic and market conditions, the IT capitalist spending environment, and our ability to expand our total available market, acquire new accounts, expand existing accounts, capitalize on our Data Fabric strategy, improve the consistency of our sales execution, and continue our capital allocation strategy. Please also refer to the documents we file from time to time with the SEC and available on our website, specifically our most recent Form 10-K for fiscal year 2019, including the management's discussion and analysis of financial condition and results of operations, and risk factor sections, and our current reports on Form 8-K. During the call, all financial measures presented will be non-GAAP unless otherwise indicated. Reconciliations of the GAAP to non-GAAP estimates are posted on our website. I'll now turn the call over to George.
George Kurian (CEO)
Thanks, Kris. Good afternoon, and thank you for joining us. Our Q2 FY 2020 results reflect the strength of our business model and the value of our innovation. We delivered gross margin, operating margin, and EPS, all solidly above our guidance ranges. Despite the ongoing macroeconomic uncertainty and the potential for continuing unpredictability in enterprise purchasing behavior, the fundamentals of our business are strong. I've just come from two great events, NetApp Insight and Microsoft Ignite, and the many conversations I had with customers, prospects, and partners both underscore the power of our Data Fabric strategy to differentiate our solutions and highlight our success in reaching new customers and buying centers to expand our market share. At this year's Insight User Conference, it was clear that we are solving real pain points for customers as they grapple with the complexity of hybrid multi-cloud IT.
I witnessed the tangible enthusiasm for how we are helping customers address these challenges by building their own Data Fabric with NetApp. I'm sure those of you who were able to join us felt that excitement. We saw an increase in overall attendance, and for almost half of the customer attendees, this was their first Insight. The number of executive-level customers was up 80% from last year, and the number of customers with cloud responsibilities doubled. Hybrid multi-cloud is the reality of customers' IT environments, and NetApp has the strategy, the innovation portfolio, and customer experience to help them succeed. At Insight, we announced that we are revolutionizing the customer experience and simplifying the business of hybrid multi-cloud with NetApp Keystone. NetApp Keystone creates a consistent experience from public cloud to the data center, helping customers transform IT to operate with cloud-like ease and flexibility everywhere.
First, for customers who want truly elastic scaling without having to manage infrastructure, they can consume NetApp technology as a cloud service through the world's biggest public clouds. Second, for customers who want a cloud-like experience on premises, we offer subscription services. Finally, for customers who want to own and operate technology in their own data centers, we've introduced a radically simplified ownership experience for how our customers buy, optimize, and grow with NetApp. Customers and partners choose NetApp because of our unique ability to offer a full range of capabilities needed to build their data fabric. NetApp Keystone complements this with a consistent cloud-like customer experience across the public cloud and on premises. Let me be clear: our approach to cloud is giving us access to new buyers and workloads, as well as increasing the relevance of NetApp to companies both large and small.
Cloud gives us both opportunity in the public cloud and makes us more attractive for on-premises deployments. While I'm heartened by the enthusiasm generated by our hybrid cloud data services, the headwinds we identified on last quarter's call persisted through Q2. Both macroeconomic and enterprise spending indicators show continued weakness. While we cannot predict when conditions will improve, we are planning our business, assuming no change in these external factors for the foreseeable future. I'm pleased with our sales discipline and the ability to capture value in this tough market. To that point, our product gross margins demonstrate that we were able to maintain pricing discipline despite the soft environment. Regardless of what is happening in the broader macro environment, I remain confident that we can return to growth because of our ability to deliver real business value to customers' hybrid multi-cloud environments.
This increases our strategic relevance and enables us to reach new buyers through new pathways, address new workloads, and expand our presence with existing customers. To better capitalize on our opportunity and replicate our proven areas of success, we laid out a plan for you last quarter that includes increasing sales capacity by approximately 200 primary sales resources by the end of Q1 FY 2021, without adding to the total operating expenses for the company. As of the end of Q2, we are well on track to deliver against this goal. The sales headcount will be deployed primarily in our Americas geography. They bring capabilities to acquire new accounts as well as engage new buyers with new sources of funding like cloud architects and existing accounts.
As a reminder, we expect it will take roughly three to four quarters to bring these resources up to full productivity, and the vast majority of the benefit of this additional capacity will be realized next year in fiscal year 2021. We are also sharpening our attack on the key market transitions of disk to flash, traditional IT architectures to private cloud, and on premises to public cloud. In Q2, our all-flash array business, inclusive of All Flash FAS, EF, and SolidFire products and services, was up 29% sequentially to an annualized net revenue run rate of $2.2 billion. We have industry-leading guaranteed storage efficiency, the highest performance, and the most complete cloud integration in the market today.
In the quarter, Gartner published its Magic Quadrant for primary storage, and NetApp took the highest ranking in the leaders' quadrant for both our ability to execute and for the completeness of our vision. Moving to our private cloud solutions, SolidFire, NetApp HCI, and StorageGRID are the building blocks for private cloud deployments, enabling customers to bring public cloud-like experience and economics into their data centers. Our private cloud business, inclusive of products and services, attained an annualized net revenue run rate of over $300 million in the second quarter, up almost 30% year-over-year. Now on to cloud data services. Based on the last month of Q2, our annualized recurring revenue for cloud data services increased to approximately $72 million, up 167% year-over-year.
We continue to see a healthy mix of customers new to NetApp in our cloud services and expect that our cloud services will continue to enable us to acquire new customers, reach new buyers, and expand the workloads managed at existing customers. Q2 is the first full quarter that Azure NetApp Files has been generally available, and we're making great progress. At Microsoft Ignite, I spoke to many customers who are planning to move a broad range of enterprise workloads like Oracle and SAP into the Azure Cloud with Azure NetApp Files. Customers love that they get the widest choice of file protocols and on-premises-class performance and availability with an Azure-consistent experience from procurement to support to billing. A global energy company that's migrating high-performance workloads into the cloud for flexibility, scalability, global access, and collaboration presented at Ignite about their experience with Azure NetApp Files.
The performance improvements they achieved are outstanding. Simulation run times were reduced from months to days and, in some cases, hours. To quote the customer, "Azure NetApp Files is a lifesaver." That is just one example of the excitement we are hearing from customers about what we are doing in the cloud. Our Cloud Volumes Service is available in all three leading hyperscalers and gives us access to new opportunities. From non-enterprise customers, where our traditional solutions do not economically reach, to new strategic buying centers in the world's largest enterprises, where we are only a small part of their infrastructure, we are expanding our addressable market with our cloud data services. Our many years of work and deep integration with the leading public clouds give us a sustainable competitive advantage in the hybrid multi-cloud.
We're delivering an enormous amount of value to a growing number of customers operating and planning to operate in a hybrid multi-cloud world. We're adding new customers each day. We're adding new use cases each week, and we're adding new cloud regions each month to deliver the world's best hybrid cloud data services. As I've said before, customers and partners are choosing NetApp because of our data fabric strategy and our unique relationship with the hyperscale cloud providers. Our cloud data services not only give us access to customers and workloads that were heretofore inaccessible with our traditional solutions, they improve our competitive position for on-premises opportunities. Only NetApp has the strategy, the innovation portfolio, and customer experience to help customers succeed in hybrid multi-cloud IT. We've made a lot of progress in delivering on our data fabric strategy.
Our on-premises solutions are highly differentiated, as evidenced by our strong product gross margin. We are now available in the three leading clouds. We have delivered both the technology and the customer experience needed for success in the hybrid multi-cloud, and we are improving our execution and adding demand-generation resources to drive new sales motions. It is early days, and we have more work to do to communicate the full scope of our capabilities. As we saw at Insight and Ignite, our story resonates with customers. Because of this, I am confident in our ability to return to growth. We will continue to return capital to shareholders while investing for the long-term health of the business and capitalizing on our unique ability to help customers navigate the complexities of the hybrid multi-cloud. Before closing, I want to share some news about our organization.
Henri Richard, Executive Vice President for Worldwide Customer and Field Operations, has let me know of his intent to retire at the end of the fiscal year. Over the past three and a half years at NetApp, Henri has done much to transform and modernize our sales force to take advantage of the strength of our Data Fabric strategy and our technology leadership as we pivoted to new buying centers and the growth areas of the market. Henri will participate in the search for his replacement and help in a seamless transition while continuing to lead the field and improving our execution. At the same time, I'm excited to announce the promotion of James Whitemore to Senior Vice President and Chief Marketing Officer. James came to NetApp in the SolidFire acquisition where he was CMO and has since been leading our demand generation and digital strategy in the marketing organization.
As acting CMO, James has already made a strong impact, and I'm glad to have him as the CMO of NetApp. With that, I'll turn it over to Ron for more details on the quarter and our expectations. Ron.
Ron Pasek (CFO)
Thanks, George. Good afternoon, everyone, and thank you for joining us. As a reminder, I'll be referring to non-GAAP numbers unless otherwise noted. As George highlighted, in Q2, we delivered strong margins and operating leverage in the face of continued caution from our customers as a result of the macro environment. Despite the demand uncertainty, we are confident in our product leadership and strategy to re-accelerate growth going forward. We also remain committed to our capital allocation strategy of returning cash to shareholders through share buybacks and our healthy quarterly dividends. Before discussing our guidance, I'll provide further detail on our Q2 performance.
In Q2, net revenues of $1.371 billion were down 10% year-over-year, including one point of currency headwind. We had zero ELA revenue in the quarter compared to roughly $20 million of ELA revenue in Q2 2019. Product revenue of $771 million decreased approximately 16% year-over-year. Adjusting for ELAs, Q2 total revenue would have been down approximately 8%, and product revenues would have been down approximately 14%. Moving down the P&L, software maintenance and hardware maintenance revenue of $540 million was flat year-over-year. Deferred revenue increased 8% year-over-year in Q2. Gross margin of 68.6% was above the high end of our guidance range. Product gross margin was 57.3%, which is an increase of 3.2 points year-over-year and above our long-term target of 56% outlined at our analyst day.
The improvement was driven by continued sales force discipline, an increase in all-flash product mix, and cost reductions, and includes nearly half a point of currency headwinds. Q2 was the 11th straight quarter we increased product margins year-over-year when adjusting for the benefit of ELAs. The combination of software and hardware maintenance and other services gross margin of 83% increased by over 150 basis points year-over-year, driven by continued productivity improvements. Q2 operating expenses of $631 million were down 3% year-over-year, driven primarily by a reduction in variable compensation. Operating margin was 22.5%, solidly above the high end of our guidance range. Despite the revenue headwinds, EPS of $1.09 was up 3% year-over-year and above the high end of our guidance, demonstrating the operating leverage in our business model. We closed Q2 with $3 billion in cash and short-term investments.
Our cash conversion cycle was a negative four days, up 15 days year-over-year. DSO of 52 days was up six days year-over-year due to linearity in the quarter and, to a lesser extent, customer mix. DIO was 23 days, a nine-day increase year-over-year. We continued to expect our cash conversion cycle to remain negative throughout fiscal 2020. Cash flow from operations was a -$53 million, while free cash flow was a -$89 million. The negative Q2 cash flow metrics are due to timing and do not reflect a change in our underlying business. The timing issues were primarily accounts receivable. Additionally, there is a shift in the linearity of cash tax payments in FY 2020. We are maintaining our expectations for free cash flow to be in the range of 19%-21% of revenues in fiscal 2020.
During Q2, we repurchased 9.8 million shares at an average price of $51.19 for a total of $500 million. Weighted average diluted shares outstanding were $236 million, down $28 million shares year-on-year, representing an 11% decrease. During the quarter, we paid out $111 million in cash dividends. In total, we returned $611 million to shareholders in the quarter. Our fiscal Q3 cash dividend will be $0.48 per share. Now on to guidance. We expect revenues for fiscal 2020 to be down approximately 8% year-over-year. We continue to expect ELAs to represent approximately 2% of total revenue. For fiscal 2020, we now expect gross margin to be in the range of 67%-68%, above our previous guidance of 66%-67%, due primarily to the improvement in product margins. Operating margin for fiscal 2020 is expected to be in the range of 21%-22%.
Implied in this guidance is our expectation that operating expenses will be down slightly year-over-year in fiscal 2020 due to lower variable compensation. As a result of the updated revenue and margin guidance, we expect EPS to be down between 5% and 8% year-over-year without the benefit of buybacks. Now on to Q3 guidance. We expect Q3 net revenues to range between $1.39 billion and $1.54 billion, which at the midpoint implies a 6% decline in revenues year-over-year, including a half a point of currency headwind. For Q3, we expect consolidated gross margin to be approximately 67% and operating margin to be approximately 22%. We expect earnings per share for the quarter to range between $1.14 and $1.22 per share. We are diligently focused on improved execution and addressing the challenges we face.
We are committed to returning the company to growth, and we remain confident our business model leverage will enable us to deliver long-term shareholder returns. With that, I'll hand it back to Kris to open the call for Q&A. Kris.
Kris Newton (VP of Corporate Communications and Investor Relations)
Thanks, Ron. We'll now open the call for Q&A. We ask that you be respectful of your peers and limit yourself to one question so we can get to as many people as possible.
Operator (participant)
Operator. Thank you. Ladies and gentlemen, if you have a question at this time, please press star, then one on your touchstone telephone. If you wish to withdraw your question, press the pound key. Please stand by while we compile the Q&A roster. Our first question comes from the line of Wamsi Mohan with Bank of America.
Wamsi Mohan (Senior Equity Research Analyst)
Yes, thank you. Your product gross margin is north of 57%. I've been very strong.
We've not seen that in a while, actually, since 2015. Can you talk about how much of that product gross margin was product mix driven versus commodity price tailwinds or maybe even federal mix? Do you feel that you can sustain or expand these margins as you go into the back half of the year?
Ron Pasek (CFO)
Yeah, Wamsi, good question. On a year-over-year basis, most of it was mix, meaning we saw a higher % this quarter of all flash than we did, say, last quarter. Some of that was also cost reduction, not just on demand, on other things as well. That was in the face of having no ELAs in the quarter, so that goes against you.
I did contemplate the ability to keep this level of gross margin through the rest of the fiscal year, and you saw that in the increase of the total margin guide.
Wamsi Mohan (Senior Equity Research Analyst)
Okay, great. Thanks. If I could, really quickly, on CDS, you exited last quarter with $5 million in monthly sales. Seems like you exited this quarter with about $6 million despite Azure, GA all quarter. Can you talk about what are some of the challenges in not ramping this faster? I know, George, you expressed a lot of enthusiasm in all your discussions with that insight at Ignite. Where do you expect CDS annualized revenue run rate could be as you exit fiscal 2020? Thank you.
George Kurian (CEO)
We aren't going to give you guidance on the CDS business.
I think, as we said, we've taken longer than we originally expected to get to general availability given the technical sophistication of what we are offering to customers. The total addressable market is there. We are seeing a lot of demand and interest from customers, and we're adding customers and growing footprints on a daily basis. We're going to just need to keep doing the work necessary to scale and enable all of the pathways associated with being able to take the solution to market and to replicate the wins that we've got across a broad range of workloads into more customers. We are focused on execution at this point.
Wamsi Mohan (Senior Equity Research Analyst)
Thank you.
Kris Newton (VP of Corporate Communications and Investor Relations)
All right. Thanks, Wamsi. Next question.
Operator (participant)
Our next question comes from the line of Rod Hall with Goldman Sachs.
Rod Hall (Managing Director)
Yeah, thanks for the questions.
I wanted to just check and see, Ron, if you could comment on the accounts receivable and the, well, the DSOs. That's the highest we've seen, I think, ever in our model. I heard you say the tail end of the it was heavily back and loaded in the quarter, but any more color on that? The ELAs, you're holding this 2% guide, yet there are no ELAs so far. Just anything you can say that would help us all have more confidence that you got visibility into that, or are you still having to run on the treadmill to get those deals? Just kind of help us understand why you still have confidence in that ELA guide. Thanks.
Ron Pasek (CFO)
With respect to AR, it was linearity within the quarter and particularly within the month.
To a lesser extent, some of the mix of customers we saw that bought in the last two months of the quarter. You saw similar phenomena in Q4 where we ended up pretty back and loaded and, of course, collected all of that AR in Q1, which yielded a bunch of cash flow. It happens sometimes. The other issue with free cash flow and cash flow, which I mentioned in my script, was larger cash tax payments. I did reiterate the full year guide of 19%-21% for free cash flow as a percent of revenue. With respect to ELAs, I'll make a comment and then let George comment as well.
Last year, this quarter, we ended up giving you a full year guide of roughly 2% of revenue with the understanding that we can't easily contemplate when those ELAs come in within each quarter, but for the full year, we felt comfortable with that. We did that based on extensive conversations with parts of the sales force, making sure they understood the importance of this and the fact that it has a huge impact on earnings because it's essentially pure profit. That was a further conversation this quarter, and it led to the continued commitment for the second half.
George Kurian (CEO)
With regard to ELAs, Rod, I think the fundamental thing that we are doing with them is to enable streamlined customer purchasing. It doesn't require them to spend the whole amount of the ELA upfront.
It's really to make their overall multi-year procurement agreements with us a lot more streamlined and to enable us to get a broader strategic footprint in the account. We know these accounts. Some of them have impending events that this would clearly enable things to get more streamlined. We are working it, right? We have visibility into these accounts. We know who these accounts are, and we're working hard to bring these forward.
Rod Hall (Managing Director)
Okay. Thank you.
Kris Newton (VP of Corporate Communications and Investor Relations)
Thanks, Rod. Next question.
Operator (participant)
Our next question comes from the line of Karl Ackerman with Cowen.
Karl Ackerman (Managing Director of Equity Research, Semiconductors and Storage Hardware)
Hey, good afternoon. Thank you for letting me ask a question. George or Ron, if I may, going back to your outlook for December, it seems to imply your non-all-flash rate business will decline about 6% sequentially. That seems to be about in line with the seasonal averages of nearline drives.
At the same time, two of your hard drive suppliers have spoken about improved nearline shipments in December and for the first half of 2020, when you also launched two new mid-range hybrid arrays at Insight. Are there competitive forces impeding your ability to do a bit better in hybrid arrays over the next few quarters, or is it just conservative? Thank you.
Ron Pasek (CFO)
I'm not really sure I understand your question. We're guiding total revenue. We're not guiding even specific product revenue and within that, not all flash. I'm not sure I quite understand where you're going with that.
George Kurian (CEO)
We feel good about our position in the hybrid array market. We are, without question, across the range of customer and analyst surveys, the best hybrid array vendor. We've introduced two new models.
I think what we are framing up for the next quarter guide is really an overall product number. We're not forecasting it to the level of specific product components at this point.
Karl Ackerman (Managing Director of Equity Research, Semiconductors and Storage Hardware)
Thank you.
Kris Newton (VP of Corporate Communications and Investor Relations)
Thanks, Karl. Next question.
Operator (participant)
Our next question comes from the line of Mehdi Hosseini with SIG.
Mehdi Hosseini (Senior Equity Research Analyst)
Yes, sir. Thanks for taking my question. George, I want to go back to the topic of install-based. In the past, you've talked about install-based that is only penetrated in the teens. How do you see, especially in the context of a strong AFA results for the October quarter? Thank you.
George Kurian (CEO)
We are up a few percentage points. We're up at 22% of the install-based now being on AFA. As we've said before, our install-based is growing.
While we ship a lot of new systems each quarter, the size and scope of the install base and its growth leaves the total AFA penetration at a small number, which allows us to have opportunity to continue to refresh over time the rest of the install base.
Mehdi Hosseini (Senior Equity Research Analyst)
Sure. Thank you. Just one clarification, if I may. Would the end-of-life support for ONTAP 7 actually help expedite or increase the penetration rate?
George Kurian (CEO)
Some of those customers that have not upgraded so far, there's a small number, but certainly some of those, if they look at the economics today of a platform like our C190, they would choose to go all flash, then go to a 10K disk-based system because the economics are already better with our solutions to replace 10K drives.
Mehdi Hosseini (Senior Equity Research Analyst)
Great. Thank you.
Kris Newton (VP of Corporate Communications and Investor Relations)
Thanks, Mehdi. Next question.
Operator (participant)
Our next question comes from the line of Aaron Rakers with Wells Fargo.
Aaron Rakers (Managing Director and Technology Analyst)
Yeah, thanks for taking the question. I just kind of want to understand a little bit on the guidance side. It would appear, based on the gross margin guidance in the current quarter, that you're not obviously factoring in an ELA. I think last time it was like a 400 basis point benefit that you saw in product gross margin. If that's true and we kind of think about the setup going into the April quarter to kind of hit the full year guidance level, number one, are you factoring in a revenue contribution to kind of hit an absolute increase in revenue in the April quarter that includes an ELA?
Therefore, we should also be thinking that the gross margin into that April quarter is significantly higher just because that ELA contribution would fall into that if you kind of hit that 2% of total revenue for the full year, or is that just not factored into your guidance at all? I'm trying to understand how you kind of think about the mechanics of the implied guide into the April quarter.
Ron Pasek (CFO)
Yeah. Remember, as we go through the fiscal year, this for Q3 and Q4, product revenue becomes a larger part of the total, which overall is dilutive to overall margin, right? You can't just look at the number and say you're holding total margin flat to Q3, therefore you don't have an ELA in it because the mix of product versus services is higher in Q3, obviously.
There is some ELA in Q3, and there absolutely is some in Q4.
Aaron Rakers (Managing Director and Technology Analyst)
Okay. On an absolute basis, April quarter versus what you've done over the past few years, I think early 2018, the storage market was fairly healthy. I'm just trying to do you have a line of sight that says, "Look, on an absolute sequential basis, you can kind of see that kind of jump that you saw back in 2018," or is there something else that I'm just not thinking about in the model?
Ron Pasek (CFO)
Again, you've got the benefit of ELAs in Q3 and Q4, which you didn't have essentially last year, Q3 and Q4, to a great extent. That helps things, all things being equal.
Aaron Rakers (Managing Director and Technology Analyst)
Okay. Fair enough. Thank you.
Kris Newton (VP of Corporate Communications and Investor Relations)
All right. Thanks, Aaron. Next question.
Operator (participant)
Our next question comes from the line of Katy Huberty with Morgan Stanley. Thank you.
Katy Huberty (Managing Director and Equity Research Analyst)
Good afternoon. EMEA was stronger than other segments. Can you talk about whether that was your own execution, or did you see some improvement in the market? Just generally speaking, can you comment on the spending environment relative to the caution that you highlighted in the first quarter in the major segments? Thanks.
George Kurian (CEO)
We saw Q2 relatively unchanged from Q1. As we said at the start of the year, Q1 was a step down from calendar Q1, which was our fiscal Q4 of last year, but Q2 was not. There were no major changes overall in terms of the trajectory from Q1 in terms of spending. Customers continue to be cautious. They are scrutinizing transactions. They're buying for what they need today. The differentiation of our offerings is clearly visible in the fact that our gross margins were really, really strong.
With regard to EMEA, our teams have done a really good job, and I want to salute our sales teams. There is a lot of execution that has been a big part of our strength in EMEA.
Kris Newton (VP of Corporate Communications and Investor Relations)
All right. Thanks, Katy. Next question.
Katy Huberty (Managing Director and Equity Research Analyst)
Thank you.
Operator (participant)
Our next question comes from the line of Matt Cabral with Credit Suisse.
Matt Cabral (Director of Equity Research)
Thank you. The services business was down a touch if you put together both hardware and software. Just wondering if you could talk a little bit about where you are in addressing some of the renewal issues that you have highlighted on prior calls and just how we should think about a return to growth for services going forward.
Ron Pasek (CFO)
We have made some progress. You can see that we are essentially flat when you adjust for FX. We still have some work to do. There is some organizational work we are doing.
There's some process work we're doing. You can't see that yet manifested itself in growth, but as George indicated, the install base is growing, and we believe that eventually that will get back to growth as well. You can see that in the deferred revenue number. It's not going backwards, which is good, as it did in Q4 of last year, but we still have some work to do.
Matt Cabral (Director of Equity Research)
Got it. Thank you.
Kris Newton (VP of Corporate Communications and Investor Relations)
Thanks, Matt. Next question.
Operator (participant)
Our next question comes from the line of Alex Kurtz with KeyBanc Capital Markets.
Alex Kurtz (Managing Director)
Yeah. Thanks for taking the question. George, on the last call, it seemed like the Salesforce productivity issue was really the main driver to the reset. I'm sure we touched on macro on that call, but it just seemed like that was really the focus from the team.
Fast forward 90 days, and you seem very optimistic about the hiring of the new reps. I just wonder, what gives you the confidence 90 days later? Because it seemed like it was a pretty big setback internally as far as how the team was working, but maybe we were overestimating that, and maybe things were not as difficult to kind of fix as far as hiring productive reps and ramping them.
George Kurian (CEO)
What we said on the Q1 call was that the quarterly results reflected 2/3 macro, 1/3 sales execution. It was a reflection of the macro in the purchasing behavior of our largest customers that drove the majority of the impact in Q1. We have always believed that our portfolio is really strong.
Given our position in the market, we have ample room to capture more accounts and to invest some of the really strong gross margin leverage that we're seeing into investment in field sales coverage. We've always believed our story is differentiated in the market. We're doing exciting things, and we have an attractive place to work. We've been pleasantly surprised with our ability to hire good quality salespeople, and we're focused on getting them productive and ramping them. I think I would just say we're heads down and focused on execution. Q2 saw an improvement relative to Q1 in terms of our ability to execute and capture the deals in front of us. We got to keep doing that, and I expect us to continue to do that through the course of the year.
Alex Kurtz (Managing Director)
Thank you.
Kris Newton (VP of Corporate Communications and Investor Relations)
Thanks, Alex. Next question.
Operator (participant)
Our next question comes from the line of Amit Daryanani with Evercore.
Amit Daryanani (Senior Managing Director)
Thanks for taking my question, guys. I guess, Ron, you're taking up gross margins fairly notably for fiscal 2020. Structurally, I'm wondering, do you think 67% plus gross margin is something that's sustainable long term, or was there some specific benefit of it maybe more one-time in nature in fiscal 2020 versus longer term? How do we just think about the levers that are enabling this upside? George, how do you think about Dell's upcoming mid-range solution and what that could do from a pricing or competitive basis for you guys?
Ron Pasek (CFO)
Amit, I think if you look at where we are in the quarter and then implied in some of the guide for the rest of the year, we are at the model we articulated at our analysts today for product margins a year and a half ago. We said 55% at that point. After the 606 change, I said 56%-57%. I believe it's completely sustainable. It's a good 10 points below one of our competitors who's an all-flash competitor. It's 10 points above where we were two years ago, so it's a really good place to be. It gives us a lot of flexibility to still be aggressive but not under-earned.
George Kurian (CEO)
With regard to your comment about Dell EMC, we feel very good about our solution set.
We are seen by Gartner and customers as the leader for primary storage, and we are the only vendor in the market with a comprehensive cloud strategy. We feel good about our position in the market, and we are going to capitalize on it, which is why we are investing in sales capacity to go capture net new accounts and expand wallet share within existing accounts.
Amit Daryanani (Senior Managing Director)
Thank you.
Kris Newton (VP of Corporate Communications and Investor Relations)
Thanks, Amit. Next question.
Operator (participant)
Our next question comes from the line of Andrew Vadheim with Wolfe Research.
Andrew Vadheim (Senior Equity Research Analyst)
Hi. Thank you. Wanted to follow up on a prior question and how it relates to guidance. You mentioned the weakness you are seeing and sort of a deteriorating macroeconomic environment, but just wondering why you decided then to tighten the full year guides, especially on revenue, kind of taking it from a five-point range to a point estimate?
Ron Pasek (CFO)
I think when you think about the guide, we have two quarters of actuals. I'm guiding Q3 discreetly. You essentially have three of the four quarters. I think it would be strange to keep the same 5%-10% down when, in fact, we kind of know where we think we'll be in Q4. Remember, Q4 last year is a relatively easy compare. We were down 3%. Getting to that number should not be that difficult, whereas the first half of this year was much more difficult to compare. Couple that with the fact that we have ELAs in the second half. We did not have them in the first half. Just felt like it was a better thing to do.
Andrew Vadheim (Senior Equity Research Analyst)
Okay. Thanks. Then separately, public sector was kind of down sequentially.
Just was wondering to what extent that was expected, and should we think of public sector sort of being in line with the rest of the company on a year-over-year growth basis in sort of Q3 and Q4?
George Kurian (CEO)
Over the last year or two, we started to shift the mix of our public sector business to be more program-related and broaden the book of business beyond just the Fed to state, local, and higher education and other parts of the market. As a result, you will see the business trend towards more of a standard pattern as opposed to a big step up in Q2.
Andrew Vadheim (Senior Equity Research Analyst)
Thank you.
Kris Newton (VP of Corporate Communications and Investor Relations)
Thanks, Andrew. Next question.
Operator (participant)
Our next question comes from the line of Simon Leopold with Raymond James.
Simon Leopold (Managing Director)
Thanks.
I wanted to see if we could touch a little bit on what you're seeing in the macro environment, given what we've heard from others reporting tonight. It sounds to me that maybe you saw some of the deterioration of enterprise demand a little bit earlier, and so this is more of an issue of timing. What I'm really looking for from you is how the demand has maybe evolved or changed over the course of the quarter versus what you talked about in August. Is the weakness shifting among verticals, steady? How's it changed? Thank you.
George Kurian (CEO)
I think in aggregate, we did not see a material change in Q2 from what we saw in Q1. With regard to the exposure of specific verticals and so on, we have a broad book of business.
We would not say that we are exposed to any particular vertical to be able to comment specifically about it. I would say it is reflective of the news that you see in the market, right? There are teams in countries like Germany where the spending pattern is tight, who are executing really, really well for us. We did see some slowdowns in other parts of the world, but nothing that is unique to NetApp. Our view is Q2 is reflective of a more stable long-term pattern that we see in the market, and it is not materially changed from Q1.
That is what we are planning our business around: to capture the value from our differentiated offerings by being disciplined on price and extracting the value that we feel we deserve, and then investing some of that benefit from gross margin and operating margin leverage into the quarter-bearing sales capacity that we talked about last time. We feel that the combination of the two should allow us to get our business back to growth over time and continue to deliver the earnings model and the returns to shareholders that we have committed to.
Simon Leopold (Managing Director)
Thanks. Just to clarify one thing, did you see seasonal strength in the federal vertical in the most recent quarter that sets up a tougher sequential comp in the January quarter? Is that material for you? Thanks.
George Kurian (CEO)
Our book of business in the public sector market is increasingly broad.
We have diversified our book of business to be deployable in program spending, which is not driven by any specific seasonality pattern. We are growing our footprint in state and local governments. The public sector business had its normal year-end pattern, but the Fed business is a smaller component of our overall public sector business.
Simon Leopold (Managing Director)
Thanks for taking the questions.
Kris Newton (VP of Corporate Communications and Investor Relations)
All right. Thanks, Simon. Next question.
Operator (participant)
Our next question comes from the line of George Iwanyc with Oppenheimer.
George Iwanyc (Executive Director)
Thank you for taking my question. George, you continue to be pretty bullish on adding new customers, especially with your cloud offerings. Can you give us a sense of whether that's shared displacement there or primarily new workloads? And is that transitioning over to some traditional storage sales as well?
George Kurian (CEO)
We are certainly seeing a broad range of workloads being deployed on our cloud solutions, e-commerce, databases like Oracle and SAP HANA, which are high-performance transactional workloads. We see genetics and bioscience applications, vertical applications for oil and gas, and healthcare. A really broad set of applications that require consistent performance and high availability. I think that's what we are uniquely positioned in the cloud for. There are customers and many that are saying that, "Listen, if we're going to use you in the cloud, we want to harmonize our on-premises environment so that we can move workloads between the two landscapes." With our announcement of Keystone, a subscription service for on-premises environments, they can now have not only the technology that allows them to standardize workload models between on-prem and public cloud, but the customer experience and the consumption offering that allows them to do that.
George Iwanyc (Executive Director)
All right. Just expanding on your Keystone comments, how long do you think the selling motion will take to get that up and running?
George Kurian (CEO)
I think that, listen, we do not believe that Keystone subscription services will replace CapEx purchasing, right? We think it will be a part of what customers want for their IT landscape. We are doing the work to enable our sales teams to be able to position that offering in the right way into customers. We think it will take time. We will give you updates as we go. With regard to our business model, we hold the assets on our books. You will see depreciation similar to where in the P&L we report cloud data services depreciation, right? It is not going to be material this year.
George Iwanyc (Executive Director)
Thank you.
Kris Newton (VP of Corporate Communications and Investor Relations)
Okay. Thank you, George. Next question.
Operator (participant)
Our next question comes from the line of Jim Suva with Citigroup.
Jim Suva (Managing Director)
Thanks very much. George, you've been very vocal about hiring more sales. Can you just remind us of the cadence? Is it kind of hire during six months, train, get relationships with growing six months after? We are kind of looking at fiscal 2021 or kind of summer of next year of all of a sudden the fruit really starts to bear from these efforts. Is that the right timeline, or I might be off on that?
George Kurian (CEO)
We said that just to go back to what we said, we said that we were going to hire 200 incremental demand generation headcount over four quarters, with the last quarter being Q1 of fiscal 2021. We are on track.
It takes three to four quarters to train a rep and to get them to full productivity. We think that the predominant benefit of this additional capacity will be in fiscal 2021.
Jim Suva (Managing Director)
Great. Thank you so much for the clarification. It's greatly appreciated.
Kris Newton (VP of Corporate Communications and Investor Relations)
Thank you, Jim. Next question.
Operator (participant)
Our next question comes from the line of Louis Miscioscia with Daiwa Capital.
Louis Miscioscia (Executive Director)
Okay. Thank you. Two questions sort of combined together. One of the things about the Salesforce, you said a good portion of the Salesforce wasn't selling the entire product line. Given obviously the relationships they have there, I assume this is just more of a re-education and maybe some adjusting to the sales plan. I'm just wondering, is that actually happening? How is it going? Combined with that, and maybe this is part of it, obviously Flash improved significantly on a quarter-to-quarter basis.
Just you went through some of the impacts last quarter, but how did you get Flash bouncing back so quickly this quarter?
George Kurian (CEO)
I want to credit the field organization for focus and execution, right? I think we said that what we were going to do was to focus on the big market transitions, this to Flash, traditional IT to public-private cloud, and the deployment of enterprise workloads in public clouds is sort of the key areas where we would attack the market. I think credit to the sales leadership and the Salesforce for the progress in all Flash. With regard to the comments you made earlier about our ability to sell the full portfolio, what we observe is that there are different buyers for some of our portfolio than the traditional storage buyer: cloud architects, DevOps staff, and workload owners like application owners.
We have been focused on reaching them and bringing them to our user conference. We saw a substantial uplift in the number of people from those pedigrees coming to our user conference, reflecting both the success of our field and marketing teams in reaching them over time, as well as the interest that they have in our portfolio, right? We need specific competency to go after those types of sales motions, and we're bringing that into the company as part of our 200 headcount. Of course, we're focused on training the storage-focused Salesforce on expanding their relevance to some of these new audiences. Work's underway. As I said, we're heads down and executing against these three imperatives. We saw the benefit of that focus in Q2, and we're going to continue to stay laser-focused on that through the rest of the year.
Kris Newton (VP of Corporate Communications and Investor Relations)
Thank you.
Louis Miscioscia (Executive Director)
Thank you.
Kris Newton (VP of Corporate Communications and Investor Relations)
Next question.
Operator (participant)
Our next question comes from the line of Ananda Baruah with Loop Capital.
Ananda Baruah (Senior Equity Analyst)
Hi. Thanks, guys, for taking the questions, Ron and George. George, at your last analyst day, you guys talked about mid-single digit revenue growth. Now that you're getting the Salesforce, sort of call it re-optimized, I mean, maybe even re-optimized is distinct from the adding. Does the optimization process put you in the position longer term to do stronger revenue growth if you're marketplace optimized? And just real quick, Ron, I believe you had some ELA expectation in the results for the quarter, and you basically did inline revenue. Did you outperform your internal product revenue targets for the quarter? Thanks, guys. Appreciate it.
George Kurian (CEO)
I think that we have many avenues to grow our business. We have a leading position in primary storage on-premises.
We have a growing private cloud business, and we are the only storage vendor who can support enterprise workloads in all of the major public clouds. I feel like we have plenty of total addressable market. We're focused on getting the company back on track to growth, right? We'll tell you more about our long-term earnings model the next time we hold an analyst day. I will just tell you that we have delivered on all of the elements of commitments we made in terms of gross margins and operating margins and so on. Barring the slowdown in enterprise spending this year, we were on track to meet even the top-line numbers that we had committed. We feel strongly about delivering on our commitments. Right now, we're entirely focused on executing against the opportunities in front of us and getting the company back to growth.
Additional sales headcount funded by the strong margin profile of our business is the first step. Getting them on board, productive, and all of that's the focus of the company right now. Ron.
Ron Pasek (CFO)
And Ananda, you're right. I did mention in the Q2 guide that we had factored in some amount of ELA, which, of course, did not come through. It was essentially the entire miss to the midpoint. It simply flopped into Q3. Yeah, we basically came exactly where we thought with the exception of that one ELA.
Ananda Baruah (Senior Equity Analyst)
Okay. Great. Thanks so much.
Kris Newton (VP of Corporate Communications and Investor Relations)
Thanks, Ananda. Next question.
Operator (participant)
Our next question comes from the line of Nehal Chokshi with Maxim Group.
Nehal Chokshi (Enterprise and Consumer Technology Senior Analyst)
Yeah. Thank you. Really nice net new cloud ARR within a quarter of $11 million, which compares to $7 million in the year-ago quarter. That's very strong net new ARR growth.
Is that all Azure Files driven or sales capacity driven or something else?
George Kurian (CEO)
The majority of our growth in cloud data services is from Microsoft Azure NetApp Files. The majority of that revenue is from net new customers, right? We do not have a single large customer that's a big percentage of the total number. We are seeing good momentum across a broad range of use cases and a broad range of customers trying things out and deploying their first workloads. As we go forward, we are focused both on continuing to acquire new customers, but additionally to expand our footprints now that we have got success in some of these customers to broader sets of workloads. Thank you for that.
Nehal Chokshi (Enterprise and Consumer Technology Senior Analyst)
If I may, my understanding is that you do have some specialists trying to sell cloud data services, although I believe also the broader Salesforce is also capable of selling the cloud data services. What's the sourcing of this new cloud ARR between these two Salesforces?
George Kurian (CEO)
It's hard for me to comment on that. I think we've got multiple pathways into the market. We've got both specialists and generalists within our field who are focused on selling cloud data services as part of their remits. We have the Microsoft pathway into market, which we are continuing to work to enable around the use cases and the expanding number of use cases of our technology. It will take time, but we're heads down and focused on it.
We're really excited about how successful the technology is in serving the customers that have come on board, right, for things like databases and e-commerce and content management and media and life sciences and an incredibly wide range of applications, frankly, more than I had expected. We have compelling business advantage that we offer customers.
Nehal Chokshi (Enterprise and Consumer Technology Senior Analyst)
Great. Thank you.
Kris Newton (VP of Corporate Communications and Investor Relations)
Thanks, Nihal. Next question.
Operator (participant)
Our next question comes from the line of Nik Todorov with Longbow Research.
Nik Todorov (Senior Research Analyst)
Thank you. I apologize for the background noise. Service margins continue to tick up despite I think you guys are still investing a lot in the CDS business, which is a headwind which should abate at some point. Ron, can you comment about the runway, or how do you see the opportunity to continue to grow services margins over time?
Ron Pasek (CFO)
It's something that we are focused on in the sense that we're trying to get more efficient. Having said that, I don't want to be too much more higher than where we are today. It's not something I contemplated in our long-term guide at our LSA, much of what you saw this quarter. I think there's good work being done. There's some more work we can do, but don't think that there's a ton of upside to that number.
Nik Todorov (Senior Research Analyst)
Okay. If I can just follow up, at some point, in order to hit the fiscal year 2021 guide for CDS, there needs to be a step function increase, I guess, on a quarter-over-quarter basis. I guess, what needs to—what work needs to be done?
Do you guys need Google also to go general availability to kind of start seeing really that inflection so investors can get more confident around that target exit in fiscal year 2021? Thanks.
George Kurian (CEO)
No, we got to general availability later than we expected, given the complexity of integrating a really high-performance service so deeply into these hyperscaler clouds. We are at GA with Microsoft. We have a clear line of sight into GA with Google. We think that there is a broad—the total addressable market's there. As I said earlier, the number of use cases that are being deployed on our platforms is broader than we originally anticipated. We have work to do to execute, to train the Salesforce, to train the Microsoft channel, get our message out to market, and bring in the customers to be able to deploy them on our platform.
We saw a good start to that with the attendance at Microsoft Insight, at Microsoft Ignite, and at NetApp Insight, where the number of people coming to talk to us and start to do proof of concepts with us were really good. We have our heads down. We have to deliver on getting these customers successful, but we feel like we got a really, really good platform, and the early results have been really good.
Nik Todorov (Senior Research Analyst)
Thanks. Good luck, guys.
Kris Newton (VP of Corporate Communications and Investor Relations)
Thanks, Nik.
Operator (participant)
Our next question comes from the line of Steven Fox with Cross Research.
Steven Fox (Managing Director)
Hi. Good afternoon. Just one question from me. George, obviously, you are not making any grand ambitions about the macro.
When you mentioned the return of growth, I assume for next fiscal year, is it mainly driven by the Salesforce execution, or how would you sort of rank and characterize what's most important in terms of getting back to top-line growth? Thank you.
George Kurian (CEO)
I think it's really making sure that we can capture the full range of opportunities that are available in front of us. As I said, we have leadership positions in a broad range of categories of primary storage. We are the only vendor with a cloud strategy and really compelling technology available in the big public clouds, all of the big public clouds. We need to be able to go and access the customers that are making those decisions, which is where the sales headcount focus is really a critical part of the go-forward plan.
The differentiation of our technology is evident in product gross margins, right? The leverage of our business model is evident in the results we just showed and the guidance we gave. I think for us, the macro is going to be the macro. We're going to go take share and to go after the addressable market. We're doing that prudently within the guidance that we gave you and by prioritizing our resources against the biggest opportunities.
Steven Fox (Managing Director)
Appreciate that, color. Thank you.
Kris Newton (VP of Corporate Communications and Investor Relations)
Thanks, Steven. Next question.
Operator (participant)
Our last question comes from the line of Matt Sheerin with Stifel.
Matt Sheerin (Managing Director and Senior Equity Research Analyst)
Yes. Thank you. Could you talk about the contribution you saw in the quarter from your big distribution channel partners? Several distributors and resellers have called out relative strength in storage following your very weak June quarter.
Is that a reflection of the middle markets being a little bit more stable or bouncing or any changes in your channel partner programs? Thank you.
George Kurian (CEO)
The contribution of indirect channels to our business was relatively unchanged in terms of the overall mix of our business. It's approximately 80% each quarter. We feel that that's reflective of our overall book of business. Nothing unusual there. You are correct that the mid-market is relatively less concerned about the impact of the global economic slowdown and some of the uncertainty there. We have more opportunities to capture share because our share in the mid-market is a bit smaller than it is in the enterprise. Our channel partners, we're focused on enabling a focused set of channel partners so that they get the full impact of NetApp's enablement resources.
We have a narrow group that we work with, and we're pleased with the progress so far.
Kris Newton (VP of Corporate Communications and Investor Relations)
All right. Thanks, Matt. I'll pass it back to George for some final comments.
George Kurian (CEO)
Before we close, I want to underscore a few key points. NetApp is helping customers deliver enormous business value in both traditional IT-led and increasingly in cloud-led use cases. Only NetApp has the strategy, the broad innovation portfolio, and customer experience to help customers succeed in hybrid multi-cloud IT. We believe we can return to growth over time by selling the value of our differentiated portfolio and investing in additional sales capacity to reach new buyers. As I saw at Insight and Ignite, we are making real progress here.
We continue to be disciplined in our spending and have a strong financial model with growing gross margins and operating margins that enable us to return cash to shareholders and invest in the long-term health of our business. Thank you, and I look forward to speaking with you again next quarter.
Operator (participant)
Ladies and gentlemen, this concludes today's conference call. Thank you for participating, and you may now disconnect. Everyone, have a wonderful day.