NetApp Inc

NASDAQ:NTAP

Earnings Call Transcript 2025-Q2

[Operator]

Good day, and welcome to the NetApp Second Quarter of Fiscal Year 2025 Earnings Call. [Operator Instructions]. Please note, this event is being recorded.

I would now like to turn the conference over to Kris Newton, Vice President, Investor Relations. Please go ahead.

[Kris Newton, executive]

Hi, everyone. Thanks for joining us. With me today are our CEO, George Kurian; and CFO, Mike Berry. 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, including, without limitation, our guidance for the third quarter and fiscal year 2025, our expectations regarding future revenue, profitability and shareholder returns and other growth initiatives and strategies. These statements are subject to various risks and uncertainties, which may cause our actual results to differ materially.

For more information, please refer to the documents we file from time to time with the SEC and on our website, including our most recent Form 10-K and Form 10-Q. We disclaim any obligation to update our forward-looking statements and projections. During the call, all financial measures presented will be non-GAAP unless otherwise indicated. Reconciliations of GAAP to non-GAAP estimates are available on our website. I'll now turn the call over to George.

[George Kurian, executive]

Thanks, Kris. Good afternoon, everyone. Thank you for joining us today. I am extremely pleased with our Q2 performance. Revenue growth was driven by a 19% year-over-year increase in all-flash storage and strong performance in first-party and marketplace cloud storage services. We achieved record Q2 operating margin and EPS ahead of our expectations. Our uniquely differentiated solutions in flash, block, cloud storage and AI address markets which are bolstered by both secular and company-specific tailwinds. We experienced solid growth across all these strategic focus areas, affirming the strength of our value proposition for both existing and new to NetApp customers.

This positive momentum not only underscores our strong execution, but also demonstrates our customers' confidence and commitment to our intelligent data infrastructure platform. We are delivering innovation at the fastest pace in our history, setting the stage for our continued success and growth.

In Q2, we held our Insight customer conference, showcasing how we uniquely address the genuine and pressing challenges that customers face in navigating the complexities of hybrid multi-cloud IT. I personally witnessed the enthusiasm among the many new to NetApp and returning attendees as they recognize how NetApp empowers them to overcome these hurdles by building intelligent data infrastructures. Organizations are proactively investing in data-driven strategies to drive competitive advantage. These businesses recognize the value of adopting a cohesive data strategy, leveraging data as a valuable enterprise-wide asset to fuel agile problem solving. To accomplish this, they require a cutting-edge data architecture founded on NetApp's intelligent data infrastructure platform.

With NetApp's expertise and state-of-the-art solutions, customers are confidently paving their way to become data-driven leaders. We again delivered robust year-over-year performance in our Hybrid Cloud segment. Revenue grew 6% and product revenue grew 9%, driven by notable strength in all-flash storage.

Broad-based success across the portfolio propelled our all-flash array annualized revenue run rate to an all-time high of $3.8 billion, up 19% year-over-year, the fourth consecutive quarter of high teens to low 20s percent annual growth. We continue to gain share in the all-flash market, far outpacing the growth rates of both the industry and all of our competition. Our leadership was further underscored with the recognition of NetApp as a leader in the 2024 Gartner Magic Quadrant for primary storage platform for the 12th consecutive year.

In the quarter, we delivered more innovation with new high-end products in our ASA block optimized all-flash and FaaS hybrid flash array families, building on the Q1 introduction of the updated AFF A-Series family of high-performance all-flash arrays. We have already seen new ASA deals close across multiple regions and industries, reaching new customers and expanding our wallet share with new workloads.

The pipeline is growing as our message of simple, powerful and affordable resonates with partners and customers. With these new systems and continued advancements to our software platform, customers no longer need to make trade-offs between operational simplicity, advanced capabilities and affordability in their storage.

Keystone, our Storage-as-a-Service offering, again delivered another strong quarter with revenue growing approximately 55% from Q2 a year ago. We added Cloud Insights into Keystone's single subscription model, enabling customers to gain an integrated view across their infrastructure from virtual machines to network to storage, on-premises and in the cloud. Only NetApp can deliver a true hybrid cloud experience with flexibility and control in an agile ago model.

Organizations are actively evaluating how to use their corporate data with AI. These discussions dominated Insight, where we unveiled our expansive vision for AI in the era of data and intelligence. Just as we bridge the gap between on-premises and the leading public clouds, empowering customers to utilize their data with any application anywhere, we are well positioned to bridge the divide between AI systems and enterprise data. We help customers bring AI to their data regardless of location or method through an approach that is intelligent, dynamic and secure.

By eliminating data silos, we give customers a unified and structured view of their array data assets. This empowers them to effortlessly explore, understand, unify and prepare their data for AI applications. Customers can leverage their existing AI ecosystem tools directly on their data while also benefiting from NetApp's AI features such as integrated data versioning, model traceability and highly efficient retrieval for model training and inferencing.

Our comprehensive solution includes policy-based classification, governance and security measures that accompany data throughout the AI life cycle. This includes automated AI data change detection and updates to keep data up to date and precise in every context. While we believe the large opportunity of enterprise AI is still ahead of us, we are already seeing accelerating momentum today.

Our AI business performed ahead of our expectations in Q2 with well over 100 AI and data lake modernization wins. These wins span geographies and industries with notable early momentum in public sector, manufacturing, financial services, health care and life sciences industries. We continue to advance our strong position with the development of Gen AI cloud and on-premises solutions in partnership with industry leaders.

GenAI is a truly hybrid workload and only NetApp has the breadth of products and services to reduce the complexity, resources and risks across increasingly complex hybrid multi-cloud environments. In Q2, we announced several updates within our AI partner ecosystem, deepening our partnership with Domino Data Labs, harnessing NVIDIA accelerated computing and AI software platforms and releasing the NetApp AI pod with Lenovo solution in its general availability version.

To make AI-ready infrastructure readily available to public sector and other highly regulated industries, we expanded our partnership with Google Cloud to provide the foundational data storage for the Google Distributed Cloud. By enhancing Google Distributed Cloud environments with ONTAP unified file and block storage and storage grid object storage solutions, customers can achieve better control over their data to efficiently scale their workloads and leverage AI while helping to maintain security and regulatory compliance. This collaboration has resulted in a number of early wins, further accelerating our success in global public sector and other regulated industries. Now turning to public cloud.

Our highly differentiated first-party and marketplace cloud storage services with the leading hyperscalers remain our focus and top priority. These services continue to grow rapidly, increasing roughly 43% year-over-year. In total, Public Cloud segment revenue grew 9% year-over-year to $168 million. We continue to innovate rapidly in cloud storage services, broadening workload support, capabilities, price and performance points, further solidifying our strong leadership position.

In Q2, we updated cloud volumes ONTAP to include our advanced autonomous ransomware protection and write once, read many capabilities, strengthening our customers' ability to defend against ransomware attacks. Additionally, we enhanced Google Cloud NetApp volumes, which is now generally available in all 40 Google Cloud regions with petabyte scale volumes and auto tiering, further expanding the number of workloads we serve. We remain focused on disciplined execution to meet the evolving needs of our growing customer base. We have broadened our all-flash storage portfolio substantially with updated high-performance flash, capacity flash and block optimized products. We have significantly increased our range of capabilities in public cloud storage with vastly more cloud data centers, more price and capacity points, new features and expanded workload support.

We have integrated more intelligent services to make our storage the most secure with simplicity built in with scale. And finally, we continue to make it easy for customers to consume our products and services how they want, wherever they want. NetApp is at the forefront of innovation, empowering customers to build intelligent data infrastructures.

Broad-based customer preference for our solutions and visionary approach for a data-driven future has enabled us to outgrow the market and take share from competitors. Our solid track record of disciplined operational management continues to yield strong earnings growth. Our focus and momentum fuel my confidence in our ongoing ability to deliver outstanding results for customers and shareholders. In closing, I want to thank the NetApp team for their dedication to our customers' success. I'll now turn the call over to Mike.

[Michael Berry, executive]

Thank you, George, and good afternoon, everyone. We executed a strong quarter, hitting or exceeding all our guidance ranges. We made progress toward our long-term Investor Day targets of mid- to upper single-digit revenue growth and double-digit EPS growth on average through fiscal year '27.

Fiscal year '25 is expected to be within both ranges. Before I get into the financial details, let me walk you through the key themes for the quarter. As a reminder, all numbers discussed are non-GAAP unless otherwise noted. As expected, Q2 consolidated gross margin was strong at 72%, continuing to trend near all-time highs. Gross margin leverage and operating discipline drove operating margin of 29%. Gross profit dollars grew 6% year-over-year, in line with revenue, while operating profit dollars grew 13% year-over-year, double the rate of revenue. Q2 revenue grew 6% year-over-year, the fourth consecutive quarter of mid- to high single-digit year-over-year growth with product revenue, cloud and professional services all growing above this rate in the quarter.

We returned over $400 million to shareholders through dividends and share repurchases. reducing Q2 fiscal '25 share count by 1 million shares year-over-year. As discussed during the last quarter's call, we intend to return up to 100% of free cash flow this year. Due to solid execution and strong operational management, we outperformed our expectations in the second quarter and expect our continued focus and discipline to deliver mid-single-digit year-over-year revenue growth in the second half of the fiscal year.

As a result, we are raising our fiscal year '25 revenue and EPS expectations. Now to the details of the quarter. Revenue of $1.66 billion increased 6% year-over-year towards the high end of our guidance range. Billings of $1.59 billion increased 9% year-over-year. This marks our fourth consecutive quarter of year-over-year revenue and billings growth. Product revenue of $768 million was up 9% year-over-year. Support revenue of $635 million grew 2% year-over-year. Professional services revenue of $87 million grew 10% year-over-year, mainly driven by Keystone.

Public Cloud revenue of $168 million increased 9% from Q2 a year ago, driven by hyperscaler first-party and marketplace storage services. We expect cloud revenues to return to double-digit year-over-year growth beginning in Q3, driven by the momentum in our cloud storage business. Q2 deferred revenue was $4.1 billion, up 2% year-over-year. Keystone, our Storage-as-a-Service offering, continues to gain traction in the market.

Remaining performance obligations were $4.4 billion. Unbilled RPO was approximately $330 million, up 11% quarter-over-quarter. Growth in unbilled RPO is a key indicator of future Keystone growth. Q2 consolidated gross margin came in at 72%. Product gross margin was 60%. We highlight that both consolidated and product gross profit dollars grew mid- to high single digits year-over-year in Q2, in line with revenue. We have made strategic purchase commitments to lock in the majority of SSD supply and mitigate rising prices in calendar year 2024, which continues to give us confidence in our product gross margins as we move into the second half of fiscal year '25.

We continue to forecast product gross margins to decline slightly in the second half of fiscal year '25 as compared to the first half, but remain in the high 50% range for the full year, consistent with our prior guidance.

Our recurring support business continues to be highly profitable with gross margins of 92%. Our support retention rates and associated margin structure represent the continuing innovation we deliver to our customers through ONTAP. Q2 public cloud gross margins improved to 74% from 66% in the prior year.

We are particularly proud of the improvement in public cloud gross margins and highlight that 1/3 of the year-over-year expansion in total gross profit was driven by public cloud in the quarter. We expect to make further progress on our public cloud gross margins and exit fiscal year '25 at the lower end of our long-term target of 75% to 80%. Operating expenses of $719 million was up 2% year-over-year and up 1% from Q1 '25.

Q2 again highlighted the strength of our business model and disciplined operational execution with operating margin of 29%, ahead of expectations. EPS of $1.87 was above the high end of our guidance, driven by higher revenues and higher gross margins compared to our initial forecast. Operating cash flow was $105 million in Q2 compared to $135 million a year ago, and free cash flow was $60 million compared to $97 million a year ago.

Our lower year-over-year cash flow results in Q2 were primarily driven by upfront payments for strategic SSD purchases, which are forecasted to be predominantly utilized during fiscal year '25. These strategic purchases resulted in much higher inventory levels versus all of fiscal year '24 and reduced inventory turns to only 6x in Q2. In the quarter, DSOs increased to 48, in line with seasonal averages. During the quarter, we returned $406 million to stockholders through share repurchases and cash dividends. We have approximately $800 million remaining on our existing repurchase authorization. We also repaid $400 million in debt with available cash in the quarter as planned. Our balance sheet remains healthy. We ended the quarter with approximately $2.2 billion in cash and short-term investments against $2 billion in debt.

Now turning to guidance, starting with the full year. We are raising our revenue guidance for the full year to between $6.54 billion and $6.74 billion, representing approximately 6% year-over-year growth at the midpoint. We expect fiscal year 2025 consolidated gross margin to be 71% to 72%, unchanged from prior expectations. Importantly, we expect gross margin dollars to increase to $4.75 billion at the midpoint, driven by growth across product, support and cloud revenue.

We expect fiscal year '25 operating margin to be 28% to 28.5%, up 75 basis points at the midpoint compared to prior expectations. We are raising our net interest income expectations slightly to $55 million, driven by higher interest income. We expect our tax rate for the full year to be 20% to 21%. As a result, we expect EPS to be in the range of $7.20 to $7.40, which at the midpoint implies 13% growth year-over-year. Year-to-date, our free cash flow has trended lower year-over-year despite higher revenue and net income due to the timing of higher incentive compensation and our strategic SSD purchase commitments in the first half of the year, which have been instrumental to our supply chain management strategy in a rising commodity cost environment.

The lower cash flow results are due to the timing of cash payments, not a change in our normalized cash conversion cycle. We expect SSD-related cash outflows to slow in the rest of our fiscal year and expect cash flow generation to be higher in the second half of the year compared to the first half and grow year-over-year versus the second half of fiscal year '24. Even with this improvement, we now expect free cash flow in fiscal year '25 to be slightly lower year-over-year, driven by the timing of these cash payments. Turning now to our third quarter guidance. We expect Q3 revenue to range between $1.61 billion and $1.76 billion, which at the midpoint implies 5% growth year-over-year. We expect Q3 consolidated gross margin to be 71% to 72% and operating margin to be approximately 29%. We expect net interest income to be $10 million in the quarter and our tax rate to be 20% to 21%. EPS is expected to be in the range of $1.85 to $1.95. While our Q3 guidance for EPS forecasts a year-over-year decline, we note that last year's Q3 represented a record high in product gross margin as well as an unusually low tax rate.

Normalizing for these factors, our Q3 EPS guidance forecasts year-over-year EPS growth. As a reminder, we expect double-digit EPS growth on average from fiscal year '25 to fiscal year '27, and our fiscal year '25 guidance is on track towards this goal. In closing, I want to thank our employees, customers and investors for their commitment and investment in NetApp. I am confident in our ability to help our customers successfully achieve their digital and cloud transformation goals. We are well aligned to priority IT investments and are committed to deliver sustainable long-term value for our stockholders. I'll now turn the call over to Kris to open the Q&A. Kris?

[Kris Newton, executive]

Thanks, Mike. Operator, let's begin the Q&A.

[Operator]

[Operator Instructions]. And our first question today will come from Asiya Merchant with Citigroup.

[Asiya Merchant, analyst]

Congratulations on strong results. If I may, George and Mike, you've talked about macro in the past and some kind of uneven recovery across certain verticals. So maybe if you could just start with that. And relative to this 5% revenue growth for the full year, how much of that is predicated on macro versus now that you have a fuller portfolio that is addressing all the external storage needs.

[George Kurian, executive]

The macro in the last past quarter has been unchanged relative to prior quarters. We are well aligned to the priority spending areas for our customers. data center modernization, the deployment of new applications, cyber resilience for data and, of course, cloud and AI and our product portfolio is exceptionally strong. We are focused on executing at the expense of larger competitors. And I think that our growth outlook for the year is regardless of the macro. We are assuming that it stays where it is.

[Asiya Merchant, analyst]

Great. And if I may, on the AI side of things. I know you've talked about in the past that this is still ahead of us. Any updates you can give how you're seeing various enterprises deploying NetApp solutions as it relates to modernizing your data storage for AI. And any insights you can give us to sort of when you think AI inferencing will be a bigger factor for you guys.

[George Kurian, executive]

We are seeing the early stages of getting your data infrastructure ready for AI. We had a large number of wins across the multiple verticals, as I said in my prepared remarks, those are leading indicators of future large-scale inferencing deployments. I would say they are today in what we call AI centers of excellence, and they have not yet hit large scale. We also have had some strong momentum with Google with their distributed cloud for AI deployments in the public sector. And so we're encouraged at the prospects of our AI business going forward. In large, I don't have an update from prior commentary. We think that it's still second half of next year. And so the growth opportunity for us is still ahead of us.

[Operator]

Your next question today will come from Amit Daryanani with Evercore.

[Amit Daryanani, analyst]

I guess just to start with, George or Mike, can you just talk about the strength and really the durability of what you're seeing on the all-flash array side, you folks have had near 20% growth for a few quarters now. How do you think of that all-flash array growth as you go into the back half of the fiscal year where compares, I think, start to get a little bit more difficult for you. I'd love to kind of just understand that. And then if I just speak to the all-flash array theme, I'd love to just understand the growth you're seeing right now, how much of that do you think is share gains versus maybe new products like the A-Series that's opening up newer workloads and new environments for you?

[George Kurian, executive]

We have had 4 consecutive quarters of high teens or 20% plus revenue growth in all-flash arrays. This is clearly outpacing the market and all of the competitors. It is because we are aligned to areas of customer spending as well as a unique value proposition, a single operating system, an advanced and complete hybrid multi-cloud capability, the richest set of data services, the most secure storage in the planet, and you can buy and consume this technology in the way you want from NetApp or from our partners. We are combining that durable competitive moat with the fastest innovation pipeline ever. We refreshed the A-Series.

We refreshed the ASA products. We refreshed our FaaS products, and you will see continued innovation coming from us over the next few quarters. And we are focused on executing in the go-to-market as opposed to many of our competitors who are distracted. So I feel very, very good about the durability of our leadership position and the opportunity going forward.

[Amit Daryanani, analyst]

Got it. And then, Mike, could you just touch on this prebuying of memory that you folks are doing right now. I guess, do I think of the sequential uptick in inventory is essentially all prebuys? And then can you talk about this -- is it -- are you changing that you look at inventory prebuying longer term? And is it something you think you're going to do on a more consistent basis?

[Michael Berry, executive]

Sure. Thanks for the question, Amit. So yes, the increase in the first half in inventories, while it's not certainly the whole amount of the inventory number, the $300-plus million, the majority of the increase is -- are the prebuys that we've negotiated at the end of '24 and '25. So at this point, we've said it before, we're not looking to do any more prebuys going forward.

We're good where we are. We've covered the majority of our expected demand in fiscal '25. So at this point, Amit, we've taken a step back. We're starting to see some softening in the NAND market. So we're going to let that play out. So we'll -- hey, we look at it every day. We'll look at it as we go through the rest of fiscal '25. But unless something changes in the market, you shouldn't expect to see us do any more prebuys for the rest of this fiscal year.

[Operator]

Your next question today will come from Tim Long of Barclays.

[Timothy Long, analyst]

Two as well, if I could. First, Mike, you mentioned the RPO down sequentially. I know there's some unbilled in there, but everything else sounded pretty strong with the billings and the outlook and the pipeline. So if you could just walk us through the RPO down in the quarter? And then secondly, I was hoping you could touch on the public sector. Pretty strong results Q-on-Q and year-over-year. Just curious what drove that and what's the outlook for that business, given the changing political landscape for that type of business?

[Michael Berry, executive]

Yes. Thanks for the question, Tim. So it's Mike. I'll do the first one. So thanks on RPO. So a couple of things. RPO is made up of two pieces. It's made up of deferred revenue, which is both short and long term on the balance sheet and then the unbilled portion of our commitments. That's where you will find Keystone because it's not on the balance sheet. RPO came down quarter-on-quarter as expected because sequentially, deferred revenue always comes down Q1 to Q2. Now importantly, in the number we look at is total deferred revenue, including short term, grew year-over-year.

It was flat in Q1 after being down slightly in the second half of last year. So that's a great sign for us. to your point, that really follows the great billings growth that we've had. So on RPO, just hey, always watch what's the unbilled versus deferred. Deferred follows a sequential pattern. We do expect to see unbilled continue to grow quarter-on-quarter, though, largely driven by Keystone. And I'll hand it to George for the public sector question.

[George Kurian, executive]

Our U.S. public sector business performed well despite the continuing resolution. As we've said in the past, a large part of our public sector business is from a number of long-term projects, which are supported by program spending that is approved across annual budget cycles. We also saw strong performance across the globe from our Public Sector segment.

With regard to our expectations for the new administration -- listen, new administration bring new priorities. We will wait to see how they play out. One encouraging sign is that there is alignment across legislature and executive, which hopefully means that policies can be implemented quickly.

[Operator]

And your next question today will come from Jason Ader with William Blair.

[Jason Ader, analyst]

Yes. George, I wanted to ask you about any potential ripple effects that you guys are seeing from the Broadcom VMware acquisition, specifically on storage projects, just as customers maybe have less budget or look to reevaluate their on-prem infrastructure plans and strategies.

[George Kurian, executive]

We have not seen anything material yet. We are seeing customers look at three paths forward. One is to optimize their existing Broadcom estate. That could be by moving our footprint from hyperconverged to external storage so that they don't pay the virtual machine tax on the storage layer. And it also gives them flexibility to move in other directions moving forward.

The second is to move to new architectures. We have seen clients deploy alternative hypervisors and we benefited in those cases from our integration into multiple different hypervisors. And then there are a group of customers who have moved to the public cloud. We have strong solutions with VMware and with the hyperscalers and our public cloud business saw some benefit from that this quarter.

[Jason Ader, analyst]

Okay. And then Mike, maybe for you, just the Keystone product or the Keystone offering, does that go in the professional services line? Is that what I heard you say?

[Michael Berry, executive]

Yes. Jason, it's Mike. Yes, that is reported in professional services. That's where the revenue goes because it is a service. So it's not in product or support, it's in professional services.

[Jason Ader, analyst]

Okay. And would we -- as we look forward in the model, I mean, should we see professional services growth in Flex because Keystone becomes a bigger part of that mix over the next couple of years?

[Michael Berry, executive]

So you did see it grow quarter-on-quarter, and that was largely due to Keystone. Professional services is a relatively stable piece of business. So as you see that revenue move up and we have forecasted continued growth, the majority of that is due to Keystone, Jason.

[Operator]

Your next question today will come from Simon Leopold with Raymond James.

[Simon Leopold, analyst]

First, I know you stopped disclosing the split of hardware from software within hybrid cloud. But I'm wondering if there's anything in particular going on in terms of the mix between your software and hardware business that might be affecting product gross margins either in the recent quarter or in the outlook?

And then as a quick follow-up, I'm just wondering if there are any specific characteristics of the customers you see experimenting with AI applications in the enterprise. For example, do you see a bias towards something like financial services or certain kinds of industries? Any patterns that you're observing?

[Michael Berry, executive]

So Simon, it's Mike. I'll take the first one. Yes, we don't disclose the hardware and software breakout anymore. We talked about that in terms of why we pulled back on that. As it relates to gross margin, what I focus you on is the mix of flash versus the rest of the business. That's really the big driver there.

As we've talked about it, A-Series, high-performance flash has always been the highest gross margin percentage and then capacity flash and then the non-flash products. So as we continue to sell more flash and part of that is the replacement of our hybrid installed base, and we're doing that on purpose. That is what we expect to continue to keep our product gross margins where they are. It's more of a mix issue. Hardware and software is really not playing into that.

[George Kurian, executive]

With regard to your question on AI, we had a large number of wins across all of our geographies and industries I think if you were to draw a trend line, maybe there's more presence in public sector, manufacturing, financial services and health care and life science. Pretty broad-based book of business, those industries had more of the wins.

[Operator]

Your next question today will come from Samik Chatterjee with JPMorgan.

[Joseph Cardoso, analyst]

This is Joe Cardoso on for Samik Chatterjee. Maybe just first question here. Can we just get an update on the competitive environment, particularly with you seeing another quarter of muted or a challenging macro. Curious that this is just -- this prolonged macro is driving you to see an increasing intensity across your peer group? And then I just have a quick follow-up.

[George Kurian, executive]

No fundamental change in the competition, the pricing environment, which is a representation of the competition remains rational. It's always been a competitive industry. I would say, following the long-term trend of the industry, the specialists are more advantaged than the integrated system vendors and there are lots of share donors across the landscape. So we are well positioned to outperform. We have been outperforming for multiple quarters now and we see no change in that position.

In fact, I feel even better today than we felt in the past. Our product cycle, our ability to meet customer demand and customer trends as well as our unique competitive moat that we have built over many years is playing through for us.

[Joseph Cardoso, analyst]

And then maybe just a follow-up on the new U.S. administration coming in. I know you touched on it real quickly, but like specifically, how are you thinking about any implications around any potential tariffs, government efficiency initiatives, taxes, et cetera, that the new administration has talked about thus far. Where are you seeing headwinds? Where are you seeing tailwinds? Any potential areas that we should be -- investors should be wary of? Or you guys are too early to tell essentially? Appreciate any color on that front.

[George Kurian, executive]

We are well protected from any tariffs being considered on China. Our supply chain and book of business has been vastly protected from that. So we don't see any material impact to our business from that. If that were to occur, I think on the rest of the policies, we are going to wait until January. And once the new administration is sworn in, we can see how that plays out. We'll update you once we have clarity on it.

[Operator]

And your next question today will come from Param Singh with Oppenheimer.

[Paramveer Singh, analyst]

First of all, good to see that your public cloud revenue is starting to improve again. I wanted to get a sense of what are some of the changes that you recently implemented that's driving a recovery in that growth? And then when do you think we can get to a teens growth back again in that public cloud revenue segment? And then I have a follow-up.

[George Kurian, executive]

I think we've done 3 things in the business, as we have said multiple times. The first was to build a focused go-to-market engine together with the hyperscalers. The second was to broaden our offerings in the first-party and hyperscaler marketplace with cloud storage. And the third was to restructure or push for stabilization in the subscription business. All of those have made good progress. I think in the past quarter, you've seen the continued strength, a really strong quarter, 43% year-on-year from the hyperscaler and first-party cloud storage services, which are an ever-increasing part of our business. And as Mike said, we expect to return to double-digit growth in the second half of this fiscal year.

That is coupled with strong gross margin performance. As you can tell, the increased of the business plus better utilization and less headwinds from depreciation and amortization has caused us to track upward in terms of gross margin, and we expect to hit our long-term cloud gross margin targets by the end of the fiscal year '25.

[Michael Berry, executive]

Sorry, you can all run your own guidance models. We talked about double-digit growth starting in Q3. And if you run that growth out, I would not be surprised if you don't hit the teens in fiscal '25.

[Paramveer Singh, analyst]

Got it. Perfect. And then as my follow-up, I want to focus a little bit on Keystone. You talked about the $330 million unbilled RPO and then assuming a typical duration of about 3-ish years, you're still pretty small on the Keystone side. What are you hearing in terms of feedback from customers? And when do you think Keystone can start to become a much more meaningful part of the overall NAP story?

[George Kurian, executive]

It's -- the feedback from customers has been stellar. We have yet to see a single customer churn on Keystone. So it has been an incredibly rock-solid product. and service customers like the flexibility we have. We continue to educate our field teams, broaden the number of partners who can sell, and we are seeing them more partners transacting Keystone. And so we'll see that growth over time, right? And I'm excited about it. It should grow faster in terms of percentage growth than our product business, but is an aid to us winning new customers and new workloads.

[Operator]

Your next question today will come from Wamsi Mohan with Bank of America.

[Ruplu Bhattacharya, analyst]

It's actually Ruplu Bhattacharya filling in for Wamsi today. I just wanted to follow up on the public cloud segment question. Mike, your first party hyperscaler marketplace storage services, like you said, have accelerated 40% year-on-year growth last year, 43% last quarter, 43% this year. Can you comment on the subscription services part, the headwinds that you were seeing. I think you had said that it's lessening over the course of fiscal '25. Any quantification on the headwinds? And how should we think about this going over the next couple of quarters into the next fiscal year?

[Michael Berry, executive]

Sure. So let's back up and go through those numbers again just so we all have them. So -- at Financial Analyst Day, we talked to you folks about the size of that business, first-party and marketplace services, a little less than half of the total cloud revenue, so a good portion of it. That grew last quarter by about 43%. Total cloud revenue grew by 9%. We -- and we've talked about this.

On purpose, we are with our customers seeing a conversion to first-party and marketplace away from subscription. We've talked about the full of marketplace, how important that is in terms of them being able to burn down their commits and then all the wonderful partnerships we have with the big 3 hyperscalers.

So the subscription business is about 20% of the revenue. It gets to be a smaller piece every day because of growth of first-party and marketplace. So it is declining on purpose. That was part of the plan. At some point, it probably flattens out, but we do expect over the next several quarters for consumption to continue to grow from the 80-plus percent it is, and it will be the very large majority of the business going forward. So we won't quantify the subscription piece. You can run your own numbers, but that is part of the strategic plan to push to first party in marketplace. And by all rights, we've seen it's really working. The other thing I'll add, and George brought this up, that's really helped from a margin perspective as well, driving much better gross margins. So all of this feels like it's really setting us up well for the rest of '25 going into '26.

[Ruplu Bhattacharya, analyst]

Okay. Maybe a follow-up for George. How much of the has now converted to all-flash. And what's the mix of existing customers moving to flash versus new customers? And what benefit have you seen from QLC? I mean, what percent of your flash business is now QLC?

[George Kurian, executive]

I think with regard to our installed base, it remains at the same number as last quarter, which is 40%. Our installed base is growing. So even if flash is growing fast, the total installed base is growing, and it is very large. So that's the first indicator. The second is, listen, we are outperforming the market and all of our competitors quite substantially.

So it is clear that we are winning new wallet within existing customers as well as existing wallet as well as net new to NetApp customers. And we saw a lot of them at our Insight conference. And so I feel really good about the book of business. It's balanced. And then with regard to TLC versus QLC, we're not going to break that out. I can just tell you that all of our flash product families did really well.

[Operator]

Your next question today will come from Meta Marshall with Morgan Stanley.

[Elizabeth Elliott, analyst]

This is Mary on for Meta. I had a question on the AI momentum that you're seeing. You noted more than 100 wins during the quarter. Can you give us a sense of what those deals look like? Have they been primarily public cloud premise? Or are they mostly a combination of the two?

[George Kurian, executive]

These are the 100 wins we talked about are on-premise wins. And we disclosed the public cloud AI wins under the public cloud segment revenue. I think on the on-premises side, there was a broad base of wins in terms of size, industry and geography. There were some clients that are in what we call proof-of-concept mode. There are others that are large product, early pilots that are preproduction pilots. So it's a mix all over the place. Like we talked about the fact that it was broad-based across the geos as well as broad-based across industries.

[Elizabeth Elliott, analyst]

Great. And just a follow-up on free cash flow. You had noted the puts and takes on free cash flow this year. But do any of the dynamics that you're seeing this year change how you think about the free cash flow trajectory for next year?

[Michael Berry, executive]

Thank you. Great question. So as we talked about, the 2 big working capital issues, changes we've seen this year are around the payment of the annual incentive compensation and the prebuys and inventory. We're not going to guide '26 or call that yet.

What I would say is from an incentive perspective, we do think that normalizes based on where we are in the year. So we don't think that will be nearly the working capital issue it is this year. We will see where we are on prebuys. Do we do those going into next year or not? That is remaining to be seen. So we'll talk about that when we guide the year. But from an incentive comp perspective, that will normalize going into next year.

[Operator]

Your next question today will come from David Vogt with UBS.

[David Vogt, analyst]

George, one for you to start. Can you maybe share some color on the success of the block portfolio in the flash numbers and what maybe sort of the revenue sort of dynamic was in the quarter as well as any potential impact on margin given sort of its new offering for you in a new market that you're really targeting aggressively.

And then I'll give you the second one also for Mike. You mentioned obviously not taking any more purchase commitments for the balance of this year as you see some softening in NAND. Can you remind us again sort of the lag effect of NAND, if it does roll over and soften a bit, what that would mean for pricing in the market and how that would affect product revenue growth over the longer term relative to your framework?

[George Kurian, executive]

We are pleased with the performance of the ASA product. It is bringing us a bunch of net new customers as well as expansions within our existing customers. And so we are excited. It's early in the cycle, but we are seeing good -- very good momentum I think with regard to the overall gross margin implications of that, listen, I'll just say that we're not going to break out ASA versus other product families.

I think overall, our view is as we move the mix of our business more and more to flash, that should continue to be a tailwind to gross margins over time. And so we're executing our strategy. We feel good about where we are in terms of the overall portfolio, and we're going to stay federal to the metal.

[Michael Berry, executive]

And David, on the related question on pricing, look, there have been a number of changes in the pricing environment. So as we look forward, what we tell you is, and we've said this all along, customers' budget on dollars, we're not assuming any significant change in revenue because of higher prices. So from that perspective, hey, we'll have to see how it looks going forward. We feel good about the prebuys in terms of the rest of our fiscal '25. A little bit of that will drift into '26, but not really. We're looking at it every day. So we'll update you on the revenue view and the margin view as we get closer to '26.

[Operator]

And your next question today will come from Steven Fox with Fox Advisors.

[Steven Fox, analyst]

I only had one question. George, I was wondering if you can expand a little bit on the comments around the partnership with Google Cloud and how that's driving more highly -- high regulated customer business and public sector business. What are the early indicators? How quickly do you ramp into that sector more and more over time?

[George Kurian, executive]

Our work with Google Cloud started with their public cloud environments. And then over about 1.5 years, 2 years ago, we started to see clients together with Google that wanted the Google stack, but in their data centers. And so we started to work with them on an architecture called Google Distributed Cloud. We announced a set of customer wins as well as the broader partnership with Google earlier this year, and we are seeing good momentum.

It's still early. These are large-scale deployments. It's still early, but we are super pleased that both the capability set that the full technology stack offers, it is entirely wallet expanding for us and the unique value that we bring to clients with Google is a consistent experience between their data centers and public cloud as well as the private clouds or on-premises environments that customers have.

[Operator]

Your next question today will come from Aaron Rakers with Wells Fargo.

[Aaron Rakers, analyst]

Yes. I guess my question is going back to earlier point, just to make clear and maybe push back a little bit. Is that -- last quarter, I think you talked about your first-party and hyperscale marketplace. Storage services, I think, was grew north of 30%. I think in that context, you had alluded to that, that contribution was about 2/3 of that public cloud piece of business.

So now you've got -- I want to make sure I'm understanding, today, it sounds like is it -- did I hear it right, it's now about 80% of that public cloud business? And if so, why would mid-teens growth be right? Why wouldn't it accelerate much higher as we start to see the lack of growth in the declining business really become significantly smaller. I'm just trying to understand if that's maybe conservatism or if there's something else there.

[Michael Berry, executive]

Yes. Aaron, it's Mike. So sorry if I confused it. So out of the total cloud revenue number, first-party and marketplace was a little less than half when we did the Analyst Day in June. That percentage increases more and more every day. The 80% number I referred to was consumption revenue, which includes more than just first-party and marketplace. There's other products in there as well. To your point, it's why we feel really good about the growth going forward is that, that piece of the business gets bigger every day. The part that's not growing gets smaller every day. So we do feel good about the growth going forward. We'll see how the rest of the year unfolds.

[Operator]

Your next question today will come from Louis Miscioscia with Daiwa.

[Louis Miscioscia, analyst]

Well, let me just blend, I guess, two questions into one. It looks like, obviously, the Americas was a little bit stronger from Europe. So can you comment on just European demand? It seems the economies are maybe a little bit slower there. And then could the difference be that the U.S. is actually doing better, trying to deploy AI applications in comparison to Europe.

[George Kurian, executive]

Listen, I think our team in Europe has outperformed. We have -- yes, you're correct about the macro in Europe. It is still choppy in some parts of the European economy. But our team has outperformed. With regard to the Americas business, listen, the new leadership team has done a really good job, and I'm super excited at our ability to outperform and really in the largest market in the world. I think that our book of business, I don't think there was anything fundamental.

Yes, there were more wins in North America for AI, but I don't think it was fundamentally different I think our business overall in North America performed exceptionally well across all segments, and it was just execution across a broad range of customer demand.

[Operator]

And your next question today will come from Ananda Baruah with Loop Capital.

[Ananda Baruah, analyst]

I guess, George, a question maybe and a little clarification. So the new high end -- here's kind of the question, the new high-end ASA product. How important is that to ASA product line, is it as important as the midrange product that you introduced a little while ago, those have made a really big impact. And then sort of in the prepared remarks, the comments about new customer -- new customer acquisition, which you referenced a few times on the call. Is that directly related to the new high-end products? Or I guess, to what degree has the new high-end products actually led to the new customer acquisition? And that's it for me.

[George Kurian, executive]

I think our flash portfolio has -- we refreshed the unified AFF products, and then we refreshed the ASA products. These have seen strong reception. I think with regard to new customers, over time, you will see the midrange bring new customers because the majority of net new logos to NetApp come from smaller, the commercial market, but the high-end products are enabling us to win wallet share within existing customers.

Block wallet share is entirely new to NetApp. We've never sold a block optimized product before. So it's all net new wallet for us. And so we're excited at the reception to those products. The unified product has continued to strengthen our positions in customers who want a consolidated data center infrastructure, more of the classic sales motion of NetApp. And so I think across the board, our flash, I mean, 19% year-on-year is a super strong number. It's the fourth consecutive quarter in that kind of altitude. And all of our products have done really, really well. So I'm really excited about the year ahead.

[Operator]

Your next question today will come from Chris Sankar with TD Cowen.

[Unknown Analyst]

This is Eddie for Chris. Just a clarification regarding the first party hyperscale service question. You talked about like 43% growth rate. Just want to make sure like -- is the conversion that's taking place from subscription to hyperscale services contributing in any material way to that 43% number?

[George Kurian, executive]

There's some modest conversion. It's not a significant percentage. There's a large number of net new to NetApp customers as well as significant expansion of existing customers and all of the hyperscaler services did extremely well. So yes, there were a few, but it was not material to the number.

[Unknown Analyst]

Got it. That's super helpful, George. And maybe just a follow-up on the GenAI topic. And using the AI deals you talked about today as an example, what pushed these customers to buy more storage? Was it just them setting up new GPU clusters and they need new storage equipment? Or is it more like an upgrade to existing infrastructure so that they can see their data lakes from it?

[George Kurian, executive]

It's a combination. There were a good number of them that were building GPU clusters. Both super pads and kind of base pods that we saw where they were essentially running the GPUs against high-performance file systems from NetApp and some that were building data lakes because their data was so scattered that they wanted to bring it together, and they chose our infrastructure to power the data lay. So a mix of them. Interesting early in the cycle. We just brought to general availability, our full stack with Lenovo, for example, with ODX, and we're doing creative work with NVIDIA around some of their software that Jensen referred to on their call yesterday.

[Operator]

Your next question today will come from Nehal Chokshi with Northland Capital Markets.

[Nehal Chokshi, analyst]

Congrats on a strong result. At INSIGHT, you guys introduced your AI vision, which is quite expensive, and I believe that has some forward-looking product developments. One of those product development, I believe, is -- correct me if I'm wrong, it's the decoupling the scaling of data management compute and data storage. Is that correct?

[George Kurian, executive]

I'm sorry, could you repeat the question?

[Nehal Chokshi, analyst]

Yes. One of the elements of the forward-looking AI vision as far as how NetApp's portfolio may evolve is the decoupling of the scaling of the data management compute and the data management storage components. Is that correct?

[George Kurian, executive]

That's right. That is one of the elements. You're correct.

[Nehal Chokshi, analyst]

Yes. And how long do you expect to before you can really introduce that? And how have you lifted this? Is this more like the lift it took to go to clustered ONTAP. Or is it more like the lift it took to optimize for flash.

[George Kurian, executive]

We have been working on scaling out our architecture over many, many years, right? And so this is not anywhere near the lift of clustered ONTAP. As we said, we expect to have these solutions deployed in customers by the end of next calendar year. So we're excited. We are making really good progress on it. Stay tuned. We'll tell you when we make those solutions are generally available.

[Operator]

Your final question today will come from Ari Terjanian with Cleveland Research Company.

[Ari Terjanian, analyst]

Congrats on the good results. First, just a clarification on the AI deals. That 100, is that deals in the quarter? And if so, that -- like what drove the doubling from 50 last quarter, it's a pretty strong result. And then just as it pertains to the SSD pricing and whatnot, to the extent that there are any pricing actions to your products, do you think there was potentially any pull forward of demand? Or do you anticipate any impact from any pricing changes?

[George Kurian, executive]

With regard to the AI deals, Listen, it's just broader engagement with customers. These deals are large deals are -- take a long sales cycle, right? So our teams have been working on these for a while. And so we just saw broader engagement across our field teams and our partner base to accelerate the pipeline. We have a good outlook for that business, and I'm excited about the prospects of it. I'll hand it to Mike for the second question.

[Michael Berry, executive]

Nice to meet you as well. So there have been some pricing changes on some of our products. What I would say is, say, every quarter, there's always pull forward and push us from a revenue perspective, nothing material, though. And keep in mind that those tend to take a while to work through the pipeline as well. So we do expect to have some impact going forward, but we'll have to see how the rest of '25 goes.

[Kris Newton, executive]

All right. Well, thanks, Ari. I appreciate your question, and I'm going to turn it over to George for some final comments.

[George Kurian, executive]

Thanks, Kris. We are focused on enabling customers to build intelligent data infrastructures with our uniquely differentiated solutions for flash, block, cloud storage and AI. These solutions address markets which are bolstered by both secular and company-specific tailwinds and represent our biggest opportunities to fuel revenue growth and increase market share. Our pace of innovation has never been stronger. We are executing well, clearly outgrowing the market and all of our competition in each of our key growth markets. Our focused and disciplined operational management positions us well for continued customer and shareholder success.

[Operator]

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.