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NetApp, Inc. (NASDAQ:NTAP)
Q2 2019 Earnings Conference Call
Nov. 14, 2018, 5:30 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good afternoon, ladies and gentlemen. Welcome to NetApp's second quarter fiscal year 2019 financial results conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time.

I will now turn the call over to Kris Newton, Vice President, Corporate Communications and Investor Relations.

Kris Newton -- Vice President, Corporate Communications and Investor Relations

Thank you for joining us on our Q2 fiscal year 2019 earnings call. With me today are our CEO, George Kurian, and CFO, Ron Pasek. This call is being webcast live and will be available for replay on our website at netapp.com.

As a reminder, we adopted the new accounting standard ASC 606 in Q1. Our historical financial results have been restated to conform to the new revenue recognition rules. Reconciliations of our previously reported GAAP results to the restated 606 GAAP results, as well as our 606 GAAP to non-GAAP results are included in our Q2 earnings release for the applicable period, which is posted on our website, along with our financial payables and guidance, a historical supplemental data table, and the non-GAAP to GAAP reconciliation. Unless otherwise noted, we will refer to non-GAAP and 606 numbers.

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 2019, our expectations regarding future revenue, profitability, cash flow and shareholder returns, and our ability to grow and expand our opportunities, all of which involve risk and uncertainty. We disclaim any obligation to update our forward-looking statements and projections.

Actual results may differ materially from our statements and projections for a variety of reasons, including global political, macroeconomic, and market conditions, and our ability to expand our total available market, introduce and deliver new and differentiated products and services without disruption, manage our gross profit margins, capitalize on our market position in cloud strategy, maintain 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 2018 and our current reports on Form 8-K. During the call, all financial measures presented will be non-GAAP unless otherwise indicated.

I'll now turn the call over to George.

George Kurian -- President and Chief Executive Officer

Thanks, Kris. Good afternoon, everyone. Thank you for joining us. We delivered another quarter of solid results. Our Q2 revenue was in line with expectation. Gross margin, operating margin and EPS were all above the high end of our guidance range. Our consistent and strong performance reflects the clear differentiation of our technology and the strength of our business model, as well as our customers' commitment to NetApp, and the significance of our data fabric strategy.

In the quarter, we extended our leadership position by introducing new partnerships and substantial innovation across our entire portfolio. Our opportunity is framed by the data-driven digital transformation of business, and defined by major technology transitions led by cloud, IoT, and artificial intelligence. The adoption of hybrid multi-cloud environments is changing how modern IT infrastructures are built and consumed, and NetApp is at the heart of these transitions.

The NetApp data fabric provides unique customer value through an easily implemented catalog of consistent data services seamlessly connecting on-premises resources to the private and public cloud, with unified data services across all environments. This capability enables customers to realize the full potential of their data across edge, core, and multiple cloud. Enterprises are responding to our data fabric strategy, and are signaling their long-term confidence in NetApp by making investments in our software.

As discussed on our Q1 call, we have seen a rising interest in enterprise license agreements, or ELAs, a form of broad enterprise agreement. The ELA represents the software-based capacity enablement portion of a multi-year engagement, and creates the framework for committed follow-on revenue in the form of systems and support services. Demand for these agreements is driven by our largest customers and is evidence of our growing importance to their IT strategy.

In September, we announced a global strategic partnership with Lenovo, designed to expand our market reach deeper into China, as well as to address silver-led purchases and FME and commercial segments not traditionally served by NetApp. The partnership also extends the reach of the data fabric strategy and capabilities into these new markets. NetApp is driving the market transition to flash, as we help customers modernize, simplify, and consolidate their infrastructure. We are displacing competitors' complex equipment, gaining share in new workload deployments, and upgrading our install base with cloud-connected all-flash solutions.

In Q2, our all-flash array business, inclusive of all-flash FAS, ES, and SolidFire products and services grew 29% year-over-year to an annualized net revenue run rate of $2.2 billion. Validating the innovation leadership and momentum of this part of our business, Gartner for the third year in a row recognized NetApp as a leader in its Magic Quadrant for solid state array.

In Q2, we introduced new innovations that further expand our leadership in the all-flash array market. ONTAP 9.5 software delivers leading cloud integration, the highest all-flash performance, and greater efficiency and simplicity. This release furthers our stand capabilities with improved performance, supported by the industry's first latency guaranty to accelerate critical workloads with industry-leading end-to-end NVMe capability. At the start of Q2, we announced ONTAP AI in partnerships with NVIDIA, which creates a seamless data pipeline across edge, core, and cloud for deep-learning deployment.

Over the course of the quarter, we extended our participation in the rapidly growing area of AI, with the announcement of MAX Data. MAX Data is the industry's first solution to leverage persistent memory in servers to delivery ultra-low latency with flash-like capacity, accelerating the performance of application-level data, and enabling faster processing of data for AI applications in memory databases and real-time data analytics. In addition to helping customers deliver better business outcomes with AI, we enable them to harness the growing data sources created by the Internet of Things.

The latest version of NetApp storage grid flash-accelerated object storage delivers low-latency performance for the billions of small objects generated by IoT devices, and cloud connectivity for best-in-class performance and data management capabilities, together with object storage economics. Enterprises choose our conversion hyperconverged solutions to accelerate their digital transformation because we help manage applications, infrastructure, and data, as one integrated resource across private, public, and hybrid-cloud environments.

In Q2, we announced the ease of managing FlexPod environments, with NetApp solutions support for FlexPod and converged system advisor software to reduce time to resolution for service incidents. We also enhance NetApp HCI, our industry-leading hybrid cloud infrastructure. We announced new element software capabilities for HCI and SolidFire, including the ability to replicate from element to cloud volumes ONTAP for disaster recovery, data migration, and remote back up to public cloud, as well as to on-premises ONTAP systems.

Additionally, we introduced new options in our HCI portfolio, including support for GTU-based compute node to accelerate VDI environments and support for Red Hat OpenShift Container platform. Through tight integration with the data fabric, only NetApp can bring the capabilities, architecture, and experience of public cloud to enterprise private cloud. We are delivering on the hereto unmet promise of hyperconvergence by enabling customers to run multiple applications with predictable performance and efficient scalability. Our architectural approach is clearly proving out.

We are seeing strong momentum in NetApp HCI, with significant wins against all of our competitors. As you've heard me say many times, our unique differentiator is cloud integration. Our entire portfolio is made stronger by the data fabric and our ability to support hybrid multi-cloud environments. A great example of the value of this integration is the cloud tiering service introduced in Q2. Cloud tiering identified infrequently used data in on-premises storage, and automatically and seamlessly moves it to lower cost object storage in the cloud, freeing up space on high-performance data center systems for frequently used data. When the cloud-tiered data is needed again, the service automatically and seamlessly moved it back to the high-performance tier.

Also in Q2, we announced substantial innovation to address distinct customer challenges in using public cloud. Container orchestration, cloud infrastructure monitoring and management, data compliance and security, and backup. Immediately following our acquisition of StackPointCloud in September, we launched the NetApp Kubernetes service which dramatically simplifies the deployment of a Kubernetes cluster and applications to public and private cloud. We also announced Trident, an open source project which supports the entire NetApp storage portfolio.

The combination of NKS and Trident enables application developers to consume high-performance storage to build and deploy [inaudible] applications on all of the world's leading clouds and on their private clouds. To help customers monitor and cost-optimize their hybrid cloud infrastructure, we introduced Cloud Insights, a hybrid multi-cloud infrastructure monitoring and management service. Cloud Insights quickly inventories resources, identifies interdependencies, and assembles a topology of public cloud and on-premises environments. By giving organizations a view into their complete hybrid infrastructure, it helps to reduce cloud infrastructure cost by an average of 33%, proactively identify and prevent failures, and improve end-user satisfaction.

Fiscal '19 is a foundational year for the SaaS part of our business. We are focused on operational readiness and deployment in the primary cloud data centers. While early, the customer response to and demand for these offerings is exciting and reinforces our confidence in our cloud strategy. Based on Q2, our annualized monthly recurring cloud data services revenue is approximately $27 million, up 35% from Q1. We remain intensely focused on disciplined execution to meet the volume needs of our growing customer base and to reshape our industry.

We are transforming our business to reflect the way customers want to use and consume our technology. We have repositioned the company, expanded our portfolio, and focused our execution to win the key market transitions. We are serving customers in new ways with focused initiatives that help them jump start their digital transformation, leveraging the innovation of the biggest cloud providers in the world, building enterprise hybrid clouds, and modernizing legacy infrastructure.

Our strategy is working because our customers know that we are aligned with their IT imperatives and their needs to unlock the value of their data to improve business outcomes. We heard that clearly at our recent Insight user conference where thousands of customers and partners shared their excitement for our solutions and our data fabric strategy, and our performance has been very strong as a result. We are leading in the areas that represent the biggest opportunities for NetApp. As we continue to grow and transform, we will maintain our focus on operational efficiency, execution, and shareholder value.

As you can see by our strong results and capital returns, we are on track to deliver against the compelling long-term model and capital allocation plan we laid out at our last analyst day. Before turning it over to Ron, I'd like to especially thank the customers who spoke on our behalf at Insight. Together with the NetApp team and our partners, we are delivering exceptional results and pushing the boundaries of what it means to be data-driven. Ron?

Ron Pasek -- Executive Vice President and Chief Financial Officer

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. Our Q2 results reflect the continued strategic importance of NetApp to our customers as they undertake digital transformations and embrace hybrid multi-cloud accelerators. As George noted, we expect continued progress throughout fiscal 2019 toward a long-term business model we laid out at our analyst day. Before discussing guidance, I'll provide detail on our performance in the second quarter.

Net revenues of $1.52 billion grew 7% year-over-year, driven by product revenue of $913 million, which increased 11% year-over-year. Product revenue reflected the strength of our all-flash array business, and expanding traction in our HCI platform, as well as roughly a $20 million benefit from ELAs.

Moving down the P&L, software maintenance and hardware maintenance revenue of $539 million increased 2% year-over-year, driven by continued growth in our install base and to a lesser extent our cloud data services business. Gross margin was 65% and above the high end of our guidance range. Product gross margin of 54% increased 1.5 points year-over-year, reflecting continued sales force discipline, the benefit from ELAs, and some one-time items. Excluding ELAs, product margin was approximately 53%. The combination of software and hardware maintenance and other services gross margins increased 1 point year-over-year.

Operating expenses of $649 million were in line with our expectations and increased 1% year-over-year. We remain committed to strong opex discipline and continue to expense operating expenses for fiscal 2019 to be roughly flat year-over-year. Operating margin was 22%. Excluding ELAs, operating margin was approximately 21%, and at the high end of our guided range. During the quarter, we repurchased 6.9 million shares at an average price of $81.41 per share, for a total of $561 million. Weighted average diluted shares outstanding were 264 million, down 5 million sequentially, and 11 million year-on-year.

EPS of $1.06 increased 33% year-over-year, demonstrating the operating leverage in our business model. We closed Q2 with $4.3 billion in cash and short-term investments. Similar to Q1, we again saw healthy growth in deferred and financed unearned services revenue, which increased 5% year-over-year. During the quarter, we paid out $102 million in cash dividends. Our fiscal Q3 cash dividend of $0.40 per share is payable on January 23rd.

Our cash conversion cycle is negative 19 days, improved 9 days year-over-year, reflecting a 12-day increase in days payable outstanding, and a 4-day decrease in days inventory outstanding, partially offset by a 7-day increase in DSO. Five days of the DSO increase was due to one of our large distributors choosing to not take advantage of our early pay discount. Cash flow from operations was $165 million. Free cash flow of $122 million represented 8% of revenue. Q2 is typically the lowest cash flow quarter of the year.

In addition to seasonality and one of our U.S. distributors not taking advantage of the early pay discount, we also had our first payment for transition taxes associated with U.S. tax reform, which we expect to pay annually each year in Q2 for the next 7 years. It is also worth highlighting that we had a particularly tough year-over-year free cash flow comparison, as we delivered an 18-day sequential improvement in our cash conversion cycling in Q2 of last year. In total, we remain confident in driving free cash flow of 19% to 21% of revenue for the full fiscal year.

Now on to guidance. We are keeping a keen eye on changes in the macro backdrop, including increased volatility as a result of interest rate, currency headwinds, and trade disputes with China. That said, we continue to focus on execution and managing variables within our control and we remain confident in both our fiscal FY19 guidance and our long-term 3-year growth forecast for revenue and profitability.

To add clarity, we are providing an estimate for the magnitude of ELAs going forward. We expect ELAs to represent roughly 2% of total annual revenue for fiscal '19 and future years. It is worth highlighting that the 2% in revenue from ELAs only represents the software capacity licensed portion of the contract. As George noted, each contract also carries a specified amount of future hardware systems revenue, along with both software and hardware maintenance.

To reiterate, we remain confident in our mid-single-digit fiscal 2019 revenue growth forecast, plus any benefit from ELAs. Now to Q3. We expect net revenues to range between $1.55 billion and $1.65 billion, which at the midpoint implies a 4% increase year-over-year, including 1 point of currency headwind. Consistent with normal, seasonal sequential decline in gross margin from Q2 to a3 associated with product revenue being a larger portion of the overall revenue mix, we expect Q3 consolidated gross margins to range between %62.5 and 63.5%. We expect fiscal Q3 operating margin to be approximately 22%. We expect earnings per share for the third quarter to range between $1.12 to $1.18 per share.

In summary, I'm confident regarding our growth opportunities, especially as it relates to our compelling data fabric strategy. Additionally, I'm very pleased with both the disciplined execution and the continued innovation momentum delivered by our team in Q2. We are well positioned to continue to deliver on the commitments we've made to our shareholders, partners, and customers. With that, I'll hand it back to Kris to open the call for Q&A. Kris?

Questions and Answers:

Kris Newton -- Vice President, Corporate Communications and Investor Relations

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

Operator

Ladies and gentlemen, if you have a question at this time, please press * then 1 on your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the # key. Once again, if you have a question, press * then 1.

Our first question comes from the line of Rod Hall with Goldman Sachs. Your line is now open.

Roderick Hall -- Goldman Sachs & Co. -- Analyst

Hi, guys. Thanks for the question. I heard, Ron, you say that 1 point of currency headwind to the guidance. I'm wondering if you could just comment on the currency impact to the current quarter as well from a margin point of view? And then also, I was hoping maybe that you guys could talk a little bit about the cloud services. I mean, the run rate looks pretty good, but obviously it's not really general GA yet. How does that pipeline look? Can you give us any more color on that? Just how you expect that revenue to flow as we look out into the next quarter and beyond. I mean, if you could say what you're guiding or what the level of guidance is like for those cloud services, that would be really interesting. Thanks.

Ron Pasek -- Executive Vice President and Chief Financial Officer

Rod, the first part of your question, as it relates to the guide for Q2, currency had very little impact on the guide in Q2. As I said, it's about a 1 point headwind for the Q3 guide. You'll see a little bit of that in margin in Q3 as well, but it's factored in the guide there. It's one of the reasons it's down sequentially.

George Kurian -- President and Chief Executive Officer

With regard to cloud data services, we're in the build-out phase within the hyperscale data centers. I think the pipeline has been good. We are certainly seeing the success of our software called Cloud Volumes ONTAP within the hyperscale marketplaces. It is the big chunk of the progress in terms of the revenue to date of cloud data services. As the cloud volume service targeting application developers comes online through the course of this fiscal year, we should be in a really good position to expand that set of bookings.

Roderick Hall -- Goldman Sachs & Co. -- Analyst

Okay. Thanks, guys.

Kris Newton -- Vice President, Corporate Communications and Investor Relations

Thanks, Rod. Next question?

Operator

Our next question comes from the line of Andrew Nowinski with Piper Jaffray. Your line is now open.

Andrew Nowinski -- Piper Jaffray -- Analyst

All right, thank you. Just a question on the gross margin. If we exclude your ELAs this quarter, it looks like your product gross margin was actually up sequentially from last quarter, but your fiscal Q3 and your '19 guidance does suggest it goes down pretty significantly from here. Given the decline in NAND prices, I was just wondering if you could maybe discuss the puts and takes on the margin guidance. Thanks.

Ron Pasek -- Executive Vice President and Chief Financial Officer

Thanks, Andy. We typically see a pattern, as you saw last year and the year before where we go down in margin from Q2 to Q3. The biggest factor in the past year and including this year has been just the weighting of product revenue, which is higher in Q3 than Q2, to service this revenue. That's the biggest part of the change. We'll also have in Q3 lower ELA revenue this year. Some one-time benefits are referred to in Q2, but it is a normal seasonal pattern you see.

Andrew Nowinski -- Piper Jaffray -- Analyst

Got it. Thank you.

Ron Pasek -- Executive Vice President and Chief Financial Officer

I will add, if you look at product margins for the last six quarters from Q1 of '18 to the quarter we just reported without ELAs, it goes from 49.5% up to 53%, so we are making progress on the product margin for the company.

Andrew Nowinski -- Piper Jaffray -- Analyst

Thanks, Ron.

Kris Newton -- Vice President, Corporate Communications and Investor Relations

Thanks, Andy. Next question?

Operator

Our next question comes from the line of Katy Huberty with Morgan Stanley. Your line is now open.

Katy Huberty -- Morgan Stanley -- Analyst

Thank you. Good afternoon. Just a clarification and then a question. On the clarification side, does the January quarter guidance include any assumption around ELA revenue? And if not, just any color as to whether your pipeline would suggest that you might have some ELA deals? Then for a question, AFA run rate growth of 29% was a slowdown. Can you just talk about whether that deceleration was slower systems growth or was it entirely driven by lower NAND prices flowing through to ASPs? Thank you.

Ron Pasek -- Executive Vice President and Chief Financial Officer

Katy, the first part of your question, I tried to bound ELAs for the full year this year of 2% of revenues. Just to recall, we did about $90 million in Q1 and $20 million in Q2. So you're pretty much there to the full-year forecast for ELAs. We might see a little bit. So the forecast assumes, it's just a forecast. There might be a little bit, but it's not going to be a lot.

George Kurian -- President and Chief Executive Officer

With regard to the all-flash arrays, I think first of all we are growing 29% year-on-year. The predominant percentage of that was due to shipments. We have not adjusted prices to deal with NAND. As we've said, we're going to monitor what other people do and then make the appropriate adjustments.

Katy Huberty -- Morgan Stanley -- Analyst

George, why do you think shipment growth slowed in the quarter?

George Kurian -- President and Chief Executive Officer

I think there's a mix between flash and hybrid-flash. I think the percentage of our business that's today all-flash arrays is very large. And if you look at it sequentially, in Q1, we had some benefit from ELAs for all-flash arrays. As you saw in Q1, our number was a very large number year-on-year. So I think it's just more of a sequential compare against a one-time set of metrics in Q1.

Katy Huberty -- Morgan Stanley -- Analyst

Understood. That's helpful color. Thank you very much.

Kris Newton -- Vice President, Corporate Communications and Investor Relations

Thank you, Katy. Next question?

Operator

Our next question comes from the line of Aaron Rakers with Wells Fargo. Your line is now open.

Aaron Rakers -- Wells Fargo Securities -- Analyst

I wanted to go to the last question I was asked, and understand maybe what you're seeing from a competitive landscape perspective in the all-flash market. As we start to or as you guys evaluate what some of the competitors are doing, how you see the potential playing out for demand elasticity as it relates to your install base opportunity that's not yet upgraded to flash. Maybe metrics around that would be helpful as well.

George Kurian -- President and Chief Executive Officer

I think from an install based perspective, we still have a very small percentage of our install base on all-flash arrays. It's in the mid-teens, and so there's plenty of headroom. I think that we are going to balance the ability to upgrade the install base with getting the best value for our offerings. We think that our offerings are very competitive in the market, and we're going to try to extract the maximum value for that. I think in terms of competition, we don't see any fundamental change in the competitive landscape. I think that we are seeing more new competitors as we attack the hyperconverged market, so we are expanding our competitive assault on hyperconverged market and we're seeing as a result of that some new players, but no fundamental change in the competitive dynamics.

Aaron Rakers -- Wells Fargo Securities -- Analyst

Thank you.

Kris Newton -- Vice President, Corporate Communications and Investor Relations

Thanks, Aaron. Next question?

Operator

Our next question comes from the line of Steven Fox with Cross Research. Your line is now open.

Steven Fox -- Cross Research -- Analyst

Hi, good afternoon. Just one question for me. George mentioned traction on the HCI side. I was wondering if you can expand on that and talk about where you're seeing that and what you expect for the rest of the year fiscal year from HCI?

George Kurian -- President and Chief Executive Officer

We're very pleased with the progress on hyperconverged. I think as we said, we have a differentiated architecture that's resonating in the marketplace. We saw a broadening book of business, and accelerating pipeline, and a growing number of competitive wins. So it proves out the thesis that we've had all along that the enterprises want a solution that enables hybrid cloud infrastructure, that allows IT to operate like a service provider, that allows applications, infrastructure, and data to be seamlessly managed, whether it's on premises or across multiple clouds.

So our strategy is working. We've got work to do to continue to expand the scaling of our go-to-market pathway and to expand the number of price points that we need to address, but we are very, very pleased with where we are year-to-date.

Steven Fox -- Cross Research -- Analyst

Great. Thank you very much.

Kris Newton -- Vice President, Corporate Communications and Investor Relations

Thanks, Steve. Operator, next question?

Operator

Our next question comes from the line of Wamsi Mohan with Bank of America Merrill Lynch. Your line is now open.

Wamsi Mohan -- Bank of America Merrill Lynch -- Analyst

Yes, thank you. I have a quick clarification as well on the product gross margins. Ron, you mentioned some one-time benefits a few times and I was wondering if you could call out what those were and what the magnitude of that was? And George, can you comment on the broader spend environment, both in the enterprise and hyperscale players? And any color by region would be helpful. It sounds like your guide it gated by some caution there. Thank you.

Ron Pasek -- Executive Vice President and Chief Financial Officer

Wamsi, the one-time benefits relate to some reserves. It was about a half a point. So not material, but just something to be aware of.

George Kurian -- President and Chief Executive Officer

With regard to the macro, no particular color that I want to share. I think we saw some movement in some of our U.S. public sector deals where they were in quarter, command programs. These are multi-year programs that are not tied to any particular budget cycle, that just had spending some out in Q3, as opposed to in Q2. So we feel very good about our ability to capture that business in Q3. Then overall, I think nothing unique that we want to comment on. I think you see the public markets reflecting some stress in some parts of the emerging markets. I think that's really the summary of the comments.

Wamsi Mohan -- Bank of America Merrill Lynch -- Analyst

Okay. Thank you.

Kris Newton -- Vice President, Corporate Communications and Investor Relations

Thanks, Wamsi. Next question?

Operator

Our next question comes from the line of Mehdi Hosseini with Susquehanna. Your line is now open.

David Ryzhik -- Susquehanna Financial Group -- Analyst

Thanks so much for taking the question. This is David Ryzhik for Mehdi. Ron, would you be able to give us some insight into just the product revenue growth expectations embedded in the Jan. quarter and for the balance of '19? Then within that, would love to get your sense of how material the Lenovo relationship can be, and would that be included in strategic or would that be in mature revenue? Thanks much.

Ron Pasek -- Executive Vice President and Chief Financial Officer

David, we don't guide below the total revenue number. We'll talk about revenue after the fact and compare year-over-year, but I don't guide the specific items.

George Kurian -- President and Chief Executive Officer

With regard to Lenovo, Lenovo has started to be in market with our products. They bring complementary pathways to the customer. They allow us to access new decision makers. We are starting to see the first wins, but it'll take us a good amount of time to get them fully scaled in terms of all of their geographies on knowing our products and taking it to market. There's very little overlap in our customer base, which is a positive. There is a reasonable about of common channel partners, but there's work to be done.

And in terms of strategic versus mature, we are no longer going to be using that breakout of the business because the majority of the mature business is now add-on storage reflecting the strategic product sales. So you'll see us just comment about product revenue and services revenue on a go-forward basis.

David Ryzhik -- Susquehanna Financial Group -- Analyst

Thanks so much.

Kris Newton -- Vice President, Corporate Communications and Investor Relations

Thank you, David. Next question?

Operator

Our next question comes from the line of Ananda Barauah with Loop Capital. Your line is now open.

Ananda Baruah -- Loop Capital Markets -- Analyst

Good afternoon. Thanks for taking the question. A quick clarification then one question. George, clarification. So just with regard to spending environment, is the takeaway that you're not really seeing anything material yet and you want to leave it at that for right now? Then I have a quick follow-up as well.

George Kurian -- President and Chief Executive Officer

I think with regard to the spending environment, there's no particular impact of tariffs that we saw. It's too early to comment. I think we're just generally cautious, trying to maintain our track record of providing clear guidance and meeting or beating it, right? I don't think there's anything that you should read into the commentary that is less in confidence or have specific color around the economic outlook. We are monitoring it. There's a lot of news, but we haven't seen specific items change in terms of their trajectory.

Ananda Baruah -- Loop Capital Markets -- Analyst

Perfect. Thanks. Then just the question is coming out of the user conference, I guess what was the vibe coming out of the user conference? What were some of the common themes from users? There seem to be, I'm there were a lot of participants there this year. The energy was great. People were talking about putting on new projects. What were the common themes coming out that you guys saw?

George Kurian -- President and Chief Executive Officer

We were very excited by the number of net new customers that were at the conference, reflecting our ability to grow footprint into new parts of the market that were historically not NetApp customers. We were excited at the number of customers that validated our solutions and our direction for hybrid multi-cloud IT, as their path going forward. And of course, there was an extraordinary amount of innovation that we delivered at our Insight conference.

It leads us to continue to have really, really good confidence that we are gaining share in the markets that we are competing in, expanding our addressable market through new solutions like our hyperconverged solutions, solutions for artificial intelligence, and changing the industry landscape through the unique combination of application, infrastructure, and data for hybrid multi-cloud IT. So we feel really good about where we are positioned and look forward to finishing out the year strongly.

Ananda Baruah -- Loop Capital Markets -- Analyst

That's great. Thanks a lot.

Kris Newton -- Vice President, Corporate Communications and Investor Relations

Thanks, Ananda. Next question?

Operator

Our next question comes from the line of Joe Wittine with Longbow Research. Your line is now open.

Joseph Wittine -- Longbow Securities -- Analyst

Hey, guys. Nice numbers. Especially given the competition out there. George, I wanted to do a quick follow-on to your prior HCI comments. We also picked up on some acceleration this quarter, including what seemed to be some nice-sized wins against players that I would consider to be higher-end, traditional reference architecture type converged solutions. Is it fair to see you're interest with HCI in the field now for a while in either more advanced customers or more mission-critical applications than you envisioned at launch?

George Kurian -- President and Chief Executive Officer

Absolutely. Our belief was that we are building on the only architecture that was designed to operate a multi-tenant service provider class HCI offering. And by bringing that to the enterprise, we are uniquely advantaged versus other players that started from a small office dedicated application. That is proving out clearly in Q2 and in our go-forward pipeline. So people are excited about our offerings.

I think as we integrate it more tightly into our hybrid multi-cloud data fabric, it both locks out players trying to enter our install base, and also allows us to capture a bigger footprint, like you said, in the enterprise data centers that we don't have footprints in. So, we really -- our thesis on the HCI market that it was time for disruption with a mainstream enterprise grid offering like the all-flash arrays absolutely playing out. We can't be more excited looking forward.

Joseph Wittine -- Longbow Securities -- Analyst

Perfect. Thank you.

Kris Newton -- Vice President, Corporate Communications and Investor Relations

Thanks, Joe. Next question?

Operator

Our next question comes from the line of Simon Leopold with Raymond James. Your line is now open.

Simon Leopold -- Raymond James & Associates -- Analyst

Great. Thanks for taking the question. During your Insight event, you talked about multi-cloud and in your prepared remarks we heard it a lot again. It's definitely an intriguing narrative and it feels like an inflection point. I think I'm struggling to figure out how to attach this to our forecasting. Maybe broadly, do you look at the emergence of multi-cloud as an element that can lead to reacceleration of year-over-year growth? Or is it basically just replacing older technologies? Is it sort of a natural evolution or an accelerating factor? Thank you.

George Kurian -- President and Chief Executive Officer

Multi-cloud plays into our business in multiple ways. The first is it allows us to access completely cloud-native customers that do not have a data center. I think at Insight you saw as a customer of that site called WuXi NextCODE, which is a genomics company that is built on the cloud. Never had a data center.

The second is it allows us to expand our footprint within existing customers, where the combination of cloud plus data center gives us unique benefit. Those could be net new customers. Like we are displacing people who have legacy data centers with our flash technology combined with cloud. Or it could be expanding footprints within existing customers, where we displace one of our competitors in the SaaN market with a cloud flash alternative.

Then the third is it allows us to bring more efficiency to our existing customers, in some cases where they want to, for example, leverage the cloud for analytics, a footprint that we historically didn't serve. So there's lots of avenues. I think that it's already helping us in leadership in flash, where the cloud brings a unique angle to our flash solutions that others do not have. Then from a pure cloud solution standpoint, you will see that reflected in the CDS business on a go-forward basis.

Simon Leopold -- Raymond James & Associates -- Analyst

Thank you.

Kris Newton -- Vice President, Corporate Communications and Investor Relations

Thank you, Simon. Next question?

Operator

Our next question comes from the line of Alex Kurtz with KeyBanc. Your line is now open.

Alex Kurtz -- KeyBanc Capital Markets -- Analyst

Thanks for taking the question. George, at the outset of the call here, you mentioned that it sounded like the top line was more in line with expectations versus beating on the margins. Are there different verticals or regions that outperformed or underperformed? Any kind of additional clarity on how the quarter played out would be helpful.

George Kurian -- President and Chief Executive Officer

I think U.S. public sector was a little bit soft relative to our expectations. APAC and U.S. commercial conversely were very strong. EMEA dealt with a point of Forex being as a headwind. So most of the theaters did really well. On U.S. public sector, as I mentioned in my comments, we have a broad book of business. Some aspects of that business are tied to multi-year programs and the trajectory of spend within a specific quarter can vary. They're not tied to the typical year-end federal spending pattern. And so we saw some of those programs move spending from Q2 to Q3. So we feel good about our ability to capture that business in Q3.

Alex Kurtz -- KeyBanc Capital Markets -- Analyst

Thank you.

Kris Newton -- Vice President, Corporate Communications and Investor Relations

Thanks, Alex. Next question?

Operator

Our next question comes from the line of Erik Suppiger with JMP. Your line is now open.

Erik Suppiger -- JMP Securities -- Analyst

Could you compare the prospects for your multi-cloud with your HCI solution? I presume the multi-cloud is further along in terms of contribution, but can you talk about what you think, how you would compare the two different prospects there?

George Kurian -- President and Chief Executive Officer

Multi-cloud has inherently become a part of what most hyperconverged solutions will have to offer. If you think about an IT department, most of them will want to have the ability to build their own clouds, or manage a portfolio of applications and say hey, I don't want to run those in my own data center, I just want to use the public cloud. We are clearly uniquely positioned in the public cloud marketplace for having the ability to connect applications, infrastructure using NetApp Kubernetes service, and data using a technology called Trident that we have to make hybrid multi-cloud deployable today across all the major cloud providers.

When we combine that with hyperconverged, you now not only get to do that on the public clouds, but also on prem. We do that in a way that is unique because unlike some of the other hyperconverged vendors, we're allowing you to use the public cloud services. All the other hyperconverged vendors have some form of wall guard and they're building in the public cloud that doesn't give you the benefits of real public cloud. So we're excited. You'll see that play out. We're just going to keep our head down and prove that out. We think we've got a really strong start the first half of the year in hyperconverged. Look out, here we come.

Erik Suppiger -- JMP Securities -- Analyst

Then secondly, any comments about NVMe? Did you see any more adoption during the course of the quarter?

George Kurian -- President and Chief Executive Officer

NVMe has two flavors. One is the NVMe connection between discs and storage systems. That's nice, but not massively differentiated. We have it. We've seen customers adopt it as they adopt NVMe drives. So we're pleased it's in line with expectations. NVMe over fabrics, which is the truly strategic part of the NVMe roadmap, is now deployed at a few customers. It's early. It's applicable for truly low-latency applications. And we're excited. We are pioneering that part of the market, and we're excited that both the support that we have from the ecosystem, as well as customer interest. But it'll take time to adopt like any new storage protocol.

Erik Suppiger -- JMP Securities -- Analyst

Thank you.

Kris Newton -- Vice President, Corporate Communications and Investor Relations

Thank you, Erik. Next question?

Operator

Our next question comes from the line of Eric Martinuzzi with Lake Street. Your line is now open.

Eric Martinuzzi -- Lake Street Capital Markets -- Analyst

A question on playing with a potential new, bigger player in cloud. NetApp plays well with Amazon and Microsoft Azure and Google Cloud. Given the IBM acquisition of Red Hat, which is expected to close in the second half of 2019, I'm interested to hear your thoughts on what this means for enterprise hybrid storage environments. And then secondly, from a product development, I'm wondering if there's any initiatives that NetApp is entertaining to maybe benefit from that pending merger acquisition?

George Kurian -- President and Chief Executive Officer

Just a couple of things. I think the first is the acquisition or planned acquisition of Red Hat by IBM is yet another endorsement of hybrid multi-cloud, right? I think that the combination of Red Hat together with IBM gives enterprises the ability to deploy multiple clouds and hybrid cloud. We already have strong relationships with both sides of that transaction. With Red Hat, we have done a lot of work across multiple solutions, both stand-alone storage, converged systems, and hyperconverged systems to support OpenShift, as well as a variety of other Red Hat Linux platform combinations.

We just announced this quarter the ability to deploy OpenShift alongside NetApp HCI. Then with IBM, we have a long-standing relationship with IBM Cloud. All the way from the time of soft player. They are a large NetApp partner. We have hybrid cloud solutions alongside the IBM Cloud, where you can deploy Cloud ONTAP Volumes on the IBM Cloud. There's a variety of innovation going on together with them as well. So we feel that this is a good combination. It affords us yet another player to work with to make hybrid multi-cloud a reality for customers.

Eric Martinuzzi -- Lake Street Capital Markets -- Analyst

I understand. So more of an opportunity that you guys are already well positioned for than something you'd need to design new product for?

George Kurian -- President and Chief Executive Officer

That's correct.

Eric Martinuzzi -- Lake Street Capital Markets -- Analyst

Thank you.

Kris Newton -- Vice President, Corporate Communications and Investor Relations

Thank you, Eric. Next question?

Operator

Our next question comes from the line of Jim Suva with Citi. Your line is now open.

James Suva -- Citigroup Global Markets -- Analyst

Thank you very much, George and Ron. A question about the past 12 to 24 months. Memory pricing has been a headwind. Can you remind us what you did historically during that time period? I think on your conference call you mentioned you'll assess going forward what the competitive landscape does. So hypothetically, what does that mean if memory prices keep coming lower? Will you lower your prices? Will you near the percent change? How should we think about that? And is it a lagging basis or just in time basis, or how should we think about just the future impact of memory prices versus the past history of 12 to 24 months? Thank you, gentlemen.

Ron Pasek -- Executive Vice President and Chief Financial Officer

Jim, if you remember about 18 months ago, we did, in fact, increase list prices for products that carried NAND. That was simply because that was what our experience was with the supply base. We were very fortunate to be able to secure supply that entire time and, in fact, knew that the pricing would eventually come down starting earlier this year. And it, in fact, did. As we said a number of times, we're not going to be the leaders in reducing list prices now that NAND prices are coming down. We're going to watch it and see what happens. On a net price basis, we are still very competitive, so we're watching that effect too. So there's what you do with list prices and then what you do with street prices. We're going to keep watching it as we go forward.

George Kurian -- President and Chief Executive Officer

We also continue to make investments in software that allows us to maximize the value that a customer gets from a piece of memory. We announced at NetApp Insight the availability of ONTAP 9.5 that has further advancements in our already industry-leading storage efficiency technology.

The second is I think as flash prices come down, it makes all-flash arrays, where we are extraordinarily well positioned, a more and more meaningful opportunity for a broader and broader mix of workloads within our customers. And so as that capitalizes replatforming opportunities in the customer base, it's clearly an opportunity for us that we're going to take advantage of.

James Suva -- Citigroup Global Markets -- Analyst

Thank you so much for the details, gentlemen.

Kris Newton -- Vice President, Corporate Communications and Investor Relations

Thank you, Jim. Next question, please?

Operator

Our next question comes from the line of Nehal Chokshi with Maxim Group. Your line is now open.

Nehal Chokshi -- Maxim Group -- Analyst

Thank you. So results and guidance are definitely within the guidance parameters that you provided previously, as well as your analyst day. However, when I exclude the impact of ELAs, I do see a slowdown in the year of your product growth, albeit still within your long-term model. So I think from 11% year-over-year in the July quarter and now it's around 9% year-over-year for this quarter. Your guidance implies that's probably going to be around 5% year-over-year. So is there a narrative that we need to be concerned about as far as why we're seeing this product revenue year growth slow down? Albeit still within the guidance.

Ron Pasek -- Executive Vice President and Chief Financial Officer

I think what we have been doing is we got the services total back to where it's not a headwind. That was what we were seeing last year. Some of that product growth was making up for the headwind we had on the services side. I think as you look at the second half of last year, we grew the Q3 quarter 9% year-over-year in total, and Q4 11%. That's total revenue growth. Product growth within that was quite a bit higher. We are looking at some pretty tough compares. We did guide the year to mid-single-digits. We're very confident we can still do that. That's without the benefit of ELAs.

George Kurian -- President and Chief Executive Officer

I think the only other additional comments that I would add is last year in some parts of the world, Forex was a tailwind. This year it's a headwind. I think that we feel very, very good about our innovation portfolio. If you look at it this time last year, we were strong in flash, but not yet at meaningful progress on the other two alternatives, which is hyperconverged and public cloud.

I think this year, heading into the second half of this year, we feel very good about flash, but we can have much more line of sight into the strength of our hyperconverged and public cloud business. So overall, we're focused on execution. We have a good start to the fiscal year. We remain committed to our outlook, which was to grow mid-single-digits without ELAs for the year, and so we're going to execute to that plan.

Nehal Chokshi -- Maxim Group -- Analyst

Thank you.

Kris Newton -- Vice President, Corporate Communications and Investor Relations

Thanks, Nehal. Next question?

Operator

Our next question comes from the line of Rob Cihra with Guggenheim. Your line is now open.

Robert Cihra -- Guggenheim Partners -- Analyst

Hi, thank you very much. Just a question on your flash versus hybrid mix. So AFA obviously growing rapidly, but obviously not 100% of your revenue. With that whatever, call it half of your business that's hybrid or drive-based, are you seeing that selling into the install base as add-on as that sort of thing? Or do you see enough genuine applications, sort of cold storage, Hadoop, whatever where those hybrid platforms are actually still best? And so there's some mix where it's not like you're ever going to get to 100% flash? I hope that question makes sense. Thanks.

George Kurian -- President and Chief Executive Officer

I think if you look at the hybrid arrays, there are two forms of hybrid arrays. One is where you've got a piece of solid state storage front-ending SaaS drives, meaning performance drives. The second is a form of hybrid array where you've got flash front-ending capacity drives, meaning 7200 RPM capacity drives. There is still some percentage of our business in the former of the two categories, which will eventually get replaced by all-flash arrays as the price point of

NAND gets better over the next year. There is going to be an enduring portion of our business for capacity-oriented workloads, for sequential workloads. For example, video, which don't benefit from solid state. Where the second form of hybrid array will continue to be an ongoing percentage of our business for as long as I can see.

Robert Cihra -- Guggenheim Partners -- Analyst

Right. Okay. Thank you very much.

Kris Newton -- Vice President, Corporate Communications and Investor Relations

Thanks, Rob. Next question?

Operator

I'm showing there are no further questions. With that, I would like to turn the call back over to NetApp for closing remarks.

Kris Newton -- Vice President, Corporate Communications and Investor Relations

Great. Thank you.

George Kurian -- President and Chief Executive Officer

I'm really excited about the opportunity ahead. We introduced a tremendous amount of innovation in Q2 that helps us drive share gain, expand our available market, and set the industry agenda. NetApp is uniquely able to help customers solve the challenges of multi-hybrid cloud environments with the data fabric. Our data fabric strategy is paying off through growing importance to our customers and yielding strong financial results.

We are relentlessly focused on execution and on delivering against our plan. And we remain confident in both our fiscal '19 guidance and our long-term 3-year growth forecasts for revenue and profitability. I look forward to talking with you again next quarter.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a wonderful day.

Duration: 57 minutes

Call participants:

George Kurian -- President and Chief Executive Officer

Ron Pasek -- Executive Vice President and Chief Financial Officer

Kris Newton -- Vice President, Corporate Communications and Investor Relations

Roderick Hall -- Goldman Sachs & Co. -- Analyst

Andrew Nowinski -- Piper Jaffray -- Analyst

Katy Huberty -- Morgan Stanley -- Analyst

Aaron Rakers -- Wells Fargo Securities -- Analyst

Steven Fox -- Cross Research -- Analyst

Wamsi Mohan -- Bank of America Merrill Lynch -- Analyst

David Ryzhik -- Susquehanna Financial Group -- Analyst

Ananda Baruah -- Loop Capital Markets -- Analyst

Joseph Wittine -- Longbow Securities -- Analyst

Simon Leopold -- Raymond James & Associates -- Analyst

Alex Kurtz -- KeyBanc Capital Markets -- Analyst

Erik Suppiger -- JMP Securities -- Analyst

Eric Martinuzzi -- Lake Street Capital Markets -- Analyst

James Suva -- Citigroup Global Markets -- Analyst

Nehal Chokshi -- Maxim Group -- Analyst

Robert Cihra -- Guggenheim Partners -- Analyst

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