Why NetApp's Earnings Results Last Quarter Frustrated Me
There's an old saying in computer science:
There is also a conflict between different goals when you design a business model. In this blog, I'll describe the key conflict in NetApp's business model, and how we've resolved it.
If you round everything to the nearest 5%, here is what NetApp's business model generally looks like. For every dollar of revenue we receive from customers, we spend 40 cents manufacturing the products we ship and another 45 cents running the company, which leaves about 15 cents in operating profit. To put this into business terminology, the "operating stack" looks very roughly like this:
The key conflict is long-term growth versus profits this quarter. To maintain growth, you have to invest for the future. If you want to sell more next year than you are selling today, then you'd better hire more sales people. If you expect to have more customers next year, then you'd better hire more customer service engineers to support them, more manufacturing people to build products, and so on.
But investments increase operating expenses and drive down profits.
Let's focus on hiring new people. Employees usually aren't very productive for their first few months, so at first, hiring new people raises expenses without improving revenue. The faster you grow, the more people you have who aren't yet pulling their own weight. I call this the growth tax. At high growth rates, the penalty can be significant. Suppose it takes people 3 months to get up to speed, and suppose that all operating expenses are proportional to head count. At a growth rate of 35%, our growth rate last quarter, the growth tax is about 3.5% of the overall stack. (Here's my math: (135%^(1/12)^3-1)*45% = 3.5%.)
That might not seem like a big percentage, but I can assure you that stock market analysts focus very closely on profitability. That 3.5% growth tax would reduce an 18.5% profit to 15% which is definitely significant. At 50% growth, based on these same dramatically oversimplified assumptions, the tax would be almost 5%.
[Aside: I enjoy applying engineering-style thinking to the operation of the company as a whole. What are we optimizing? Can we model the result? And so on.]
Summary: To grow you must hire, but hiring drives down profits.
The management team at NetApp has decided to optimize for long-term growth, as opposed to optimizing for short-term profits. We believe that optimizing for profit would actually be damaging to the company, because it would doom us to being the perpetual underdog.
That's why I'm frustrated with our earnings results last quarter (FY2007 Q2). By many measures, Q2 was wonderful. It was our largest quarter ever, with $652 million in revenue. That was a 35% increase over Q2 a year ago, which is an awesome growth rate for a company our size. The profit level was also unusually high. We had a non-GAAP operating profit of 18.2%.
It's that operating profit that frustrated me. We believe that the optimal trade-off between growth and profitability occurs at roughly 16% operating profit. (The range we target is 15.8% to 16.4%.) Generating higher profit meant that we invested less. At $652 million in revenue, that 2.2% difference comes to almost $15 million that we could have invested in future growth but did not.
At our annual analyst day conference a couple of years ago, we were describing our business model to investors, and we got an interesting question. Laura Conigliaro, an analyst at Goldman Sachs, said, "If you are targeting a 16% profit model so that you can invest in the future, does that mean it would be bad news if your profit level were to rise? Would that mean that you had run out of new ideas to invest in, and that growth was going to slow?"
We're certainly not out of ideas. In the earnings call, Dan summarized it like this: "We missed an opportunity to get more aggressive this past quarter, and I'd like to see that not happen again."
Fast, cheap, reliable—choose any two.The point is that these goals are in conflict. Improving one tends to hurt the others. Sometimes a new technology paradigm lets you improve all three at once, but within the new paradigm there will still be a conflict between the three.
There is also a conflict between different goals when you design a business model. In this blog, I'll describe the key conflict in NetApp's business model, and how we've resolved it.
If you round everything to the nearest 5%, here is what NetApp's business model generally looks like. For every dollar of revenue we receive from customers, we spend 40 cents manufacturing the products we ship and another 45 cents running the company, which leaves about 15 cents in operating profit. To put this into business terminology, the "operating stack" looks very roughly like this:
40% COGS (Cost of Goods Sold: components, labor, overhead, etc.)(For the real numbers, see the transcript of our Q2 earnings call.)
45% Operating Expenses (sales, marketing, engineering, salaries, etc.)
15% Operating Income (profit from running the business, before taxes)
The key conflict is long-term growth versus profits this quarter. To maintain growth, you have to invest for the future. If you want to sell more next year than you are selling today, then you'd better hire more sales people. If you expect to have more customers next year, then you'd better hire more customer service engineers to support them, more manufacturing people to build products, and so on.
But investments increase operating expenses and drive down profits.
Let's focus on hiring new people. Employees usually aren't very productive for their first few months, so at first, hiring new people raises expenses without improving revenue. The faster you grow, the more people you have who aren't yet pulling their own weight. I call this the growth tax. At high growth rates, the penalty can be significant. Suppose it takes people 3 months to get up to speed, and suppose that all operating expenses are proportional to head count. At a growth rate of 35%, our growth rate last quarter, the growth tax is about 3.5% of the overall stack. (Here's my math: (135%^(1/12)^3-1)*45% = 3.5%.)
That might not seem like a big percentage, but I can assure you that stock market analysts focus very closely on profitability. That 3.5% growth tax would reduce an 18.5% profit to 15% which is definitely significant. At 50% growth, based on these same dramatically oversimplified assumptions, the tax would be almost 5%.
[Aside: I enjoy applying engineering-style thinking to the operation of the company as a whole. What are we optimizing? Can we model the result? And so on.]
Summary: To grow you must hire, but hiring drives down profits.
The management team at NetApp has decided to optimize for long-term growth, as opposed to optimizing for short-term profits. We believe that optimizing for profit would actually be damaging to the company, because it would doom us to being the perpetual underdog.
That's why I'm frustrated with our earnings results last quarter (FY2007 Q2). By many measures, Q2 was wonderful. It was our largest quarter ever, with $652 million in revenue. That was a 35% increase over Q2 a year ago, which is an awesome growth rate for a company our size. The profit level was also unusually high. We had a non-GAAP operating profit of 18.2%.
It's that operating profit that frustrated me. We believe that the optimal trade-off between growth and profitability occurs at roughly 16% operating profit. (The range we target is 15.8% to 16.4%.) Generating higher profit meant that we invested less. At $652 million in revenue, that 2.2% difference comes to almost $15 million that we could have invested in future growth but did not.
At our annual analyst day conference a couple of years ago, we were describing our business model to investors, and we got an interesting question. Laura Conigliaro, an analyst at Goldman Sachs, said, "If you are targeting a 16% profit model so that you can invest in the future, does that mean it would be bad news if your profit level were to rise? Would that mean that you had run out of new ideas to invest in, and that growth was going to slow?"
We're certainly not out of ideas. In the earnings call, Dan summarized it like this: "We missed an opportunity to get more aggressive this past quarter, and I'd like to see that not happen again."
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