NetApp Inc (NTAP) 2003 Q1 法說會逐字稿

Good afternoon, ladies and gentlemen and welcome to the Network Appliance Q1 fiscal '03 earnings release conference call.

At this time, all participants are in a listen-only mode.

Following today's presentation, instructions will be given for the question-and-answer session.

If anyone should need assistance at anytime during the conference, please press the star followed by the zero and an operator will assist you.

As a reminder, this conference is being recorded today, Tuesday the 13th of August, 2002.

I would now like to turn the conference over to Mr. Dan Warmenhoven, please go ahead sir.

Thank you.

Good afternoon, and welcome to the Network Appliance earnings release conference call for the first quarter of fiscal year 2003.

This was Dan Warmenhoven, it is my pleasure to welcome all of you, and to thank you for taking the time to join us today.

Today's conference call is being webcast over the Internet, and will be available at our website at www.netapp.com.

Before we begin the discussion of our first-quarter results, I'd like to take a moment to discuss the organizational changes we also announced today.

Jeff Allen, who has served as the CFO for Network Appliance for more then five years, is taking on a new challenge and a newly created executive position with the company as Executive Vice President of Business Operations.

In his new role, Jeff will be responsible for the integration and execution of our various lines of business, including NearStore, content delivery and our new block or sand storage systems.

Jeff will also continue to have responsibilities for manufacturing operations.

I'm very pleased to announce that Steve Gomo is joining the executive team of Network Appliance as our new Senior Vice President of Finance and Chief Financial Officer.

Steve, as many of you know, has served as CFO of Silicon Graphics, and worked with both Jeff and myself during his 24 year tenure to Hewlett Packard.

Most recently Steve was CFO of Gemplus International, a smart card manufacturer headquartered in Luxembourg.

Welcome aboard, Steve.

Thanks Dan.

I'm certainly glad to be here, and I'm looking forward to working with the team.

Also joining Jeff and myself on the call today along with Steve is Tom Mendoza, President of Network Appliance.

At this point, I'd like to turn the call over to Jeff, who will review the financial portion of the press release we issued today. Then following Jeff's comments I'll share my own comments on events during the quarter, and then provide you with a financial outlook, and conclude with a question-and-answer period.

I'd like to introduce Jeff Allen.

Thank you, Dan.

Good afternoon, ladies and gentlemen.

In the course of today's conference call we may make forward-looking statements and projections that involve risks and uncertainty.

Actual results may differ materially from our statements or projections.

Factors that could cause actual results to differ from our projections include but are not limited to a continuing general economic environment and customer demand for our products and services.

Other equally important factors are detailed in the company's 10-K and 10-Q reports on file with the SEC and also accessible through our website.

Our press release is available on the business wire and on our website.

I'd like to provide some commentary about our results for the first quarter of fiscal year 2003.

As indicated in the press release, revenue for the quarter was $206.8 million, up just over 3% year-over-year from the $200.4 million reported in Q1 last year.

Revenues were up 1% sequentially from the $204.9 million reported in Q4 of last fiscal year.

Business in Europe was weaker than the past few quarters, down $11.5 million dollars sequentially, and on a percentage bases down from 30% to approximately 25% of our revenue.

We saw relatively better performance in North America and the rest of the world, with North America contributing approximately 62% of total revenue, and [ICON] rest of world contributing approximately 13% of revenue.

Revenue from our NetCache product line continued to be lumpy at approximately 8% of revenue compared to the 12% reported last quarter.

Book to bill ratio for the quarter was one to one.

Pro forma operating expenses totaled $107.2 million, down $7.5 million from the $114.7 million reported last quarter.

As expected, sales and marketing expenses came down from the prior quarter. And this quarter we successfully collected previously accused account specific bad debt provisions, which benefited G&A expense by approximately $1.5 million.

Gross margin for the quarter was 62.4%, down 1.6 points from the prior quarter.

Last quarter, if you recall, we had a nonrecurring benefit of about a point and a 1/2 in the reported margins.

Software as a percentage of revenue was approximately 23% of revenue, again contributing to strong gross margins.

Software products were approximately 16% of revenue, and software subscription upgrades were again approximately 7% of total revenue.

As discussed during last quarter's call, we're providing this software mix breakdown because the revenue treatment is different between software product sales, which are recognized upon shipment, and software subscription upgrades, which are recognized over the life of the subscription.

Revenue from services, which includes hardware support, professional services, and educational services, was approximately 9.7% of total revenue, about the same as we reported in Q4 of last year.

Other income was down approximately 23% from Q4 levels due to lower levels of interest income, and higher levels of currency-related expenses related to our exposure and the movement of the dollar versus the Euro.

Pro forma pretax income for the quarter was $24 million, or 11.6% of revenue, up 25% from the prior quarter.

Pro forma net income for the quarter was $18 million, or approximately 8.7% of revenue, up almost 23% over the prior quarter.

And pro forma earnings per share were five cents based on a weighted average of approximately 350 million shares outstanding.

The tax rate used in the quarter was 25%, which we now expect to apply for the full fiscal year.

We reported a GAAP net income of $16.2 million.

We're also five cents per share this quarter.

We've provided a reconciliation between our pro forma and GAAP income in the condensed statement of operations of our press release.

The difference between GAAP and pro forma this quarter includes intangibles and stock compensation totaling $2.4 million from acquisitions.

We also reported a permanent impairment of an investment, and a gain from the sale of a portion of our content management tools.

Headcount at the end of the quarter was approximately 2,350 people, up approximately 70 from last quarter, a result of selected additions in sales and customer service.

Cash and investments at the end of the quarter were $479 million.

Cash generated from operations during the quarter was approximately $27 million.

Days sales outstanding of accounts receivable were 62 days, compared to 65 days reported last quarter.

And inventory turns for the quarter were 11 turns, down from the approximate 12 reported last quarter. And this relates to inventory that we have put into production for our next generation systems platforms.

I'd like to provide a few summary points for the quarter.

The business environment remains quite challenging.

Both Europe and NetCache did weaken in the mix quarter-over-quarter, while our farther business in North America and Icon showed sequential growth.

We do expect to continue to make selected investments in key areas, particularly those areas that generate revenue, while continuing to make progress on our quarterly earnings.

At this point I'd like to turn the conference call back over to Dan.

Thank you, Jeff.

We continue to build and expand our enterprise customer base during the first quarter. Some key wins during the quarter included British Airways, Commonwealth Bank of Australia, and Delta Airlines.

The U.S. Department of State deployed NetApp FA-40 filers and NetApp Stamp Manager for Microsoft Exchange, in an environment that supports 30,000 Microsoft Exchange e-mail users.

This deployment resulted in an increased stability of their Exchange environment, while enabling them to more easily manage the backup and recovery of their exchange data stores.

In addition, the Department of State's Bureau of Counselor Affairs is deploying filers to support very large Microsoft soft sequel server databases containing passport data for every U.S. citizen.

The State Department projects are also an excellent example of the strength of our Excentra relationship.

Moving on to products, NearStore continues to see strong customer acceptance during its second full quarter of sales.

I'd like to highlight a couple of key wins during the quarter.

Saudi-Aramco has been using NetApp filers to store mission critical geoseismic data, and needed a more cost-effective solution for mirroring their F-800 series filers.

They are now deploying over 50 terrabytes of NearStore as their solution for protecting this important information.

Land America Financial Group is architecting an image archive and disaster recovery application to enhance access to reference data for its real estate title services.

The NetApp R-100 will be used as a [INAUDIBLE] line enterprise storage solution to provide online, secure access to customer and client information. Which improves turn around time and scope of service, while reducing their costs, which are the most influential factors in attracting and retaining customers.

I'm very pleased with the progress that near stores have made up to this point.

The F-880 series was presented with the Best Complete Storage System award at the 2002 Network Storage Conference. Peripheral Concepts, the promoter of the conference, teamed with Commuter Technology Review and Infrastore Magazine to officially launch the first network storage awards program, designed to recognize outstanding achievement in storage networking, and we're very pleased and honored that they selected our F-880.

Giga Information Group recently released the first study determining the total economic impact, or TEI, of Network Appliance's business [INAUDIBLE] solutions.

More than just total cost of ownership, Giga's TEI methodology qualifies the full impact of a technology investment.

The study found significant three year cost savings on a rapid ROI for customers using Network Alliance's business [INAUDIBLE] solutions, and reinforced our belief that high availability remains the top priority for customers.

The full study is available on our website at WWW.netapp.com.

Database related projects were again over one-third of filer product booking for the quarter.

We have recently completed certification for Oracle [INAUDIBLE] database with real application clusters, also known as the Oracle 9I rack, with their [INAUDIBLE].

The certification demonstrates the strong and growing relationship between Network Appliance and Oracle, with both companies committed to building integrated data management and storage solutions that drive a lower cost of ownership, to simplify deployments, and collaborative support services.

We also announced that we have just joined the SAS R&D partner program as a platinum level member.

This allows Network Appliance to collaborative on global technology research & development with SAS.

As part of the global alliance, we will work closely to provide seamless platform integration and develop best practice guides, that help our mutual customers easily and efficiently deploy SAS and NetApp solutions in large scale enterprise environments.

In summary, we continue to expand the partnerships, product lines, and customer base that are keys to our success in the enterprise.

And we have a very exciting set of upcoming announcements in those areas that we'll be making over the next few months.

We're also planning our first-ever Analyst Day, which will be held at the Millennium Hotel and Hudson Theater in New York City on October 1st.

SO please mark your calendars and save the date.

I'd now like to take a moment to talk about our business outlook.

This outlook is based on our current business expectations, and it reflects our pro forma presentation.

Again I'll remind you that we're making forward-looking statements and projections that involve risk and uncertainty.

Actual results may differ materially from our statements or projections.

We continue to be pleased with our ability to execute well in a very difficult economic environment.

We expect revenue for Q2 to be up 2 to 5% sequentially.

We expect Q2 pro forma earnings to be in the five cents per share range, depending on the revenue level achieved.

That concludes our remarks for today, so at this point I'd like to open the call for questions.

I would like to ask that you limit yourself to one question each, so we can address everyone in a timely manner.

And then we'll go back through the cycle again if there are more.

We'd like to keep the call to under an hour.

Thank you.

Thank you, sir.

Ladies and gentlemen, at this time we will begin the question-and-answer session.

If you have a question, please press the star followed by the one on your push button phone.

If you would like to decline from the polling process, press the star followed by the two.

You will hear a three toned prompt acknowledging your selection.

Your questions will be pulled in the order they are received.

if you're using speaker phone equipment, you will need to lift the handset before making your selection.

One moment please for our first question.

Our first question comes from Kimberly Alexi. Please state your company name, followed by your question.

Yes, thanks. It's Prudential Securities.

Quick clarification and a question, clarification just around comments that you made on backlog levels.

I didn't catch that. If you could go over that.

And then the question, Dan, maybe you could just talk about when you look sequentially and you look at the pickup that you saw a little bit in the U.S.

and some of the weakening in Europe, can you give us any color in terms of any areas where you're seeing some improvement or deterioration as it relates to either customer verticals or any types of trends that you saw in those different geographies that were different than your expectations? Or any kind of color that you can give us there.

Book to bill was one.

We maintained our backlog levels from the fourth quarter.

Kimberly, this is Dan.

First of all, just to reiterate the points we did make in the conference call opening.

Europe was down significantly. It was mostly in the what we call central Europe areas, Germany and the Germanic countries.

They have been a star performer for us during the North American downturn over the last year, and it looks like Germany may have finally softened somewhat.

Also the cache product line was down, I think it was last quarter as I recall, it was 12% of mix, this quarter's it's about 8. And that's not too surprising. You'll notice this quarter there were two competitors at least that withdrew from the cache business, [INAUDIBLE] and F5. That's a market that has struggled, and especially the enterprise sector, and most of the cache deployments have been through telcos.

This particular quarter -- in prior quarters, we've seen very lumpy results with the telcos. This quarter, there were no single large transactions of any particular telco,

and I think that's why it fell off.

A couple of sectors which I think were particularly good for us this quarter were energy, which grew in our mix, manufacturing was down a little bit, telco actually up then down a little bit.

Federal was up. Federal looks like it's really on a roll. And, you know, the rest have been reasonably flat.

I think we've seen the bottom, however, in the both the Internet space and the high-tech space.

In fact, high-tech was up a little bit in the mix, not material, but I'm encouraged that it's the first time in four quarters we didn't see a decline.

Great, thank you.

Our next question comes from Don Young, please state your company name, followed by your question.

Yes, thanks you, it's UBS Warburg.

And good evening guys.

I'm wondering if there's a chance you could give us a little color on the amount of mix or the amount of block IO capable products you had, and the idea of the magnitude of the NearStore sales if that's possible.

hey Don, this is Dan.

First of all, on the block products, we're not in a position to break those out certainly yet.

The introduction of the block products would not be until during our fiscal Q2.

So there was no revenue of the new sand-based products in Q1 at all.

I meant the Microsoft Sequel and Exchange products in particular that you were talking about, the block IO over IP.

That one we very candidly sold as an embedded capability as one of the licensed product programs. As you by a filer and you add this capability on top which makes the filer operate in block mode.

And so it's not a full system level.

It's part of the I think roughly 16 or 17% of revenue that's one-time software product sales.

And it's embedded in there.

And it, it's showed significant growth quarter-over-quarter.

But it's hard to tell how much in the way of total systems revenue that leveraged.

Does that make any sense to you?

Sure --

[overlapping speakers] % of the total revenues, and obviously there's a lot of system drag with that.

The State Department case I mentioned, which uses Stamp Manager For Exchange, for instance, was significant in term of size of the deal.

But the software content which drove it was fairly minor.

If I could do one follow up on your comments on database, I always thought your strongest database operation was in the German area, or the Germanic countries.

Where you picking up more strength in database in new markets that you traditionally didn't sell database products into.

Absolutely.

We've been very successful, particularly in areas like data mining, and as I mentioned, the sequel environment. We've seen a great deal of success in the Oracle world, especially as customers have moved towards a Lenix environments, blade servers, and the 9I rack kind of thing. As well beyond the initial success we had in Germany.

This is now, in fact, I think North America did about a third of their business in database. And it's across most of the major verticals.

Okay, thank you.

On NearStore, we made good progress this quarter.

Revenues were up several million dollars from the prior quarter.

So I think that we're moving steadily along our goal of getting the product mix to approach 5% and ultimately 10% of our mix.

Don, this is Tom Mendoza. Just to comment in the energy sector, one of the things that was very interesting is we saw a number of sales go down with large Lenix servers, in fact lots of Lenix servers, using Oracle and NetApp as the back end as a very, very cost-effective answer to any other way they were doing it before. So I think that's trends you're going to see more of, starting in energy, probably starting in government, but you're going to see a lot of other generic verticals like financial services and things like that move more toward Lenix, and we're a good back end for that.

Our next question comes from Dan Renaurd. Please state your company name, followed by your question.

Hi, it's Dan Renaurd from Baird.

I just guess I have really one question and one kinds of housekeeping for Jeff.

Could you just give us the CAP-X and deprec -- DNA?

And then the second question I had was if you could may be give us a longer term view -- you gave guidance, specific guidance for this quarter, but if we could get your thoughts on the I.T.-- overall I.T. environment, and what you see out, sort of the rest of this year, how should we be thinking in terms of I.T. spending

recovery [INAUDIBLE]

I'm going to pass on that.

I don't think I have an answer to that.

We're kind of managing our business quarter by quarter, trying to manage our growth in both the vertical markets and the footprint in some of our largest customers.

But you know, the environment to me hasn't changed much at all, and we've seen some rotation as we talked about into Europe this quarter.

So, you know, I don't think we're in a position to venture a guess or make a claim about what we think's going to happen here.

I would have to underscore that.

You know, there are multiple different surveys you can look at that show anything from there's going to be a surge in spending at the end of the year to everybody's going to lockdown again. And we don't have any better visibility to what the real answer is than anybody running those surveys. Our customers are all over the map.

There are strong sectors like the federal government, Homeland Defense certainly has some priorities, things of that nature. And then there's areas of growing concern, as Jeff mentioned, like Germany. So it's very difficult for us to forecast more than a quarter out.

But you don't see things getting worse, at least what's right in front of your face.

I don't.

I see it on a slow recovery path.

I'm actually fairly pleased

we've seen over the last three quarters successive growth.

We're forecasting modest growth going forward.

I don't see anything to change that trajectory.

One of the things that I would comment on, a trends that I've noticed, that we actually took advantage of, specifically in North America this quarter. It's clear to me that CIO's are looking at all the applications that are running on their expensive storage -- most expensive storage, and determining if there's a way that they can find a highly reliable source to put that storage on that's a lot less expensive.

So as opposed to -- it's kind of like what happened to main frames, I think. All of this storage needs to be main framed, and as recession set in in the early '90's, you found a lot of that moved to other types of storage.

This past quarter we did a number of significant wins that we were specifically brought in because they wanted to move off what they considered too expensive storage to a secondary source, [INAUDIBLE] that data, and made their liability requirements.

I think that trend will continue and pick up.

It's a matter of whether overall I.T. spending will will pick up. But that -- within overall I.T. spending, I think that's the trend we're going to see.

I'll have Rod Matthews follow up on the CAP-X.

I don't have that in front of me.

Our next question comes from Bill Lewis.

Please state your company name, followed by your question.

Yes, J.P. Morgan.

Could you talk for a minute about the environment out there competitively, what you saw in terms of pricing during the quarter, discounting that you had to do, and I guess related to that, how successful you were at pulling costs out commensurate with that?

Thanks.

Hi, this is Dan.

I haven't seen any significant change in the competitive environment at all.

Discounts were down a little bit from the prior quarters, and I don't think that was meaningful.

I mean it's normal statistical fluctuation from quarter to quarter, but slight down trends.

I've read a lot of things about people talking about storage cost declining at 50% per annum, and now slowing to 30. I'm wondering on what basis people came up with those numbers.

You know, since the time we introduced our first product, we reduced the cost per megabyte at about 40 to 50% per annum. And so having it be at 50 didn't mean much.

In fact, you know, it used to be the disk drives doubled their density every 15 to 18 months, and obviously that lowers the cost per meg. And there was a period there when the drive manufactures went 15 to 18 to 36 to 73 gig drives in nine month increments, and it came down in a steeper curve. And that's actually what you saw during 2001 and late 2000.

We're now at a more normal kind of evolutionary cycle, back to where we were.

And I think the cost per Meg declines are back where you used to see them.

I haven't seen any structural change, and all this commentary I read in the industry I think just misses the point.

I don't think it's been competitively driven.

I think it's been cogs driven. It's been cogs driven largely by the capacity of the drives.

And the cost reductions, they're basically following normal patterns in most categories.

So I wouldn't expect any big changes there.

Okay, thank you.

Next up is a question from Mark Kellerher.

Please state your company name followed by your question.

From First Albany, thanks.

Could you give us an update on your DAFs initiative? How's that progressing?

When can we see some revenue coming from that?

Mark, this is Dan.

We don't intend to break out DAFs in a quantitative sense in revenue, but I can assure you it's been a key factor in a number of customer wins and new accounts.

The DAFs code is shipping. It's being used in production largely in Oracle environments, although there are several other application environments that we think will be deployed in production, probably during this next quarter.

The DAFs component, as I've indicated in the past, is a -- from our vantage point, new and more efficient method of creating an interface between the database environment and the storage subsystem,

allowing for very efficient transfers, reducing the overhead on a server.

And it has, in fact, yielded the desired result.

It was the basis for our record producing PPC benchmark that we did in conjunction with Fujitsu-Seamens, running Solares, where we set the world's record for lowest dollars per TPC-OP, and it was based on using DAFs.

So it's been a very fundamental piece of the database strategy.

It you quote on a percentage basis what percent of filers are implementing, or being sold with the DAF interface.

I don't have that number in front of me, but it's starting to grow as [INAUDIBLE] competes for database business.

But you should think of it as increasing our competitiveness.

All it really does is when somebody buys a DAF solution, they are's selecting that as an alternative to a standard Gig-E interface.

Okay. Thanks.

Our next question comes from John Roy.

Please state your company name followed by your question.

Yeah, Merrill Lynch.

Guys, can you give us some more color on the block product and how that's going this quarter?

I guess it's going to come out soon.

And I wonder how many beta sites and if you can give us any kind of idea how that's going.

I'm very pleased with the progress.

The betas are coming to an end.

We intend to introduce the product in the next few weeks, probably end of September, early October.

The feedback from the betas has been excellent, and you know we're very, very pleased with it.

We achieved the objective that we set out to achieve, which was to simplify the world of sands. And that's the feedback the customers have given us. And we've had beta environments in a variety of different applications, both in North America and Europe, and I believe we'll have some pretty good stories to tell at the announcement.

Great, thanks.

Our next question comes from George Ellings. Please state your company name followed by your question.

Thank you, it's Deutsche Bank.

Competition is now more generic,

as everyone, including yourself, is seeking out a broader storage platform.

What are you seeing from your key competitors that may be different from the way it was a few months ago.

The thing I've noticed first of all is that EMC seems to have retracted.

I noticed in announcements yesterday that the vaunted NetApp killer has disappeared. I guess it died.

The IP-4700 was noticeably absent from their product lineup, with no replacement announced. So, I'll not sure if I agree with your assessment.

I think everybody's trying different solutions but, you know, I'm not sure anybody's got a -- other than Network Appliance, integrated vision [INAUDIBLE] play together.

If you look across, for instance, EMC announcements yesterday, they have four separate platforms that are noninteroperable. And I don't understand how you can call that a unified vision.

It's a variety of different point products, it's not clear how they even position them.

And I don't see anybody else any different.

You don't see any [INAUDIBLE] products out there that provide block services, other than ours. I don't see any [INAUDIBLE] suitable for database. In fact, EMC says specifically don't use NAFs for database.

We believe that there are a large number of database environments where [INAUDIBLE] is particularly well suited, provides great price performance results, and improves the overall operations through simplicit ease of use.

So, I think we've got a very differentiated story than the rest of the market.

I think actually many of the competitors are very confused about how to position this stuff.

Our goal is to go drive them to conversions.

Where the customer doesn't have to make a technology choice, but can use our systems in whatever mode he thinks are best suited to his application needs, and doesn't have to make a choice between different types of technologies.

Our next question comes from James Berlino.

Please state your company name, followed by your question.

It's Morgan Stanley.

I was wondering, did you guys give gross margin guidance.

What are you seeing the next upcoming quarter and then if you can, out further?

We're not giving any specific guidance on gross margins.

I think I would just amplify Dan's comments. As the pricing environment seems to be following its natural trends at this point, and our cost reduction efforts both from engineering as well as supply management and our partner relationships seem to be following that curve so I don't see any big changes at this point.

Alright, thank you.

Our next question comes from Robert Montov.

Please go ahead with your question.

Thank you, RBC.

I'm wondered, with some of the one-time events -- I asked this similar question on the Op-X line, kind of what do you expect a normalized OP-X to look like in the second quarter, and since that is a controllable element, maybe what are you planning for OP-X investment through '03.

We're not going to, you know, specifically put plans in place for OP-X growth until we see pretty darn good signs of revenue growth.

So we've made very selective investments that we think are the investments necessary to give us our best shot at driving the top line.

Sales and service.

I think this quarter we had a benefit of about a million five.

And so if you project that ahead I think we'll see modest, very modest growth in expenses.

Okay great, thanks.

Our next question comes from Peter Laid, please state your company name followed by your question.

Name's Labain, Nutmeg Securities.

I want to talk a little bit about market share.

Do we think storage spending was down on this quarter so that we're relatively flat performance would actually be an increase in share, our networks gaining direct access, declining.

It's sort of is happening on the overall share picture?

Peter, this is Dan. I do believe very strongly that direct detached storage is declining.

Although there are a number of customers who are trying to extends the life of their install base by adding more direct detach storage as opposed to making an architectural shift in network.

I believe every customer out there is looking at some solution in the area of network storage is where their future is.

And yeah, I do believe that trend continues.

I don't see any significant difference between the adoption rate of [INAUDIBLE versus SAN in that.

I think they're both continuing to be integral to most customers total solutions sets. And, you know, it's too hard for me to take a sample of one quarter and say things are up, down or sideways, and there for our share was up, down or whatever.

We feel pretty good about the head-to-head competitive wins we had this quarter if there's any indication of share.

But it's difficult to quantify in our market in particular how the shares stacked up this quarter.

Okay, Dan.

Thanks.

Our next question comes from Andrew Ness, please state your company name followed by your question.

I understand that you won't want to make a lot of guidance about the current quarter.

Last quarter or somewhere around there you talk about your goal was $1 billion this year.

Given where you are and given the guidance you gave for the next quarter, have you had an opportunity to revisit that goal for the year?

This is Dan, I think I mentioned that was certainly the internal goal that we were driving for, was to get back over a billion, which is what we were in our fiscal year 2001.

Clearly the further we go without a significant uptick, the harder it is to get there.

So I mean, you don't have to be a rocket scientist to figure out that the trajectory has got to change. [INAUDIBLE] the slope of the hill gets too steep.

I have got the company focused on let's get back to where we were, and that's the over riding theme. And as Jeff said our number one goal is to grow the top line.

But we don't see it showing up yet, and we're not doing anything to grow the expenses until we do see it materialize.

Thank you.

Next question from Richard Stites.

Please state your company name followed by your question.

Standard & Poors Equity Research.

Hi, guys.

Two things quickly.

One a question and a clarification.

In terms of the software revenues making up 23% of the total amount, what sort of goal do you have going forward in terms of how of much the total you would like that to make up.

And then on a clarification

Tax rate coming in at 25% this year, but I believe on the call last time -- last quarter you said you expect it had to be about 28% for FY '03, so I was wondering if you could just talk about the difference there.

Yeah, the tax question is probably too complicated to answer.

I always give my best estimate at the time. But, you know, we basically have some very specific international tax rulings and mix of business that drive that.

So we feel pretty confident in that number for this year now. So, we're doing the best we can to give you forward looking estimates of where we think it's going to go, and then we give you a progress report on those.

As far as the software mix, I'm very pleased with our software mix.

I think if you just look at penetration rates across our systems, of our mirroring capabilities ,our multi-protocol software capability, and our application specific software products in the Microsoft environment, they're all very healthy. And so, you know, I don't expect any significant movement one way or another at this point.

The progress we made has been substantial over the last couple of years, and it's really contributed to a lot of the health of our gross margin at this point.

I want to remind also that our strategy is a little different than some of our competitors.

The way we make our products to market is basically a software base solution right from the outset, including functionality that many other vendors charge separately for. Such as our snapshot technology which is bundled into the base system, and every other customer's implementation I believe is a separately charged item, and therefore reported software revenues.

We don't think of it that way.

We think about providing a simple, easy to use solution for our customers, and all of our technology is software-based.

It's a question of how we choose to package it to take it to market. So that is not a meaningful metric in our case.

Another statistic I give is that about 85% of our engineering resources are software engineers, so that's another reflection of what's inside the system.

Okay.

Great, thanks.

Our next question is a follow-up from Dan Renaurd, please go ahead.

Hi. Jeff, could you just clarify, what was that $1.5 million benefit again? What exactly that was. And then, just your total sales to your install base, if you could give some sort of sense to what that was, and then that particularly relative to a year or two ago, what that ratio looks like?

Thanks.

Yeah.

The specific was reserve is to customer-specific bad debt provision, which we have a very low probability of collection as we see it at the time.

We successfully collected some of those this quarter.

So that's really what that reflects.

And I have your answer to your question on capital spending.

We spent about $14 million this quarter, and had $11 million in depreciation.

Dan, this is Dan.

I don't happen to have the breakdown between install base and new business.

To be very candidly with you, we're in the process of converting from a more manual method to an automated method of sales force tracking.

And don't quite have all the i's dotted and t's crossed in that system, so I don't have quantitative information on the sales -- the new versus existing accounts.

But, any sort of anecdotal feel, or is it pretty hard to tell at this point?

Well, we look at win rates, and that's a good way of looking at it. And the win rates have stayed very, very consistent, and are consistent across installed base versus new.

That is -- they're different obviously, because a new accounts many times the competitor is an incumbent, and we're trying to out seed them. So win rates in our existing accounts are much higher in general, and that's been consistent with prior quarters, and win rates in new accounts have actually trended up a little bit.

Tom, you want to add to this?

Yeah. I would say that the main difference I believe between this year and last year, I agree with Dan on the quantitative basis, just looking at new account totals, they would be about the same percentage-wise.

What I think is different is which new accounts.

We put a strategic program together about a year ago, which was very successful for us.

We've enlarged that fairly dramatically this year. And i think our penetration into very large accounts, in some significant key wins, is far, far higher than a year ago.

I also think that NetApp about 18 months ago started a initiative, or a different way of looking at the market.

At that time we were trying to take advantage of hyper growth.

But it's also paying off in a down economy, which we realized that the next step for us was to get into the data center, not necessarily always where you have your synchronized [INAUDIBLE] applications, but many applications in the data center are now being moved to other types of storage, as I said before. And we've taken advantage of that in some very large significant accounts, like Southwest Airlines and Verizon and others, where they're taking advantage of our type of storage now.

That is more prevalent in the last two quarters than before.

And I think that's one of the main reasons North America is starting to feel better and uptick this quarter is those -- when you go into an infra structure sale it doesn't happen in six months.

It takes six to nine months because of the testing required, but we are in more of those by far than we ever were before.

Great, thanks.

And then Jeff, if you could just explain -- just one last issue on that $1.5 million.

That was essentially costs that you incurred over several quarters, or was there a specific quarter that you're incurred that cost that you're now reversing back out?

It's likely over several quarters.

So you basically built it up over several quarters.

And again it's not a reserve.

It's specific provisions for accounts that we have already aged substantially.

Right.

And we're basically providing for the potential for a bad debt.

Gotcha.

Thanks.

Our next question comes from Shelby Sherraffi. Please state your company, followed by your question.

Yes, it's A.G. Edwards.

Can you provide me with terrabytes shift, both total and near store, and talk about terrabyte growth? That's one.

And secondly, going forward, should we expect cache to decline yet again in the current quarter, and filers to continue to grow very well?

I noticed that they grew about 6% sequentially, should we expect more of the same.

I did my math and got seven.

The filer units, as I recall, were pretty flat.

The units were bigger and, therefore, generated more revenue.

I don't happen to have this quarter to break down [INAUDIBLE]bites, but it was pretty consistent with prior quarters.

I got units of drives, for instance, in last quarter we shipped 2 1/2 pettabytes of 72gig drives, and in this quarter we shipped 2 1/2 pettabytes of 72gig drives.

I mean, we also shipped 36's and 18's and so on and so forth. But that's a pretty good indicator that the capacities were about the same.

You know, NearStore, like we said has trended up nicely.

And certainly this quarter showed growth over last.

Okay.

And also can you talk about the flow of business as you see it or saw it and see it.

For example, in July, how did that track for you and how is August tracking so far?

August, it's too early to tell. I think I made a comment last year, you know, the first two weeks in August -- first of all, we ask all of our own sales employees to stay and finish the quarter in July, which means implicitly they're asked to take their vacation in August. I mean to tell you last year I remember trying to make a call to somebody in France, and nobody answered the phone.

It's not too surprising.

So August always starts slow, and that's to be being expected.

You know, we feel good about where the sales funnel is in terms of the breadth.

So that's the best indicator I can give you.

We exited the quarter with a book to bill of one to one, so the backlog is in the same position this quarter as last. And we're reiterating the guidance we gave you of 2 to 5% growth.

It should be -- just to back up for a second, maybe I can give you a different metric on your storage.

It looks like the capacities of the midrange to high end increased fairly significantly, from 2 1/2 pettabytes on average to over three on average.

As a for instance,.

Okay. And finally, you did reduce operating expenses while increasing headcount by about 70 people, so how did that happen?

Well as I mentioned, last quarter we did have the accelerators from a year end commission-related costs, as we exited last year, and we had a number of marketing programs that we had implemented last quarter that we scaled back on this quarter.

Thank you very much.

Our next question comes from Glenn Hanis.

Please state your company name followed by your he.

Hi, Needham and Company.

In addition to the block appliance, could you give us a summary of the key R&D projects in the pipeline.

And secondly, maybe more for tomorrow Tom, can you talk about the kind of the major projects that are driving sales at this point, still server consolidation, storage consolidation, or the nature of projects, and whether there's been any change to the types of projects you're seeing out there?

Thank you.

Yes, this is Dan.

As far as the product programs, clearly it's about that time again for us to refresh the high end of the product line.

We'll be bringing out in the fall some new high end systems, and they're right on track. And obviously, you know, as is our normal way, we'll come back and refresh the low end of the product line, and have something new out there after the first of the year.

Certainly from an architectural viewpoint, the block level products are where most of the energy is going at the moment.

Like I said, we're very pleased with that.

We're also investing quite heavily in extending management systems.

Virtualizing file naming and locaters, management of resources and problem management solutions.

And we've gotten excellent feedback from customers on some of the early versions of some of those new products, which you'll see coming out in the fall as well.

As far as what type of things you're seeing, start with the cache side. That side, as Dan said in the enterprise, clearly it's not getting funded in many places.

Things like e-learning, but what is being funded are major telco type activities, and almost always -- almost all overseas.

And NetApp at this point is the defacto standard. We won a very large [INAUDIBLE] as we mentioned a quarter ago --

or two quarters ago a [INAUDIBLE] I think we have a few more of those that we're working right now.

But in general the major activity that we're seeing is being driven around data consolidation, the R-100 is the best thing that's happened in NetApp the last 12 months at least. It's a tremendous product, and it's drawing us into many activities that people hadn't even thought they could do before.

So many of the deals that we've won there are dragging storage, they're looking at it for dr and for back up.

And finally as I've said -- two other things.

One is Windows consolidation continues to be a big play for us, we have a far better solution than anybody else.

And our relationship with Oracle, as Dan mentioned at the beginning, has gotten very, very strong.

Both are a very large internal customer. If you ever take a tour of Oracle, you're going to see a whole lot of NetApp, because they like to show that it drives the cost [INAUDIBLE] the overall solution.

And secondarily, many, many customers are very comfortable with data warehousing and other things, moving their databases to the NetApp type architecture.

So if I had to say where our sales force is spending their activities, it's around those.

On the software side, any color on what might be -- you might be doing a little more or less of sales-wise there, and cluster fell over, what sort of percentage% are you doing there.

Cluster fill over.

Does that feel like it's been about like it's been in the past?

Yes, in fact, it trended up just a little bit.

Any other comments sort of on the software side, what products are, you know, most significant or selling best?

You know, as Tom indicated, we're adding a lot more values in the Windows arena these days.

The Staff Manager for Exchange, snap drive product, the sequel server and others, but nothing that's particularly stands out in the mix I don't think.

Clustering has been pretty consistent in terms of percent of revenue.

Oh, the one I guess that probably is a high growth item is coupled with Near Stores is Snap Bulb, which is a way of doing a backup, automated back up, if you will, copying from a filer environment to a NearStore environment.

And bailer restore [INAUDIBLE] as well.

So it's a, you know, a Data vault, almost an HSM kind of application, and that is coupled if you will to NearStore.

Many people have come to the conclusion that the math just doesn't work the tape long term but they don't think there's alternative.

Without fail, I can't think one where we test our NearStore, we kind of specked out as a right place and put it in, the reaction is tremendous from the customer, and they see a very large savings on the operational side of it. So I think that's long term and going to continue to be a high growth area fot company.

Thank you.

Our next question is from Harry Blum.

Please state your company name followed by your question.

Hi, guys.

Just a quick question on the decline in accrued expenses, Jeff, you talked about that a little bit, that you've tightened the screws on that. And just saw that even though it's down sequentially from the prior couple quarters, it is more in line with your first quarter historically.

Is there some seasonal impact as well related to that related to accruals for the full year on the accelerators?

And also any commentary on what percent of revenue you got from the six target verticals and the federal government as a percent of revenue, as well as strategic accounts as a percent of revenue?

The accrued expenses on the balance sheets do go down in the first quarter, and that's really just recording the accelerated expenses associated with the prior year.

So we see that every year.

So that's really what's going on, as you accrue it, as you -- as the liability is incurred, and then you pay it out in the first quarter.

This is Dan, Harry.

On the vertical markets, we actually look at eight individual verticals. We still have certainly the tech sector in there, as well as the online environments.

The mix shifted around from one to the other a little bit, but net-net about 75% of our business came from those target verticals last quarter, and 75% came from those eight target verticals this quarter.

And that includes high-tech.

And then on the strategic accounts as a percent of revenue.

I don't have that information.

besides, we're going to change that number so dramatically every time we add or delete accounts, you wouldn't be able to track it. It wouldn't be meaningful for you.

Great, thanks.

Now we moved a number of accounts into that program, as Tom mentioned.

We also took a number of contacts out that have program.

So it's going to be a constantly fluctuating base.

In the mix of accounts in there.

Some of them are existing accounts that we have focused on and been able to grow fairly significantly by taking a global view of it, and some other are large NetApp accounts, but haven't been. But why we were encouraged last year was that business grew fairly dramatically in both the new accounts and the existing accounts in areas where you look at that your business it's kind of surprising they did.

It was very clear that those businesses appreciate having a global view of them, global pricing model, global accounts strategies. No matter where they went in the world, they'd get the same effect.

We've invested in that group more than any other area of sales in the last nine months.

That's why over time I'm seeing that start to pay off.

It's an area we're very happy with.

Just one other quick followup.

You gave the year-over-year comparison on service revenue.

How does that look on more of a sequential basis?

I think it continues to grow slightly faster than the overall revenues but, you know, a big pick up happened kind of over the last six quarters as we put a lot of those service capabilities into place.

Service revenues you should remember tied to the size of the installed base.

And so it's going to change in the mix.

If the new shipments are fairly flat, you'd expect to see the service revenue trends up slightly.

Thanks.

The model is not generate the significant amount of our business mix in service.

You start with the word appliance, and then you generate value added services on top of that.

So that's really the long range model.

Next we have a question from Don Young.

Please state your company name followed by your question.

Yes.

I was curious, you mentioned about the relationship with the [INAUDIBLE] helping out in some of the government deals.

I'm wondering in general the use of systems integrators, is that really changing a lot in your business mix, and are you instituting any new systems in particular with the large S.I. players.

Internationally we've used large S.I.s for a long time. But domestically, in the past year, we've invested [INAUDIBLE], which has been most effective in the energy sector. And that's in the seismic sector working with Landmark Graphics, who have 85% market share in NetApp. Which is, of course, where a great deal of storage is.

We have now over a hundred [INAUDIBLE]bites and seven of the top energy firms in the world, and a number of those are [INAUDIBLE] accounts. So [INAUDIBLE] have a go to market strategy that is very effective.

We're now working with Extensor on other verticals that we can penetrate the same way, instead of just doing a generic one.

We're also working with IBM Global Services on some specific offerings around [INAUDIBLE], and also in the antique consolidation area.

They are one of our key back up, excuse me, our service partners around the globe.

And our standard service partner in the U.S.. And so we're starting to offer some services with them, which I think a number of customers are taking us up on. They already are the infrastructure player. And so they're rolling out NetApp and they're reselling our product in that particular case.

And we have efforts underway with PWC -- the former PWC, which is rolling into IBM, and also CSC.

So I would say that we started really working on those guys about a year ago. We're seeing significant successes and major deals, they're all major deals when you work with those guys.

The second thing that we're doing, just as an aside, is we are ramping our reseller program in North America fairly dramatically. And you guys have asked me about that in the past.

We've put a lot of investment internally here to put marketing programs together.

Our goal is not to have a bunch of them, but to have a few relative to what other people try to do.

And then we look for not only distribution, we're looking for sophisticated resellers who'll make an investment with NetApp, and we can make an investment back as a way of expanding our field presence.

We're hosting a day here today which is interesting in a sense that a lot of key people from very, very large resellers here who really think that other products are over distributed.

They're in some cases, for instance, when Dell entered the mix, it doesn't do much for reseller channels for some people. And so we're seeing a lot of people have seem to want to come to NetApp to do partnerships, and we're very much on the other side that have positioning ourselves to be a good partner back.

So I think in the future you're going to see more channel activity fairly dramatic over the next 12 months For NetApp in North America.

Great, thank you, Tom.

One other point to add to that, some of these partnerships are, in fact, vertically focused. So, for instance, the federal government sector on the nondefense side it's largely [INAUDIBLE]

But on the defense side it's largely Computer Sciences Corp, which is certainly in our top 3 in terms of strategic systems integrators.

Our next question comes from Clint Vaughn.

Please state your company name followed by your question.

Solomon, Smith, Barney.

Thank you.

You talked a little about it about your systems and the fact that they were getting larger. Obviously there's more software going with it and you mentioned the capacity data points.

Can you give us more specificity as far as why you think that's happening and if you think that's a trend that's going to continue.

And then also, you have a lot of contact with end customers, and I'm cure curious to get your thoughts on any potential government budget flush that you're seeing by the end of September. And any potential appetite you're seeing out there by the corporate budget flush by the end of December.

Thank you very much.

Do you want me to talk?

Yes.

As far as the government, they are going to be spending money between now and the end of September.

Where you're probably well positioned in the intelligence community.

That's why are NetApp has been well positioned for five to six years now.

I remember giving my first presentation, when I talked about sharing data. And they alerted me they don't share data, as an aside.

But we have had a large presence there in the past year.

We've got a number of large integrators. So I know that the federal budget has not been spent because of different Congress initiatives, and so we're actively working to try to take it, as you can imagine.

As are other people.

I think if we're successful, which we have a lot of things going right now, it's going to be in the intelligence community, and this is the quarter it should happen.

So we're hoping that will help us.

It's going to be a budget flush though, and I certainly don't think that's going to be a budget flush on the nongovernment side.

That is a commercial side of the world as you asked.

I just don't see anybody with a sense of urgency to spend money. And that's what it'd have to take to have a budget flush. So I don't see that I coo of process going on.

If anything right now customers who have budget lack a sense of urgency.

It used to be the case a customer would have a project, a schedule, the project can be funded.

he's got to make certain decisions on certain dates, got to get it into production by a certain date. And now it seems like the dates are wide open.

There's no sense of urgency to get something done in a hurry.

That would be a through the front to the notion that there is a going to be some kind of a budget flush at year end.

People are not going to spend for anything they feel they don't absolutely need, and I don't see that changing any time soon.

Yeah, in fact my comment was that the security area of the federal government is probably the on area that you can come across that feels like on an ongoing basis they need to do some things for obvious reasons.

The rest of the economy I think what Dan and I find, as I mentioned before in conference calls, we're getting more reacceptivity and ability to play at larger entities than ever before. But there's few projects being rolled out and funded.

And when they do -- and this isn't NetApp specific, this is in general, they're funding pilots, as opposed to full roll outs at the beginning, because they're not sure of the budge.

One of the things I will say to you is I think the people most disadvantaged in that scenario are people who only have large systems, because they don't want to start large.

One of the opportunities and advantages we have is you can buy whatever size NetApp you want and grow it. And when we say our systems are growing I think in a lot of these cases they're getting more confident to NetApp, and they'll roll to agree, and that's why they're getting larger.

But I think in summary if the money turns on, we're better positioned than we ever were before. But no one on this side of this conference call, and probably not on that side, really understands when the money will turn on.

Thanks.

And the size of the systems.

I think that's a trend that we've seen, kind of on an ongoing base.

It's going to be cycled through based on product introductions.

But I think customers, large customers gaining more confidence in our systems apply into bigger application areas areas, and I see it as a trends.

Do you think that's more of a function of you penetrating enterprise accounts that have an appetite for bigger systems, or do you think it's a product trends that you guys are driving?

I think it's all of the above.

Also a part of the force of nature.

If you did the average growth rate over the last seven years, when we went public in 1995 an our largest system was 50 gigabytes.

Now it's 24 Tara bites or something.

[INAUDIBLE] kind of trends line, customers are moving through it, so system scale up,

applications scale up, but you know people's expectations scale up.

There are a couple of things that are playing to our advantage, our clustering has been out for a long time so people are very, very comfortable clustering our systems.

Secondly our snap products, specifically snap mirror is -- when we go in it's not like they say prove it.

A couple of years ago, it's gee, if I get the multiple terrabyte, how am I sure I can sail it other.

Today it's common for our [INAUDIBLE] systems to be snap merged.

So we get in our major competitions what was once a competitive difficulty, which is why I'm going to fail it over and how do I know I can do it that.

There are many, many companies that can do this, and that's how they [INAUDIBLE] very comfortably and in a nice way or nice fact, it's a whole lot less money than doing it than different ways so that is not a sales block any more.

It's a very straightforward.

Our products are out there.

They've been out for years and they work.

It's an advantage against many of our competitors.

Thank you.

There are no further questions at this time.

Please go ahead.

Ladies and gentlemen, I'd like to thank you very much for joining us this afternoon.

We look forward to having you join our call at the same time again next quarter.

Thank you very much.

Ladies and gentlemen this, concludes the Network Appliance earnings release call.

If you would like to hear a replay of today's conference, please dial 1-800-405-2236 and use the passcode 488205.

Once again, that phone number is 1-800-405-2236, and the passcode is 488205.

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