NetApp Inc (NTAP) 2003 Q2 法說會逐字稿

Good afternoon, my name is Korry, and I will be your conference facilitator.

At this time, I would like to welcome everyone to the Network Appliance second quarter conference call.

All lines have been placed on mute to prevent any background noise.

After the speakers' remarks, there will be a question and answer period.

If you would like to ask a question during this time, press star then the number one on your telephone keypad.

If you would like to withdraw your question, press star and the number two.

Please pick up your hand set when asking a question.

Thank you, ladies and gentlemen.

At this time, I would like to turn the conference over to Mr. Dan Warmenhoven, CEO Network Appliance.

You may begin your conference, sir.

Thank you, Korry.

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

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

Today's conference call is being webcast over the internet and will also be available for replay on our website at www.netapp.com.

With me today are Tom Mendoza, President of Network Appliance, and Steve Gomo, our Senior Vice President of Finance and Chief Financial Officer.

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

I'd now like to introduce, Mr. Steve Gomo.

Thanks, Dan.

Good afternoon, everyone.

In the course of today's conference call, we may make forward-looking statements and projections that involve risk 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, the continued decline and general economic condition in customer demand for 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 accessible through our website.

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

I would now like to provide some commentary about our results for the second quarter, fiscal year 2003.

As indicated in the press release, revenue for the quarter was $215.2 million, up approximately 10.5% year over year from the $194.7 million reported in Q2 last year.

Revenues increased approximately 4% sequentially from the $206.8 million reported in Q1.

North America contributed approximately 63% of revenue, up slightly from Q1.

Europe contributed approximately 26% of total revenue, up slightly from the previous quarter, while ICON contributed approximately 11% of revenue.

We're very pleased with bookings during the quarter and the book-to-bill ratio finished well above 1-1.

Software as a percentage of revenue was approximately 24%, a historical high for the company and contributed to strong gross margins.

Software products were approximately 16% of revenue and software subscription upgrades were approximately 8% of total revenue.

As a reminder, we're providing the software mix breakdown because the revenue treatment is different between the software product sales, which are recognized upon shipment and subscription upgrades, which are recognized over the life of the subscription.

Revenue from services, which include hardware support, professional services, and educational services was about 10.1% of total revenue up from the 9.7% reported in Q1.

Services have risen steadily as a percentage of revenue, as we have filled to an increasing number of enterprise customers who typically purchase more complete service packages.

Gross margin for the quarter was 62.4%, flat with the prior quarter.

This includes the favorable renegotiation of a supplier commitment, which resulted in a one-time benefit to gross margin of about 6/10 of a percentage point.

Pro forma operating expenses totaled $113.7 million, increasing $6.5 million from the $107.2 million reported last quarter.

As we discussed previously, last quarter benefited from a $1.5 million deduction of bad debt provision.

As expected, this was not duplicated this quarter.

The primary driver of the remaining $5 million of increase was sales and marketing.

We had slightly more than a million dollars in expenses associated with the event held in New York, which is not going to be incurred going forward.

Most of the remaining $4 million came from higher selling expenses associated with a growing mix of enterprise customers and associated global account programs, as well as additional investments in partner programs.

The ramp up of these expenses reflects the acceleration of our success in selling complete solutions to the enterprise, which Dan will discuss later in this call.

Other income was $2.7 million, up about 25% from the $2.2 million we reported in Q1.

The increase was due to a favorable change in foreign exchange rate and the underlying foreign currency exposures.

We reported a GAAP net income of $15.8 million, or 5 cents per share this quarter.

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

The difference between GAAP and pro forma this quarter includes amortization of intangible assets and stock compensation.

Pro forma pretax income for the quarter was $23.3 million, or 10.8% of revenue, about the same as the prior quarter.

The tax rate used in this quarter was 25%.

Pro forma net income for the quarter was $17.5 million or approximately 8.1% of revenue.

Pro forma earnings per share was 5 cents based on a weighed average of approximately 347 million shares outstanding.

Turning our attention to the balance sheet, cash and investments at the end of the quarter were $500.8 million, that's up $22 million from the prior quarter.

Cash generated from operations during the quarter on a GAAP basis was approximately $37.6 million.

Capital purchases of property and equipment was about $17 million during the quarter.

Days sales outstanding of accounts receivable were 65 days, up from 62 days reported last quarter.

Inventory turns for the quarter were approximately 10, down from the 11 in the prior quarter.

The decrease in terms was related to new products introduced during the quarter, new reseller partners and programs, and new demo and evaluation equipment in the field.

Deferred revenue was $130.2 million, up $14.9 million or 12.9% quarter over quarter.

Head count at the end of the quarter was approximately 2390 employees, up approximately 40 people from the last quarter as a result of selective additions in sales and R&D.

In summary, we're pleased with the revenue and bookings level achieved during the quarter and the gross margins are roughly in line with our expectation.

Expenses increased from the prior quarter but reflect our success in reaching targeted customers and market segments.

At this point, I would like to turn the conference call back over to Dan.

Thank you, Steve.

We continue to make great progress in the enterprise during the second quarter.

Some key customers during the quarter include the Federal Bureau of Investigation, Invesco, Nissan, Petrogras (phonetic), RBC Centura, which is the personal and commercial banking platform in the U.S. for the World Bank of Canada Finance Group, Renaissance Technologies and Vodafone (phonetic).

The Australian Department of Defense Information Services Branch, the entity responsible for managing a majority of the Australian Defense Department's IT infrastructure, chose Network Appliance as its preferred storage supplier.

NetApp enterprise filers will be deployed to major strategic data centers and operational facilities in many remote areas of Australia.

With respect to vertical mix, we saw significant strength in our U.S. federal business, which increased over 10% of revenue.

This growth was largely associated with strong sales at the end of the fiscal year in September.

This growth was offset by a significant decline in sales to the technology sector, which dropped from about 25% of our mix last quarter to just under 20% of the mix in Q2.

Sales for the other target verticals were largely unchanged.

Q2 is a big quarter for new product introductions, many of you I believe attended the Media, Analysts, and Customer Day we held in New York at the beginning of October, which was the biggest corporate event in the history of the company.

We unveiled our vision and strategy for the evolution of storage in the enterprise, introduced the concept that not all data is created equal, and for those of you not able to attend the events, streaming videos of our presentations are available on our website.

The (indiscernible) around the event included many new solutions, partnerships and products, including the launch of the industry's first unified storage architecture.

We introduced our new fiber channel SAN products, new and expanded partnerships with Brocade, Oracle, and Veritas, and new versions of our data fabric manager and SnapDrive products.

Anchoring these announcements was a FAS900 series products, which have gotten off to the fastest start we have ever seen for a new high-end platform.

The FAS900 products represented over 20% of filer revenue during the quarter and the FAS960 was shipped with an average configuration of about 4 terabytes, the largest we have seen to date for a filer.

In addition, only two weeks after it was launched, the FAS960 was given the Innovation of the Year Award at the Exhibition Forum Stockage in Paris.

To make good progress of the new fiber channel SAN products during the quarter, this protocol is available as an option on the FAS900 series products, as well as the F880 and F825 systems.

We are, in fact, on track or ahead of our internal goals.

SAN customers included ABN Amro (phonetic), (indiscernible) Media Systems, RTL, a major agency in the Department of Defense, the Microsoft Exchange 2000 project, (indiscernible) Dynamics, the Defense Division of SAAB, and Seimens IS for Oracle and SAP deployments.

Our SAN solutions were endorsed during the quarter by CYBASE (phonetic) and were included on the Microsoft Windows hardware compatibility list.

We also announced the new data fabric management services program and managed on-tap solutions, announced partnerships with CA and BMC Software and announced our support and full endorsement of the storage networking industry associations new interoperability standard CIN-SAM 1, also known as Bluefin.

These activities highlight Network Appliance's strong track record of delivering robust interoperable management tools, while adhering to interoperability standards, making it easier for our customers to manage their wide variety of distributed data and storage resources.

Filers deployed for database related projects again accounted for well over a third of total filer booking.

During the quarter, we announced an alliance with Oracle Consulting to launch the first ever Oracle on NetApp Center of Excellence.

The Center is staffed with both Oracle and Network Appliance resources and is designed to help customers deploy Oracle and NetApp-based solutions, using common best practices and improve time to productivity.

This cooperative and unique approach provides customers the ability to gain a new level of service and value by leveraging technical expertise and knowledge from both companies.

Our Windows products continue to experience strong customer acceptance.

With Windows protocol related units rising significantly from the previous quarter, the snap manager product did very well with licenses growing 44% sequentially, and over 500% year over year.

The SnapManager product did very well during the quarter with licenses growing 44% sequentially, and over 500% year-over-year.

The SnapManager product has supported Microsoft Exchange 5.5, Microsoft Exchange 2000, and we announced support for Lotus Domino during the quarter.

That manager is now integrated the two most popular enterprise collaborative applications, offering a comprehensive data management solution for hosting and automating backup and restore of Lotus Domino and Microsoft Exchange databases, while improving customer productivity and administrative efficiency.

NearStore continued to see strong customer acceptance during its third full quarter of sales.

We have shipped over two petabytes of NearStore and recently announced we have over 100 NearStore customers, clearly demonstrating our Nearline storage market leadership.

Key NearStore customers during the quarter included Inmax Corporation, Butcher Allen Healthcare, Los Alamos National Lab, Motorola Cellular, PlaceWare, Susquehana International Group, and the U.S.

General Services Administration.

With more than 2000 beds, more than 7,000 staff members, Lutheran University Hospital is one of the largest healthcare providers in Europe.

The hospital deployed a NearStore R100 to accommodate the large volume of online PAX data to (indiscernible) the impact system and the store image is generated by 450,000 radiology procedures.

This project reflects the success, our goal of partnership and certification for filers and NearStore with the AGFA Corporation.

We have also announced NearStore application integration of partner solutions including Backbone NetVault, Nogato Disc Extender, Documentum, Tivoli Storage Manager, and Tom Volt Galaxy.

Revenue from net cash was nearly flat with the previous quarter, at a little over 7% of total revenue.

The net cash C-1200 introduced during the quarter ramped very quickly and accounted for almost a quarter of the net cash it had sold.

We also began shipping the industry's first file-caching products during the quarter.

Western and Southern Financial Group is deploying over 120 NetCache units through 100+ offices, to improve software distribution performance and deliver enhanced real network streaming media capabilities for training and communications applications.

Other significant net cash customers during the quarter included Kodak and eBay.

Services has became increasingly important as our enterprise customer base grows.

As Steve mentioned, service revenue has risen steadily over the last year, reflecting our success with the larger customers.

As part of the event in New York, we launched new services packages and consulting methodologies with corresponding professional services, all designed to more effectively support our enterprise customers.

During the quarter we also announced a number of significant improvements to our web base support site called NetApp on the Web or NOW.

Customer satisfaction at the NOW site is at an all-time high.

I'm very pleased that our global support centers were support center practices certified by the Services and Support Professionals Association for the second year in a row.

I would also like to congratulate our services organization for being a Diamond Award winner in the Fifth Annual Services Marketing Excellence Awards sponsored by the Information Technology Services Marketing Association.

A simple appliance architecture, robust service and support capabilities, and strong partnerships with organizations such as IBM Global Services and Accenture are key competitive advantages as we move ahead in the enterprise.

Earlier, Steve mentioned additional investments we've made in partner programs.

To further our progress in indirect channels, we recently announced our new Star Partner Program in North America, which offers qualified Network Appliance partners and resellers the opportunity to generate business and increase profits through enhanced technical support, marketing, and selling programs.

We're happy to welcome Foresight Solutions Group Incorporated and Data Link Corporation as our first Star authorized resellers and look forward to announcing additional authorized resellers in the Star program.

In addition, Fujitsu Seimens Computers announced the expansion of its product portfolio to include the new FAS900 series as part of the existing European distribution agreement for Network Appliance's enterprise network storage solutions.

We'll continue to focus on indirect channel as a key opportunity for growth.

In summary, we made great progress during the quarter in all of our targeted markets and with our new products, partnerships and solutions, which are all off to a great start.

I will now turn the call back to Steve.

Thank you, Dan.

I'll now comment on our business outlook.

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

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

Actual results may differ materially from our statements or projections.

We continue to be pleased with our execution and we expect revenue for the third quarter to grow sequentially by 2 to 5% and be in the range of $219 million to $225 million.

Growth and operating expense dollars will moderate significantly.

And we expect op ex to decline as a percentage of revenue as we balance tradeoffs between growth opportunities and prudent spending.

We expect net income to grow with Q3 pro forma earnings in the 5 to 6 cent per share range, depending on the revenue levels that are achieved.

I will now turn the call back turnover to Dan for final comments.

Thanks, Steve.

That concludes our remarks for today.

So at this point, I would like to open the conference for questions.

We would like to ask that each of you limit yourselves to one question so we can address everyone in a timely manner and keep the call to an hour.

Thank you.

At this time, if you would like to ask a question, you may do so by pressing star and the number 1 on your telephone keypad.

If you would like to withdraw your question, press star followed by the number two on your telephone keypad.

We'll pause for just a moment to compile the Q&A roster.

We'll take our first question from Bill Lewis with JP Chase.

Great, thank you.

Um, looking ahead into this January quarter, can you talk about, um, what you're expecting in the month of January and how that factors into your guidance, um, and specifically I'm recalling over the last couple of years where January's been particularly uncertain for you?

If you could comment on the environment today and the outlook for the rest of the quarter?

Thank you.

Yeah, Bill, January, as you pointed out, has always been a challenging quarter, partially because of the alignment of our fiscal quarter on the calendar.

Our quarterly structure is generally a 4-4-5, meaning four weeks, four weeks and five weeks, and in this particular quarter, the first two weeks of our third fiscal month, our fiscal January, actually occur on Christmas and New Year's weeks where we have extremely low productivity, as you might expect.

Furthermore, over the last couple years, we've noticed that many of our customers don't have their budgets closed and approved as they start the new calendar year, and that obviously leads to, um, a certain degree of uncertainty relative to the bookings.

Historically, customers have come in with the budgets approved and be ready to order at the beginning of the new year.

So,we are being fairly cautious about January in particular, we're expecting pretty good performance during November and December, and, um, and we intend to have everybody get back to work right after the first of the year and go finish it off.

But having the Christmas holidays in the middle of that period make it very challenging.

Thanks.

Your next question is from John Roy from Merrill Lynch

Hey, Dan.

Are you guys seeing any competition from HDS or Clarion Celera, and what kind of impact do you think that might have on pricing?

John, this is Dan.

I'll have Tom comment on this as well.

We don't seem to compete against HDS all that much.

The most frequent competitors are still, certainly EMC leads the list and Clarion's very frequent in that, although Symmetrics is by far the more frequent competitor.

The other one we see a lot of is StorageWorks.

We still compete, I think in third place is still Sun with HDS or the T-3, but it's not through HDS per say, it's the Sun environment.

Tom, do you want to comment?

I would say what I have seen is that, John, is that it's becoming very obvious to people that the most expensive storage is not necessary for all data.

So where they once would have looked at one unified high-end solution for all their storage, they're now looking to put a lot more on what we would call midlevel storage, which leads right to what NetApp has been strong at.

When Dan took you through a lot of the wins, a lot of that was sales focuses where we started against Symmetrics or Hitachi, and once it became clear we could do something for a whole different price point, they may have shifted products, but we in general, we won on the merits of we can produce total cost of ownership lower than those particular products.

We go up against, um, the Clarion line, typically our feature set, and we are not that far off from price typically, so our feature set is much richer, and the fact that you can go low to high on our product with one file system, without having to juggle product families, is playing out as a great strength in this market.

As people look at total cost of ownership, they're becoming more savvy about, I don't want three or four different products tied together by some software to simplify my life.

They like the idea they can use SAN Net, top to bottom, have one file system and they don't have to make the exact size choice up front because they have flexibility.

The answer to your specific question about price pressure, we have not seen any additional price pressure than in the previous quarters.

All right, thanks, guys.

The next question is from Andrew Neff with Bear Stearns.

I wanted to get a better sense of your take on the environment.

You know, you talked about the book-to-bill being substantially greater, what was the word you used, well above 1.1, but your guidance sequentially is fairly muted.

Could you try and put the two together what -- what, you know, given the order pattern, why weren't you more optimistic about the outlook?

This is Dan.

You will notice the big increase in deferred revenue this quarter, and the comments that Steve made about increases in both service and software subscription.

That accounts for the overrun of the bookings, um, most of the dominant portion of the bookings in excess of revenue were contracts which are typically one year in length and are amortized over a fourth quarter period.

In terms of the environment generally, you were quoted elsewhere saying it was still tough.

Do you see signs of it getting better?

Worse?

Or what's your take on that?

I don't see any significant change personally.

I spent a lot of times with the customers.

They don't seem to be anxious to spend their money.

Tom, you want to comment?

I would say that -- one thing I would say is that we have focused on the enterprise, as you all know, for the last 12 to 18 months, and what I believe is happening is a lot of the sales campaigns are now starting to bear fruit, and when you win in the enterprise, it's typically a long gestation period where they test.

Once you start to role, you have a different customer set.

The mix of customers is going to much bigger accounts.

The end of the previous, not this last quarter, the end of the quarter before this, we saw signs that our win rates were going up and the size of the deals were going up and the size of the opportunities we were involved in were more significant.

This quarter, that paid off.

A number of those early investments came through, so my personal take is that people have now concluded they want a -- total cost of ownership is very, very critical.

We're in the right deals, our sales presence is now well-known in many of those deals.

We're getting included in deals with Hitachi and EMC, as a way of looking at business, not just having to force ourselves.

The most difficult part is still forecasting revenues on a regular basis given the economic time and what might happen in January.

If I knew for a fact that people would fund their new budgets very early next year, my sense is, we're gaining momentum verses our competitors, and I think that's what the numbers are starting to show.

We still have to be somewhat cautious.

All right, gentlemen, thank you.

We'll take our next question from Kimberly Alexy with Prudential Securities.

Thanks.

That EMC, obviously had talked about a pretty significant followup in their business in quarter end, and we heard the comment from a couple of other enterprise vendors, and obviously, you guys have a relatively strong quarter.

One of the comments or questions that I have was if you could talk about linearity within the quarter, within the August, September, October time frame, both in aggregate, and then if you could also hone your comments by geography, maybe talking about what you saw in Europe in particular, and how you're thinking about, um, those geographic regions as you go into the January quarter?

Kimberly, this is Dan.

On the question of linearity, first of all, this quarter was pretty typical, um, you know, somewhere in the upper 40s%, you know, 45 to 50% range of the revenue came in the last month, which is pretty typical.

August started kind of light, as you might expect, um, and that is, as we expect every year, so I would say our linearity was not as good as the prior quarter, but very close to normal, especially for a normal Q2 with August stuck in it.

Bookings this summer were very strong throughout the whole period.

I mean we continue to see strength against all the major competitors.

Let me make another follow-up comment on the competition to the question that was asked earlier.

In terms of frequency of engagement, the rank order is EMC followed by Hewlett-Packard, followed by Sun, which includes, incidently, both their own product and the Hitachi product, in fourth place, Hitachi.

When you look at EMC, about half the engagements are head up against the Symmetrics.

Another 25% are Symmetrics with the Celera product and the remainders are the Clarion.

So you kind of get a sense as to where we're focused.

We're winning and we had a good quarter, and I'll leave to you conclude what happened.

North America, Kimberly, was strong this quarter.

It was strong all the way through, so it wasn't any one deal, any one activity coming on late.

All three areas met their objectives, and we felt -- I guess what I was trying to say before is we have had a message (indiscernible) these accounts for a long time that all your data is not the same, it doesn't have to sit on the most expensive stuff.

We're no longer having to tell people that.

People are telling us they're looking for a solution to a problem to lower their cost, and we're finding ourselves, we have invested in a lot of these major accounts, as Dan pointed out before, and we're in active large engagements now.

Where a year ago, we sat here we said this is our goal to get into active engagements.

The New York, after the New York session, the big fallout for us was, many people said now wanted capabilities they didn't have before, and our sales force is finding themselves not having to be so evangelical, and are more focused on what exactly can I propose to this customer to solve their problem.

Having a NAS SAN unified solution makes that conversation even easier.

So throughout this quarter, we saw strong performance by North America.

Europe had a good quarter, and Asia was about what we expected, I think.

And the outlook, in terms of your linearity comments going into January, obviously, you're looking sort of a weakish month of January is expected, but how about from a geographic standpoint.

Any sign that Europe is an incremental concern for you or -- .

No, not at all.

Historically, I never quite understood why, but our fiscal Q3, we would normally see a surge in the mix in favor of Europe.

They seem to drop off a little bit in Q4.

Um, I mean their revenues continued to grow.

In a mix sense, they drop in the percentage.

We're seeing the same kind of thing in terms of forecast.

Great, thank you.

If you go back to -- January wasn't always a difficult month.

In fact, for a number of years it was a fairly good month, because people did business as usual.

Year's wrap-up, you have your year-end buying, lose a couple of weeks and then in January they go about their business.

I think what Dan was commenting on before, in the last two years of uncertain economy, people have been slower to say this is the number, go ahead and spend it.

That's why it's more difficult.

Part of our job as business people is to sort out who will have their budget sorted out early and make sure we focus on that.

Our next question is from Don Young of UBS Warburg.

Thank you.

Really quick, Dan, now that you have the (indiscernible) capabilities, in addition to a good caching product and a strong NAS offering, is there anything the product offering is lacking or do you think this is what it takes to continue to make inroads in the enterprise?

And I apologize, this is Jonathan for Don.

Okay, Jonathan, no apologies required.

Happy to have you on the call.

No, to answer your question in a nutshell, I don't see anything that we're lacking.

There are always areas we can continue to expand, right?

We'll probably focus next on the low end, we have traditionally gone up and then down, you know, it's time to do some price performance work at the low end.

But, you know, it's nothing in terms of major features that were missing that keeps us in any way from competing aggressively on every deal.

You know, we've got a lot of opportunities, expanding the NearStore product line.

I don't think we even mentioned, we now have two miles on NearStore, a 7 terabyte, in addition to the original 12 terabytes, and we'll keep expanding out that product line.

The Cache end product line has the best price performance points in the industry and stronger than ever before.

I mean it's a very complete solution up and down and across the product line.

When you look at the environment, people, let's say they invested in a SAN, it wouldn't have mattered if it was Symmetrics or a Shark or Hitachi.

Typically they have a high end SAN platform built, then they decide, typically if network appliance is in, that network attached storage would make sense.

And if that's the case, most vendors don't even have the solution.

If they do, it's a different product.

If they decide they want to distribute, they get a third product.

If they decide they want to use some kind of back up to disc, they get a fourth product.

Four different products that don't interoperate, pulled together by software.

As I've said to clients, I can't imagine if you had a clean sheet of paper, that would be how you would design that.

So what we came out with this last quarter was -- we're already very, very strong in the mid tier lower end, and we have a scalable system to the high end, and with NearStore, we had this disk to disk backup.

The interesting thing about it, though, we have one software platform that controls all of that, the same software, SnapMirror, SnapShot, and all those things, and you can go top to bottom with one file system, and you can make that same device now as you're saying.

I think what we will add over time, are more and more capabilities to our SAN offering with our partners.

But I would say this, what I believe to be true is, what our competitors have, we will have in that area because they have been at it longer.

What we have, they'll never have, which is a simple way of architecting these solutions.

And that's what I think is starting to get a lot of appliance attention.

Tom, you'd mentioned that it's less of an evangelical sell.

I assume that's probably on the NAS lineup.

What are the key challenges for the Block IO products for NetApp sales force going forward?

What I meant by less of evangelical, we would walk into environments before where people would say it's their opinion that a particular application should be on SAN, and our guys would argue why it actually could run on NAS equally or better.

And they could be right.

But that hits people as evangelical as opposed to listening to what they are saying.

They may say, I already have an environment that's built for SAN.

I would like you to fit into that.

And we would argue about why you don't need to do it that way.

This way, where we currently are, we can say, yes that worked, yes that worked, so we can go either way.

So, what I particularly meant on the SAN side is, we announced various platforms that we support, various switches that we support, and you are going to see more of that in the future as the product matures and we're working with partners.

That all comes in time.

There are no new architectures we need to come with.

But we spend a lot of time in training with our sales to be more question-based selling and what the customers are clearly saying, they're less interested in technology arguments as, do I have a budget, I need to cut it, and I need to solve X amount of problems with storage.

And I think we have given them through new storage, the caching of applications, through having a NAS SAN solution that's scalable top to bottom with one file system, a very elegant way of solving those problems cost effectively by driving simplicity to drive out costs.

Jonathan, one other follow-up point on the question of the SAN products in particular, the only issue we're facing from a competitive perspective is the one I think we highlighted in the October launch, which is the number of servers we can support, host attach kits for at the moment, is limited.

It's primarily Sun and Windows environments.

In the very near future, we'll be introducing host attach kits for most of the other popular servers.

Great, thanks a lot and congratulations on the quarter.

Thank you.

We'll take our next question from Laura Conigliaro with Goldman Sachs.

Yeah, um, back to the book-to-bill thing.

First of all, Steve, can you once again, go into the explanation that you went over quickly about, um, some of the incremental bookings that led to backlog being as high as it was?

And I guess what I really want to hone in on is the fact that you have had, um, a goal in the past of roughly four weeks of the next quarter's, um, revenues in backlog, and at least in the aggregate, it would seem that you are well above that right now.

So maybe you can give us a sense of, um, as far as, um, the currently shipping kinds of product, rather than the ones that are associated with longer term contracts, where do you stand, as far as next quarter, weeks in backlog?

And then, again, back to the January quarter, um, given what you said about the month of January, Dan, can you give us the kind of percentage that is typical for what your month of January tends to look like.

Laura, Steve Gomo here.

Basically what I said was that we were very, very pleased with our execution of this quarter and that our book-to-bill finished significantly over the 1-1 ratio.

But Dan pointed out, in the follow-up comment was that, um, you know, if you look at the growth in our deferred revenues, that is an indication that some of the, um, orders, um, that we incurred, we turned around and ship.

But some of those orders were made up of service products, you know, um, professional services, et cetera, which are booked in the period but shipped over the, you know, period for which they're valid, i.e., the following year, so they're amortized, if you will.

So as a result, you don't necessarily have a product backlog buildup, um, you have a buildup in subscriptions for software, you have a buildup in services, et cetera, which are leaked out, and that was the point I think we were making.

I understood that, and that's why I was trying to get more clarification on this whole concept that you have been talking about in the past, which is next quarter, weeks of revenue in backlog, and where you are on that, considering that you're talking about sort of apples and oranges in a way, and let's sort of look at the apples part, the part that shifts on a regular basis and isn't, um, more of an annuity-type of revenue and where do you stand on that?

Laura, this is Dan.

In all the historical discussions, right, we have been focused on manufacturing backlog, which is separate from what gets amortized into the P&L as revenue from the deferred revenue category.

So the objective has always been to have the factory loaded with four weeks of backlog at start.

That's the key metric.

That's independent of what's in the deferred revenue category.

You're right, it's apples and oranges, it's hard to take a look at bookings only.

You have to take a look at the two separate categories.

And the real thing we're trying to optimize here is the linearity inside our own manufacturing production facilities.

And we do not disclose how much we have in that particular backlog.

And the linearity thing?

Yeah, let me -- I went back and pulled some history from last year.

So, um, normally we see, um, in the months, Q1, Q2, and Q4, about roughly 45 to 50% of our total bookings occur in the last month.

In Q3, um, we see closer to about 35 to 40%, and it's skewed more towards the front end of the quarter, toward the November and December months.

And, you know, that's a reflection of how to, you know, customers spend at the end of their calendar year, right, and the softness that Tom talked about, the start of the next fiscal year for most of them.

So it's -- as opposed to 50/50, it's more like 60/40, the first two months versus the third month.

Thank you.

Our next question is from Harry Blount with Lehman Brothers.

Hi, guys, um, quick question on the federal government and also on the capacity shipments.

You indicated you saw a pretty strong federal contribution, this quarter is over 10% of revenue, and then you saw strong benefit because the federal government was on kind of an October year.

So trying to make some kind of assessment as to what a normalized federal government spending level's going to look like the next few quarters, given you're not going to have the year-end benefit, um, so that's question one, is really trying to determine how much of a one-time incremental benefit you felt you got this quarter?

And then the second part of the question, trying to get a sense on the capacity shift.

It looks like you trended up in terms of hardware gross margins the last 3 or 4 quarters, it looked like it might have dipped down a little bit this quarter.

Hi, this is Dan.

On the federal piece, you're right, we saw a little bit of a surge in the mix this time.

I think that's going to be a normal seasonality.

The fiscal year for the federal government actually ends the end of September, and, um, unlike most commercial customers, when they have a budget, they try to consume it all, so, you will see that in an ongoing pattern.

The federal business has ramped nicely for us, and ramped very progressively.

I would guess, however, it's going to be hard for them to match next quarter what they did in terms of percent of the mix this quarter.

I think you will see it come down from 10 to more like 7%, um, and then continue to grow from that base, right?

You know, we've won some major new deals in federal, like the (indiscernible) one we won last year and so on, so our federal business continues to perform extremely well.

They do have a bit of a seasonality effect.

The second question you asked, Harry, was about margins, and I'm not sure I understand why you think they shifted.

It looks like, you know, for instance, in the, um, going back to say July, October a year ago, it looks like your hardware gross margins were meaningfully lower, looks like they ramped sequentially over the last five or six quarters and, at a minimum, it looks like they may have either flattened or even tapered down a little bit, so I was really asking the question on capacity shift.

You said a couple of quarters ago you were about 3.8 --

I would have to go do more research to give you a definitive answer to this question; however, let me tell you what I believe to be the case.

The hardware gross margins have stayed pretty flat, the software as a percent of revenue went up, which is what drove our reported aggregate gross margins up, so software in the mix is what kind of drove it.

And this past quarter, services, which have a lower gross margin, are higher in the mix as well.

So you saw it dampened just a little bit.

The hardware gross margins, in general, stayed reasonably flat.

Plus or minus a few tenths of a percentage point, around median.

I make some calculations on your gross margins based on the mix between software and services.

All right, I can circle back offline on that one.

Okay, this is Tom.

Let me make a comment on government business.

Two things I would say.

One is that we have always done very well in the intelligence community, for years and years and years, and, um, in the last year, we have continued to make strides that are not only in the United States, Dan just talked about the Australian government, but there are a lot of places in the world that do a lot of intelligence stuff with mapping and things like that.

That's why Dan brought up Nema (phonetic).

We do very, very well in that space here and offshore, so I expect that in the next year, probably to continue, given current events.

And number two, um, in the last year as we have talked about before, we focused a lot on partnerships.

I don't think we have been more successful anywhere with partnerships than in the federal space.

When you line up who the premier vendors for partners with contracts that have either been let, or are going to be let, where they are looking to refresh for less dollars, our federal team has done a spectacular job of putting us in a position we have never been before to introduce our technology into those accounts.

So we think over the next year to two years you are going to see us do better, both in the U.S.

Federal Government and other interrelated federal agencies.

Great, thanks.

You're welcome.

We'll take our next question from Dan Renouard with Robert W. Baird & Associates.

Good afternoon.

Just one question.

Steve, could you talk a little bit, you mentioned that favorable renegotiation with a supplier that contributed to gross margin.

Could you just give more detail on that and then whether that was included or excluded from pro forma?

Thanks.

Hi, Dan.

Yeah, we just had a, um, purchase commitment that was renegotiated and in the interest of the, you know, the relationship, the long-term working togetherness, if you will, the partner decided to wave an obligation that we had, and we're moving forward.

So that is -- that benefit is included in your pro forma numbers, correct?

Yes, it is.

Okay.

So going forward?

Not expecting anymore

Okay, thanks.

You bet.

Your next question is from Clint Vaughan with Solomon Smith Barney.

Thank you.

Um, first a clarification if I can?

Is there any hardware revenue in your deferred revenue category, especially associated with the new product?

This is Steve Gomo.

It's just that we have some leases in there.

Okay.

Very few and very small.

But very small.

Okay.

Great, thank you.

The majority of service and software.

You bet.

And then a question I have is regarding your product portfolio.

Clearly you have a lot of new products on the hardware platform, such as NearStore and your new SAN entrants.

Could you talk a little about where those products have been successful?

Has it been in your existing account base or is it new customers are kind of signing on to them, you know, how you're selling this and what is being successful on the sales fronts?

In other words, you talked a lot about packaging.

Is it a package sale?

An add-on sale?

Also, could you comment about any percentages of revenue that NearStore represented or, you'd mentioned that within four quarters you think that, um, the SAN product could represent 10%, based on the NT penetration when you first ramped an NT.

And then also on the product side, could you talk about the serial ATA.

[Laughter] What happened to one question?

It's a detailed question, but it's a long one.

I'm not even sure I got the whole thing.

Sorry.

Um, let's see.

First of all, we sold SAN products primarily to existing customers.

It would be hard to penetrate a new account with a now product in just a few weeks.

Besides, we focused our sales force there and the customers that know us, we already have an existing relationship with, who know our technology, and um, you know, like the simplicity of the product, that's the easiest place to go procure a new customer.

So almost all the SAN products are sold to what I would consider to be existing accounts.

What was question 2?

NearStore.

Oh, NearStore.

Well, NearStore I think, is an interesting combination there.

Many of our large accounts anticipate, and this is a way to improve recovery time, and backup, or to pretty good buyins, but there are two significant things that happened there, I think.

One of the real areas where people are investing right now is in data consolidation.

When they used NearStore, they find they can consolidate more machines because it improves their recovery time.

A lot of our existing customers who have done testing, did testing with NearStore and both effected their initial data consolidation and their restore.

I think existing customers did a lot.

But we also saw a number of accounts use it, where we didn't have a relationship, and we're also seeing new markets open because of it, specifically hospitals with companies like AGFA and others now putting PAC software together for hospitals.

It's not a place where Net App has played, it's typically a solution sale, and NearStore's getting a lot of attraction there.

When we first announced NearStore, we said, we're going to learn a lot about where this could be used.

We're learning a lot and I think it's going to drive a lot of interesting strategies.

The last thing Dan was asked, was about ATA technology.

You want me to comment on that?

What was the question again?

How do you see serial ATA impacting the industry and impacting your product portfolio?

Where do you see it popping up first?

I project forward a few years, like two to three years.

It's my belief that our product line will have a variety of price performance points in the sense of the processor, and the customer will have his choice of whether he wants to attach fiber channel drives or serial ATA drives.

It will be customer choice only.

Do you see anything in the near-term?

No, not as much.

Serial ATA I think is going to be slow in the adoption.

There are still a lot of issues around.

When you change the interface on the disk drive, you've got to change all the packaging, and interconnect, the management systems and so on and so forth.

Right.

It's a slow adoption rate.

But leap forward two years and I think you get a very different picture.

Great, thank you very much.

Our next question is from George Elling with Deutsche Bank.

Thank you.

Could you comment a little bit, you indicated the FAS900's gotten off to a real good start.

I know at the analyst meeting a few months ago, you had indicated you didn't expect it to represent a significant portion of revs this year.

But it sounds like it's representing more than you expected.

Could you make some comments on that, and did you say it represented 20% of sales?

I'll tell you where I think the disconnect is.

And this has actually showed up in many cases.

The FAS900 is not synonymous with SAN.

I think the comments in the launch were, we don't expect the SAN products to represent a significant piece of the revenue.

But that's a separate question on what you expect the FAS900 to do.

So the new product platforms can be used as either or both.

By far, the bulk of the system shift in the FAS900, were as NAS products and historically, you know, we have introduced a product with only about a month left in the quarter, which it might achieve 10% of revenue, this one actually did 20.

The feed back we're getting is that the performance has exceeded many of people's expectations, and second, the reliability features we built in are tremendous hits.

So the product itself, regardless of why we decided to go over is getting tremendous feedback.

Thank you.

One other point to emphasize it.

There are four products in the product line, which are SAN and NAS capable.

There were two brand new ones introduced, the 940 and the 960, but the 880, which has been around for a year, and the 825, which was recently introduced as a low-end kind of system, all four of those can be configured to SAN or NAS.

I think the confusion came because we introduced the SAN capability and the 900 series on the same day.

Yeah.

That's exactly it.

In fact, we've rolled our entire product line.

All the processors are new, 825, 880, 940, 960, and all of them can run the SAN interfaces.

Right, thank you very much.

We'll take our next question from Shebly Seyrafi with A.G. Edwards.

Yes, thank you very much.

First of all, did you provide the filer and caching breakout?

I may have missed that.

But my question is, I noticed there were two weaker segments, the ICON Geo and the Tech Vertical.

I am getting your ICON Geo around 15% sequentially.

I would like you to maybe provide your outlook for those two weaker segments, whether they're both going to improve or whether one is?

Any color would be appreciated.

Thank you.

This is Dan.

I think the comment we made about mix was that the caching was about 7%.

I don't even have a filer percentage here handy, but-- On the international mix, ICON dropped just a little bit, I think, they were at 11% of revenue, which is pretty close to where they were last quarter.

I think they were in a, um, roughly that same zone.

You know, we expect to see some strength this quarter in Europe, mostly because we have historically seen it in Q3.

ICON continues to perform and is -- and the mix moves around a bit, but, you know, but somewhere in the 11 to 15% range in this quarter.

I think we're expecting right around 12.

It's not a material shift, in other words.

It's a normal fluctuation.

The last three quarters on ICON, just to rattle them off, and there were five quarters, 12, 12, 11, 13, 11.

And that's exactly where we would expect to see it go.

On the Tech Vertical?

You know, Tech is now dominated more by our strategic accounts, than tech as a kind of a vertical sector, and, therefore, the deals are bigger and lumpier.

I think you will see more fluctuation in the mix.

I have to tell you our position, the technology sector is particularly strong.

Obviously, you know, we have a lot of strength in a weak sector.

The biggest strategic accounts, TI, Motorola, Cisco, the ones you hear about time and time again, Siemens, those are great customers but again, their purchases happen to be fairly lumpy.

I'm wondering whether the tech vertical that might go below 15% of revenues, around 20% in the current quarter?

Not unless we see continued, you know, downward pressure on techs in general.

I think they're coming back, personally.

We're starting to see, you know, more deal activity looking forward.

Okay, thank you.

Your next question is from Robert Montague with RBC Capital Markets.

Good afternoon.

I really -- most of my question's answered, but do you have any measure of the percent of your product that was SAN-attached, your new product launch, and overall percent of revenues that are from new products, let's say since NearStore was introduced?

Thanks.

No, I don't have that level of detail.

We comment the 900 family in aggregate is about 20% of the filer revenue, um, which is pretty good.

Um, NearStore as a percent, somewhere in the 5 to 10% range.

I'm not sure -- does that answer your question?

Putting anything on the percent of the FAS600s or the new family that were SAN-attached?

That's going to be less meaningful going forward.

The duel attachments, it's hard to report a number, right.

We can report at what percent age a system had a particular feature.

And most of the systems actually went out SAN-enabled but not necessarily SAN-attached.

I mean, you don't see a host attach kit with it.

So, it's really hard to tell what the customer plans to do.

You know, I think you're going to have to look at it.

They can connect to either, it has like two plugs on it, right, and it's really hard to tell which plug somebody's going to activate first.

Okay, great.

Thanks.

Your next question is from Glenn Hanus with Needham & Company.

Hi, may be you could sort of detail and prioritize, sort of, your key R&D projects and road map here.

Thanks.

This is Dan.

I'll give you a couple of them.

One is (indiscernible) we're continuing to press hard on that.

Um, we're continuing very hard on the path of the virtual filer kinds of notions.

You may have seen we introduced the capability to have a filer act as multiple virtual devices and, um, you know, firewalls between them.

We would also like to go the other way.

Have multiple filers appear to be a single virtual device.

So, a lot of the things are on what we consider to be storage virtualization, Clearly a lot more in the area of system management services and APIs associated with that, um, those are the big ones.

It's aimed right at, you know, simplifying data management, which has been our big mantra.

Thank you.

Our next question is a follow-up from Don Young of UBS Warburg.

Yes, thank you.

Um, Dan, you mentioned during the call that you were going to put more focus on the low end of the line.

You also talked about, um, some investments to build up channel programs.

I'm wondering if you're planning a big push at the low end.

Is that what you're signaling here after revamping at the top end of your business?

I didn't mean to imply that that strongly.

No, I think we were really focused on building a channel aimed at what I would consider a medium-sized business.

We have our sales force focused on strategic accounts and key named accounts and we're trying to fill underneath that with channel partners.

It's time, however, as we often do, we alternate back and forth between refreshing the high and refreshing the low end, so the next series of platform announcements you should see from us is a refresh on the low end.

We're getting pretty serious about pushing that low end down.

We have some very interesting product designs underway, we're pretty excited about it.

Eventually obviously, we'll cross-connect those two questions, right, which is the essence of your question, and, um, certainly one of the design objectives to this next family is that it be skewable.

We've never had a build to stock product capability.

It's always been build to order.

We have to have a skewable product before we can really say we have a real indirect channel product.

Even things sold now through indirect channels are sold build to order.

They have a specific customer and give us a specific configuration to build to and, um, ultimately at the low end, we would like to change that model.

But it's not going to happen in the near future.

Excuse me one second, this is Tom.

Our view of the low end is still the edge of the enterprise.

You know, even in -- not Fortune 500 companies-- any large company, their business problem is when they get outside their data centers, they have, um, a lot more costs than they expect because it's difficult to manage things that have general purpose operating systems on it.

We've often said, never get that storages as simple, ours stuff is simple.

So, and everybody else has tried (indiscernible) attached storage, when they put it on remote, they find out they still have to manage it.

We believe that, or we drive it all the way to the bottom, to a very low cost.

They can put it in their remote office, they can back it up using our NearStore, using our SnapMirror (indiscernible), reduce the cost of backup and solve many problems and then have one file system they can do, both in their remote or their data centers and grow it.

That's the product we're aiming to build, not something to sell everybody once, for instance.

Well, how do you define what is a low-end filer today and how do you think that will shift as far as say, price points?

I'd define it to just what you said, by price point.

I mean it's typically configured at a terabyte or under.

In fact, I think our entry level product today goes up to only about 600 gig or something in that range.

But typically it equates to price point.

You're talking about something certainly under $20,000, and, um, in fact, as you move down, it's probably closer -- [ Indiscernible ] We would like to drive that number down to, you know, like the $10,000 range.

Okay.

Congratulations

Thank you.

A $10,000 terabyte box, I think, would do well.

Ladies and gentlemen, we have reached the end of the allotted time for Q&A today.

Are there any closing remarks?

Yes, I would like to thank everyone for joining us this afternoon and we'll look forward to seeing you this time in February.

Thank you.

This concludes today's Network Appliance second quarter conference call.

You may now disconnect.