NetApp Inc (NTAP) 2003 Q3 法說會逐字稿

Good evening.

My name is Denise.

I will be your conference facilitator today.

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

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

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

If you would like to ask a question, during this time, simply press star, then the number 1 on your telephone keypad.

If you would like to withdraw your question, press the star and then the number 2 on your telephone keypad.

Mr. Warmenhoven, you may begin your conference.

Thank you.

Good afternoon.

Welcome to the Network Appliance earnings conference call for the fiscal year 2003.

This is Dan Warmenhoven.

It is my pleasure to welcome you and thank you for taking the time to join us today.

Today's conference call is being webcast on the internet and will be available for replay at www.netap.com.

With me are Tom Mendoza (ph), President of Network Appliance, Steve Gomo (ph), Senior Vice President of Finance and Chief Financial Officer, and Mr. Dave Hits (ph), founder and Executive Vice President of engineering.

At this point, I'd like to turn the call over to Steve who will review the financial portion of the press release.

Following his comments be I will share my comments.

We will move to the financial outlook and conclude with the question and answer period.

I'd 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 of projections that involve risk and uncertainty.

Actual results may differ materially from the statements and projections.

Factors that could cause actual results to differ from the projections include but are not limited to, demand for our products from customers, demand for our services from customer, and any decline in general economic conditions.

Other equally important factors detailed in the company's 10K and 10Q reports on file with the S.E.C. and are accessible through the web site.

The press release is available on the business wire and web site.

I'd like to present commentary for the third quarter of fiscal year 2003.

As indicated in the press release, revenue for the quarter was $228.5 million, up 15% year over year from the $198.3 million reported in Q3 last year.

Revenues increased 6% sequentially from the $215.2 million reported in Q2.

This represents the fifth consecutive quarter of growth.

The deferred revenue balance is $156.4 million, up $26.2 million or 20% quarter over quarter, and up 74% from the $90.1 million reported a year ago.

The growth and deferred revenue over the prior quarter indirectly attests to the strength of bookings which exceeded revenue again this quarter.

Revenues from services, which includes hardware support, professional services, and educational services was about 10.3% of total revenue, up from the 10.1% reported in quarter 1.

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

The growth in our deferred revenue accounts reflects strong customer acceptance of the largest, more robust service and support offers.

Add-on software as a percentage of revenue was approximately 27% a historical high for the company.

Software products were approximately 18% of revenue, and software subscription upgrades were approximately 9% of total revenue.

Add-on software includes software products that are sold in addition to the base systembase system.

As a point of clarification, the base systembase system also carries a significant amount of software value, including data on tap, the waffle file system, snapshot and the first access protocol.

The add-on software category includes products such as snap restore, snap mirror, snap bulb (ph)and any additional protocols purchased by the customer.

The software percentage we disclosed does not represent the total contribution of software to our revenue.

It will become less meaningful as various product structure changes create a mixed shift between the base systembase system and add-on software products. -- base system.

North America contributed 55% of total revenue, Europe contribute contributed 32%, and icon contributed 13% of total revenue.

Revenue in Europe grew 34% sequentially as a result of strong performances in the northern and western Europe.

Gross margin for the quarter was 61.3%, a decline of 1.1 percentage points from last quarter.

As you recall, last quarter's gross margin included a favorable renegotiation of the supplier contract which resulted in a one-time benefit to gross margins of about .6 percentage points.

Lower service margins in Q3 accounted for the majority of the remaining .5 percentage points of Delta.

Pro forma operating expenses $115.1 million, increasing $1.4 million from the $113.7 million reported last quarter, and declining as a percentage of revenue to 50.4%.

This was an improvement of 2.4 percentage points from Q2.

Other income was $3.3 million, up approximately 24% from the $2.7 million we reported in Q2.

The increase was due to a favorable exchange transaction associated with the hedging program.

Pro forma tax income for the quarter was up 61.6 percentage points from the prior quarter.

We have reduced our effective tax rate for fiscal year 2003 from 25% to 23%.

This 2 percentage point reduction is the result of a favorable increase in the estimated percentage of our profits being earned in AMIA and icon geographies.

We have implemented a tax tragedy whereby profits earned at tax rates earning significantly lower than the North America geography.

Based on the forecast by geography, the expected annual effective tax rate for fiscal year 2003 is now 23%.

The effective tax rate used in Q3 was 19.7%, reflecting the benefit of the cumulative catch-up adjustment for the first and second quarters.

Pro forma net income for the quarter was $22.7 million, or approximately 10% of revenue, up 1.9 percentage points from the prior quarter.

Pro forma earnings per share was 6 cents based on a weighted average of 351 million shares outstanding.

Just as a note, pro forma earnings per share would have remained at 6 cents had the previous tax rate of 25% been used.

We reported a GAAP net income of 19.7 million or 6 cents per share this quarter.

We provided a reconciliation between the pro forma and GAAP net earnings.

It includes restructuring charges, amortization of intangible assets and stock compensation.

Now, turning our attention to the balance sheet, cash and investments at the end of the quarter were $538.6 million, up $37.7 million from the previous quarter.

Cash generated from operations during the quarter on a GAAP basis was $38.4 million.

Capital purchases of property and equipment was $14.4 million during the quarter, while depreciation and amortization was $14 million.

Day sales outstanding of accounts receivable were 67 days, up slightly from 65 days reported last quarter.

Inventory turns for the quarter were approximately 9.5 time, down from 10 in the prior quarter.

The decrease in terms was related to new products recently introduced.

Head count at the end of the quarter was approximately 2,375 employees, down approximately 15 from last quarter.

Well, in summary, we're very pleased with the levels of revenue and bookings achieved in the quarter and gross margins are in line with expectations.

We had good expense management in the quarter and the balance is healthy and continuing to strengthen..

Now I'll turn the conference call back to Dan.

Thank you, Steve.

As Steve indicated, we are very pleased with our performance during the quarter that represents the fifth consecutive quarter of revenue growth and third quarter of accelerating growth.

We were particularly pleased with the progress we made in the enterprise expansion in the quarter.

It included china unioncom, and (inaudible), integris health, John Deere, MFS financial services, Wells Fargo, western GECO, and several major U.S. defense agencies.

Key customers of the service (inaudible) include AOL, APS, Investco (ph), Sony and Texas instruments.

With respect to the vertical mix we saw sequential growth in major, manufacturing, energy, high-tech, financial services and tellco.

Revenue from the U.S. federal business declined following a seasonally strong Q2 driven by the federal fiscal year-end in September.

We saw sequential declines in the life sciences and internet verticals.

Revenues that we track accounted for the same percent of revenue for the prior quarter.

The FAS 900 series products experience outstanding customer acceptance and last quarter's conference call, we said that the products had gotten off to the fastest start that we had ever seen for a new platform.

That momentum continued into Q3.

The FAS 900 products that support the unified platform represented almost 50% of the final revenue during the quarter.

The average con Federal Governmentation of the FAS 960 shipped -- showed a significant increase in the number of bytes per system and is by far the largest that we have seen to date for the filer.

The FAS storage platform was honored by storage magazine as one of the best products of 2002.

The FAS 900 series was noted for the innovation, performance, ease of use and value, end quote as it enabled enterprises for the first time to manage data cross both network attached storage and storage area networks.

We continue to make good progress with the new fiber channel SAN protocol products and the protocol is available as an option in the FAS 900 series and F-80 and F-25 systems.

San customers included integris health, MFS investment management, north Texas Tollway and Thompson Coborn, LLC (ph).

They were providing key windows consolidation to MFS investment for several years.

This past quarter, MFS completed an evaluation for a financial application and selected it on the basis of ease of application and performance capabilities.

Thompson, coborn, LLC, one of the largest law firms in the midwest was experiencing high rates of data storage growth and was looking to improve.

The messages and home directory environments.

They wanted to deploy a network storage solution that combined performance with the upgrade path that guaranteed a low total cost of ownership for the entire data center storage operations.

Thompson Coborn chose a net ap unified solution that was technically and economically superior to the solutions offered by our competitors.

Integris health is Oklahoma s largest health care provider and plans to use NetApp for the win dose consolidation project to manage shared remote clinical data throughout the organization.

Integ ris plans include using San and nas protocols on the storage network.

Configuration includes NetApp.

Nearstore continued to see strong customer acceptance with almost 4,000 Terabytes in the store today.

Key customers were MDRCO petroleum, Edward Jones (ph), Vidia (ph) and TRW.

We announced new another store application with partners includes Atempo, backbone software, -- and thinksort.

During the third quarter, TRW, chose NetApp near store filers to provide centralized data storage, backup and disaster recovery to satisfy the internal and their external customer requirements.

This 50 Terabyte project is a great example of NetApp's market penetration in the growing aerospace and government businesses.

Revenue from the net cash product line was up a bit from the prior quarter at a little over 8% of total revenue.

During the quarter, the net cashC 2100 was awarded 2002 product of the year award by network computing Asia.

VERIO Croat net cash (ph) as the smart content delivery service to insure the rich media internet content can be distributed closer to and viewed instantly by end users as the NetApp solutions as the platform for smart content (inaudible).

VERIO along with NTT communications offers smart content delivery to extend the full suite of IP services and enables the customers to reach end users with new applications and content with remote geographic locations.

Our windows products continue to experience strong customer acceptance for the second quarter in a row on the unit basis, sales of the windows protocol outpaced the Unix (inaudible)Unix case (ph)Unix (ph) protocol.

Clearly windows customers have a need to consolidate their data to a multistorage architecture that meets the needs of a windows administrator.

As an example, Glaxo Smith Klein has deployed the first NetApp solution for a windows consolidation and disaster recovery in Europe.

Sony Ericcson chose them to consolidate their data center storage operations including, Unix case (ph)Unix case (ph) and file services for oracle onto a FAS-960 C platform.

Glaxso Smith Klein and Ericcson chose the storage solution for superior ROI, ease of use and advanced functionality.

The hard group (ph)selected the FAS 960 solution for a consolidation product for 250 windows servers, including the company's home directories and oracle database storage.

These are typical examples of the consolidation wins we are experiencing with the highly scaleable, highly available and easy to manage storage solutions for the Microsoft windows platform.

During the quarter, we signed a communication protocol license agreement with Microsoft under the Microsoft settlement program.

The license agreement grants net network appliance access to a broad set of win dose communications protocols.

Additionally, NetApp is licensing the set of windows media protocols through the settlement program.

As a result of our participation Network Appliance has advanced our ability to deliver leading edge network storage and data management solutions to the customers for their windows data storage and information access needs.

In December of 2003, we announced an agreement between Network Appliance and Hitachi to market and sell solutions.

This benefits NetApp and HDS customers looking to reduce the complexity of the I.T. infrastructure, increase data availability and simplify storage management under the terms of the agreement, they will offer NetApp, gateway solutions for Hitachi freedom storage environment managed by framework tools.

Together Network Appliance and Hitachi data systems to provide better storage asset management and investment protection.

While specific product end resulting from the agreement have not been introduced by HDS, we are pleased with the volume of customer interest in the partnering solution.

Company received several significant recognitions during the quarter.

Network Appliances was chosen by intelligence enterprise magazine as one of the quote, companies to watch unquote, in 2003.

It was based on the development of the enterprise and full line storage supplier in the infrastructure category.

In addition, it was named by Fortune magazine as one of the 100 best companies to work for, debuting at number 39.

Network Appliance was the only storage company recognized for its premier work environment.

In summary, the growth reflects the success we achieved in expanding the customer base and strengthening the partnerships.

Strong market reception of the industry leading unified storage and near store family demonstrates that we are continuing to lead the industry in delivering unmatched simplicity, innovation and value.

At this point, I'd like to turn the call back over to Steve.

Thanks, Dan.

Now I'll comment on the business outlook.

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

Again, I will remind you that we are making forward-looking statements and projections that involve risk and uncertainty.

Actual results may deliver materially from the statements or projections.

We continue to be pleased with our execution.

We expect revenue for the fourth quarter to grow sequentially by 2% to 6%, and for revenue to be in the range of $233 million to $242 million.

Operating expenses will continue to decline as a percentage of revenue as we take advantage of growth opportunities while continuing to prudently manage our spending.

We expect net income to grow with fourth quarter pro forma earnings in the 6 cents to 7 cents per share range depending on the level of revenue achieved.

I'll now turn the call back over to Dan for final comments.

Thank you, Steve.

That actually concludes our remarks today.

At this point I'd like to open the conference call for questions.

We'd like to ask that you limit yourself to one question.

We'll go through the rotation as many times as necessary.

But we would like to address everyone's question in a timely manner and keep the call to an hour.

Thank you.

At this time I'd like to remind everyone, if you would like to ask is a question, press star and the number 1 on your telephone keypad.

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

Your first question comes from John Roy (ph) of Merrill Lynch.

Hi, guys.

You used to give the database percentage.

Can you give us what that is for the last quarter and where you this that might be heading?

Hi, John.

It's Dan.

Database as the percent of filer bookings, it was up just a smidgen from last quarter, just a hair over 50%.

And you think that's going to stay there pretty much?

Yeah.

I think it's going to fluctuate around.

We have seen a lot of mix shifts on application both windows and Unix kind of move around a little bit, UNIX move around a little bit.

We don't count exchange of the database.

Which means that the database as a percent comes down.

I think it's in the 40 to 50 range.

Great.

Thanks.

Your next question comes from Harry Blount of Lehman Brothers.

Hi, guys.

Just a quick question regarding the competitive dynamics.

Dan, you had in response to a question last quarter commented in terms of frequency of engagements and wondered if you could give color around that if you see the dominant and then the Del as less than 5% in terms of frequency of engagements.

Del was up slightly, not in terms of total number of engagements, about the same range as last quarter.

Certainly, EMC still leads the list, but we have seen a shift within that to more competition last quarter from Clarion as opposed to symmetrics.

EMC and aggregate was about the same, but a little mix shift there.

It's just a function of the fact they introduced the new Clarion family and had not yet introduced the Simms 6.

Second on the list in frequency was the storage works family or Hewlett-Packard Compaq in aggregate but primarily storage works.

Great, thanks.

The next question comes from Shelby Seyrafi (ph) of A.G. Edwards.

Thank you very much.

Good afternoon, Dan and Steve.

What I'm doing in my modeling is looking at the hardware gross margin separate from the software gross margin.

I note that the software percentage increased from 24 percent of revenues to 27% of revenues and the product gross margin declined sequentially.

With my modeling, it looks like the hardware gross margin is following and has been falling for a few quarters now.

Should we expect that trend to persist going forward?

Thank you.

Shannon this is Dan.

I'm not sure why you're concerned about it, because we're not.

The hardware gross margins are down largely as a result of larger storage configurations.

The larger configurations drag larger software.

The larger the configuration and what the customer wants to have value-added software such as mirroring and disaster recovery solutions and so on.

So, those correlate together very nicely.

So, you may see system gross margins come down as systems get larger, and corporate gross margins that stay pretty flat.

I guess related to that, how high can software grow as a percentage of revenues.

I don't really care.

I care about the corporate gross margin.

As Steve said in his remarks.

The delinination (ph) between what is the value-added piece of software and what we embed in the base system is very arbitrary happened has to do with market considerations and not economic ones.

If we embed more software in the base, we expect to see the average sale price at base unit go up, but you would see the add-on oft wears as a percent of revenue come down.

These are very arbitrary decisions.

We don't have the same model as some companies that you follow.

We tried to articulate that to the analyst community for some time.

We charged separately -- we do not charge separately for snapshot, for instance, whereas the competitors generally do.

These are packaging decisions.

These are not structural in a financial modeling sense.

I don't think you should look to that as a serious indicator as what the mix considerations really are.

Shelby Seyrafi Thank you.

Nice quarter.

Thanks.

Your next question comes from Sabrina Richy (ph) of Deutsche Banc.

Hi.

Good evening.

I have a question about the FAS-900 product.

It sounds like it's a significant proportion of total revenues already.

Are you planning on having this product essentially supersede the 800 line and totally transplant that or are they being marketed in slightly different ways.

Follow-up would be sounds like Sans are picking up there and any more elaboration there would be helpful.

We have always had either four or five different price performance capacity points in the product line.

Most of the competitors do also.

But that seems to be standard.

The 940 and 960 are the new high end, but obviously that leaves room underneath for things like the 825, 810 and F-87.

That's really kind of the product lineup we have today.

Five different models with five different price performance capacity points.

The 880, 840 which was the workhorse for us for a couple of years is now out of production.

I believe we just sent out notice to the field that the 880 is now superseded by the 940 as well as no longer in production.

Does that answer the question?

That's the extent of it.

Just in terms of the San-piece of the business here, I guess what are you confronting when you go out in the field and now you are presenting a San and NAS combination.

What are you hearing from customers?

this is Tom.

You know, that's very interesting.

People ask you what's the difference between our solutions.

It is really pretty straightforward.

If they bought or looked at solutions from other vendors.

Let's say you bought a high-end San and you wanted a file system because NetApp was competing.

You buy a second product.

If you wanted to distribute that you buy a third product.

Eventually this company or that company buy software to tie that together.

What people like about our approach.

I asked people if you were going to design a NAS and San combination, would you want three products with a proproprietary software to pull it together.

Probably not.

What happened for the team is they can go into a situation where we clearly have the lead in the area let's say with SOLARA or Clarion, from the market space as far as the product.

You can tell the customer that you can take a product that you can scale up to very large sizes.

You can do a mid-tiered down it a distributed model.

You can back it up to disk with one file system in the same software regardless of NAS or San.

The effect of that has been extraordinary in the enterprise because I guess it ahas allowed us to be less evangelical and be more of a listening company, I which think was the next step president customers now feel like we fit into their environments better.

The second thing is when you combine that with the new store product line, we're finding that people find that we're helping them get more value out of the current architectures.

All over the world, I have completed a pretty good tour of the world, as has Dan, the message has resonated, and I think that's why the 900 series has taken off.

The enterprise customers like it a lot.

Great.

Thank you.

welcome.

Your next question comes from Mark Keller (ph) of First Albany Corporation.

Thanks.

As a follow-up to that, can you perhaps tell us what percent of the revenue, or can you even tell how much of the 900 is being connected to San?

It's really hard, Mark, to be honest with you.

It's an embedded attachment feature.

We can see it coming through the pipeline.

We can't measure in the revenue configuration between the order funnel and the manufacturing funnel.

It's running somewhere in the range of about 8% to 10%, roughly.

And about 75% of the units that are going out as San units are going out as combined San-mass.

Those are approximations.

Okay.

All right.

Thanks.

Your next question comes from Laura Conglero (ph) of Goldman Sachs.

Yes, thank you.

A question and clarification.

You basically talked about your geographic results.

You talked about Europe being particularly strong, but by the same token, your North American revenues appear to be down 7%.

Maybe you can give us observations on that.

Your European and international revenues seem so much stronger other than what we have seen in the most recent quarters, maybe you can give us a sense also of what kind of revenue impact you might have seen from currency.

On the clarification side, curious, you didn't make any comment about the environment which you typically do, and does that suggest that you believe that your business is now kind of rising -- kind of moving beyond any influences from the environment, and then finally, can you clarify, Steve, the whole book to bill situation?

Don't bookings also include both subscriptions and transaction revenues so that bookings can sometimes include multiyear events?

Thanks.

I'll do my best as recalling all of those.

First, North America was actually down -- the only segment in North America that was down was federal.

That's the primary cause for the decline.

A secondary thing.

North America had a great quarter in a booking sense, but you will see that the bookings were not on the same linear pattern as Europe.

Europe had a terrific finish in December, and therefore, most of that converted to revenue in January.

North America was skewed a little further out.

It also included more deferred component, which as you point out right is a booking, but doesn't turn the revenue as the single transaction.

Steve, do you want to talk about the bookings?

I think she also asked a question about the currency impact on European performance.

Laura, the currency impact on our European performance was about 4 percentage points of growth.

Europe grew, I think we said sequentially, 4%.

The natural growth was 30% on a currency basis.

Finally, you asked the question about the book to bill ratio.

You notice we're no longer providing that information.

It's true that books include both the deferred portion of our business as well as the product portion, which we can recognize as we ship it in the period type of thing.

To give people a sense for the bookings, we direct them towards the deferred revenue balance, which as you can see increased dramatically during the quarter, indicating that orders must have been fairly strong, and that the deferred portion of the orders were fairly strong as well, and both were the case.

I'm sorry, can I just --bookings, that would mean that your booking include both current business, per se, as well as the kind of business that I guess would be characterized more as kind of multiperiod business.

That's fair.

Those are added together in the bookings sense.

Right.

And, yes, some books are recognized as a single event, shipped, and others are recognized over the period of the contract.

But, yeah, that's right.

Both are in the bookings category.

Book to bill is more than one to one.

You also asked about economic condition.

We're feeling pretty good about the business as contrasted to some of the other major players in the storage space that guided down for the quarter.

I think in fact somewhere of 8% to 10% down, ours is up 2% to 6%.

We think we are gaining share.

We are not counting on a major economic recovery.

We recognize just as everybody else the great deal of uncertainty in the world economies, and lots of questions about impacts of potential war and things like that.

We're -- we believe that the I.T. spending this year is pretty flat, plus or may news a small percentage change from last year.

I think that's consistent with most of the research that I have read.

We think we can take share.

We think we have got something unique.

We think we can take -- we can create a new market segment with near store.

That's going extraordinarily well.

We think we can take share because of the coast of openership solutions.

We think that the flexibility offered in the unified storage approach is compelling.

We're feeling very good.

Laura, I'd like to add one more piece of color.

Two years ago when we were still rocketing up, we created a strong focus in the company to talk about it to create the enterprise.

We talked about we were going to move into what you call traditional enterprise.

Today, no matter how you categorize the business that's true.

As a dynamic to the enterprise that I don't think everybody appreciates.

If you are coming at it as a new vendor to the account, it probably takes four months before you get to the right person.

Once you get there and you have a proposition, you will then probably test you for four to six months, because they're going to roll this out as infrastructure as opposed to a workgroup technology.

You are now ten months in.

At this point,.

Major banks in New York as for instance have turned to us and said let's take an application that's probably large global, but is not core.

It's not the center of the application.

For instance, windows consolidation.

We have had very large window net.

You roll that out for six months to seven months.

Now, you are a year-and-a-half in which is where we are with many of these.

They say, you delivered on what you said.

It is less costly to manage anything that you have.

Let's look for other applications to move to NetApp.

I think, I think I'm very sure that a big part of what's happening is we're much further along the continuum than people outside the company recognize.

We are absolutely positioned in more major global deals including many of the wins in Europe where by large global accounts that are decided geo simultaneously and are rolling bigger applications.

That in my opinion is what's happening.

Thank you.

Your next question comes from Tom Corwin (ph) of RBC Capital Markets.

Good afternoon.

Part of the discussion on the previous question related to deferred revenue.

I wondered if you could take us through the dynamics of deferred revenue which is rising every quarter and providing greater visibility for you.

How you separate out short term versus long term and specifically is -- as you look forward over the next 90 days, is there a general rule of thumb that we can use about the percent of (ph) that revenue that is recognizable over the next 90 days?

Tom this is Dan.

So, just to review, we have two types of items that you can order from us.

One is a product that is recognized at the time of shipment that includes software licenses, the initial license, and the other is in two separate categories, software subscriptions, which entitle you to upgrades on an ongoing basis for a finite period of time as well as system support services, which again are typically for one year period or slightly longer, and we recognize the revenue there over a period of time.

Now, it turns out that this category of deferred revenues is a reflection of the strength of the enterprise business that Tom was talking about.

Enterprise customers typically buy more service and support.

They almost always include software subscription.

So, what we have seen is a mixed shift in the booking, if you will, from a 90-10 product service to more of 80-20.

That is a service and software subscription.

That's a direct reflection of the strength of the enterprise business.

The duration of those contracts is also lengthening.

It used to be typically a year.

It's now moved to 15 to 18 months.

We have seen some go as long as three years.

So, you take a single order, for instance for a three year period, it goes on the category deferred revenue.

Invoiced up front.

Typically, we get the cash up front.

It goes into the deferred revenue category and comes off over the period.

Does that answer your question?

it did in part.

I wonder, so clearly, that tends to throw an average more of that revenue or deferred revenue to the short term category and then as you look at the short term category, is there a rule of thumb?

Is that recognized linearly across the period in terms of short terms so that maybe a quarter of that is recognizable over the next 90 days?

Tom, I think if you are looking at the balance sheet, you are looking at the long term deferred versus the short term deferred.

The short term deferred are those pieces of revenue that were -- that -- those pieces of deferred revenue that will become revenue within the next year.

The long term deferred are those pieces of the contracts that will not be recognized as revenue for over a year.

Are you recognizing in terms of the short term, is that essentially spread out evenly over the next four quarters?

That's spread out evenly across the contract, if the contract happens to be -- you are looking at a single aggregate number.

I don't think we have an answer to the question.

I think it's a waterfall chart.

Each contract is based on (inaudible) dates.

A quarter is not a bad approximation of the aggregate.

The tough approximation works fine.

Thank you

Your next question comes from John Roy, a follow-up question of Merrill Lynch.

Yeah.

Actually, I wanted to be specific.

Could you make any comments on the pricing environment out there.

That's one of the reasons that we have. -- that's one of the concerns that we have.

What's your concern?

Pricing is still aggressive.

I think that we have seen our price per Meg bite come down.

Most of that is actually a result of new technology.

We started shipping 144 gig drives, right?

One of the strategies over time is to be one of the first to market with the next generation density drives that allows us to be competitive without having to give deep discounts.

The price per megabyte these days is under a nickel in a fully configured system.

It's trending toward 3 cents or 4 cents.

Drive prices have come down as well as capacity goes up.

Do you think that you will go to serial ATA soon for the main line stuff or sticking with that?

I don't think they're ready for the main line yet.

Dave, do you want to comment on the serial ATA.

I wouldn't use the word soon.

Okay.

I think that's -- if you look at what we did with the ATA.

The goal with the ATA technology and bringing it into near store was to create an opportunity for people to say, there's some of my data that is database data and especially databases that are containing numbers that are dollars.

I'm not going to touch that with ATA or serial ATA anytime soon.

You have other day that that would be stuff that people want to look at that's older.

Either older data, in past times that you might have migrated onto tape, people are more willing to make decisions about availability and cost tradeoffs.

We think there's different styles of storage.

Serial ATA, I don't think you should expect to see that replacing fiber channel and high enterprise in the core business anytime soon.

The real question is when can you get that into the near store product line and the more cost effective places.

Even though it's going to be a little while.

Thanks, guys.

The next question comes from Jim Lovolino (ph) at Morgan Stanley.

Hi, guys.

I was wondering, do you expect to have any other agreements more to the Hitachi agreement with other larger vendors anytime soon?

I don't know.

Is there anybody we should be talking to?

I don't know.

I a lot of people out there with disks and no software.

It takes two to tan go.

Let's make sure we're clear.

We're receptive to having the discussions.

I think we have said this before with any other storage vendor, but it does take two in order to provide a solution to the customer.

And Hitachi was in fact -- in fact, Hitachi, if I recall directly, made the first overture.

We have no other discussions going on with any other (inaudible) at this time.

Thank you.

Your next question comes from Andrew Ness (ph) of Bear Stearns.

Two things.

One is receivables were up in sales and dollars this quarter.

Grew faster than sales.

Can you explain what's behind the receivable increase.

Second, just as you look at the competitive environment, you talked about what you were seeing in terms of ENC, are you seeing the Microsoft, SAK, Del, and HP at all?

Part of it -- let me address the AR question first.

Part of what the increase in deferred bookings was the piece of that.

Part of it was the normal seasonality situation.

Europe was a part of that.

At the end of the quarter.

I don't -- frankly, I was not surprised to see a two-day shift around it.

It will do that.

That's within the limits of what we expect.

Hi, Andy.

This is Dan.

On the competition, as I indicated, we saw a shift within the EMC category from symmetrics to Clarion.

I made a comment that Dell was up a little bit.

That was Clarion as well.

That was not SAK.

We rarely compete with SAK.

I want to underscore very rarely.

It is just not in the same category that we are offering product.

In terms of frequency of competition, Sun was down a little bit.

Dell was up by almost the same amount.

So, it's just about a wash.

The two leading ones are still EMC with all products, and HP with primarily the Storageworks products and in Europe HP is number one.

Dell is like number five or six on the list.

This is Tom.

The recently I talked to a large account that did a big offer with four vendors.

They said you know what we concluded after that.

We concluded that network attached storage is not simple.

Your network attach the storage is simple.

They tried everybody else's.

The goal was to distribute this on a global basis to manage it on that infrastructure and make it simple enough to treat it as a network device.

We were not the incumbent prior to winning.

They really realized that network appliance over the many years has developed an architecture that you can do exactly what we say, install it quick, scale it quick, manage it easily.

Everybody else, including people at the SAC and other architectures come out with some kind of operating system that they try to skinny down.

They work with a low cost manufacturer and ship it.

The reality is when you put it in the remote data center, it's not simple to imagine, scale or service.

So, we feel our biggest edge is that we have the same technology in the file system at the very, very low end that scales all the way to the top in a consistent way of managing that, we have more than 50 thousand of these out there.

We can manage them all with the same file system that's consistent.

I think people are really starting to, as you are looking for ways to decrease costs in the freaks at some point, the only way to decrease costs is to simplify that architecture.

I think that we have a huge advantage on the competition.

You are mentioning it in that area.

Thank you.

Your next question comes from Glen Huntis (ph) of Needham Company.

Good afternoon.

You mentioned that the service margin, I think was down a little bit in Q3.

Could you give us a little color on your outlook on gross margin from a -- you know, a product and a service standpoint.

You know, flat, up, down, any outlook there on the margin front, and maybe secondly, you could talk a little bit about sort of key R & D projects.

I discusses, your view there, is that causing you to reshuffle your priorities in what you are working on.

Any color that you can give us there.

Thanks a lot.

Hi, Glen.

This is Steve.

I think I'm going to be fairly consistent with what I have told you before.

That is that over the intermediate range here, we expect to see a relatively modest, but fairly steady decline in our gross margins.

We have talked about coming down from where we are in the over high 50's range.

Is that related to the mix of service growing a little faster than product and just in that --and that has lower margins, or are you looking for the margin on the predict line to --product line to come down independent of any mix shifts?

Well, as we talked about, it's a little bit of both.

Service will continue to grow very rapidly.

It's the fastest growing part of our revenue today.

And it has the lower gross margin.

The good news is that service margin is improving, and although we stepped down from the prior quarter, service margin that you see this quarter is the highest that we have recorded in, you know, many, many, many quarters going way back in time.

So, the margins improving, and we expect further improvement in the service margin over time.

However -

Why did the service margin decline this quarter?

It has more to do with some one-time effects that occurred last quarter.

Things like educational services and support.

Training and installation that we bill in the period as opposed to amortizing than it does with anything else.

So, we expect the service margin to improve over time.

Although it will not come up to the corporate average.

There are other forces at work, tending to drive down the product gross margin.

That includes channel shifts.

We expect to shift more through channels over time.

The low end of the San market will tend to have a little bit loser margin as we expand the footprint in that segment of the market.

Those are the forces at work on a gross margin.

The product side, I think I should make -- turn this over to Dave to talk about kind of where we are at.

You know, just one aside.

I saw speculation that we would be refreshing a particular area of the product line.

I made a comment last time that I will reiterate.

We generally alternate between high end and low end.

Whoever wrote up the first call, I forget who it was, said we would be refleshing something else.

The next iteration is low end.

We did the high end in October, you should expect in the spring the low end.

I'll leave it up to Dave on how we are doing on (inaudible).

Our goal is to be shipping (inaudible) support this quarter.

The important thing to remember is that the (inaudible) support that we will be shipping is part of the overall software content.

What that means is that at the point that we ship the new software that support I-discussed, the entire install base becomes (inaudible) ready.

That's one of the things that is very attractive about the approach that we have taken.

We think that gives customers a lot of flexibility in how they would consider using (inaudible).

I don't believe that (inaudible) is going to take on fiber channel at the high end of the data center.

People are going to continue to use fiber channel in the same way they -- before. (inaudible) creates wonderful points of flexibility.

You have a high end database doing transactional stuff.

You may want to run that.

Imagine that you are doing support generation.

You might want to create a clone of that volume and export the clone via (inaudible).

Our product supports that.

That gives people a lot of flexibility.

I think the growth areas for (inaudible) are in the place where the costs just don't line up for fiber channels.

I think in win dose and LINUX is going to be the space that you will really see growth.

Microsoft is (inaudible) I think for that reason.

I -- my personal goals for the (inaudible) is to see how quickly we can transfer or infrastructure change.

Can you reiterate that question.

It had a when are you going to stop beating your wife component that I wanted to reiterate and compute.

I didn't mean for NetApp at all.

I meant -

I don't think it is for the market, either.

Okay.

I believe Microsoft has committed publicly that 90 days after the spec is done, we'll have product in the market.

We believe they're on track for that.

They hosted a major (inaudible) interoperatability activity, multiple vendors.

Anybody who is anybody.

I think he they were all in Redmond last week.

They are not just active.

They are facilitating it.

Let's be clear about the target market for (inaudible).

I don't believe that you are going to go see a lot of people say we're retiring the fiber channel to change it into (inaudible).

You will see people direct attached storage to some sort of network storage.

Direct attach storage we can complain it's hard tore manage, and all of these other things but it's cheaper than San.

I think (inaudible) can help change that dynamic.

Thanks for the thorough answers.

Your next question comes from Kevin Hunt (ph) of Thomas Weisel and partners.

Thanks.

I'm trying to look at your reasons for optimism, I guess here, going forward.

Probably one of the things that I'm doing is looking at the last quarter.

Correct me if I'm wrong on that, but I think usually December is your strongest month and January falls off a little bit.

And from what I heard you saying it sounded like December was very strong again, but -- you also might have had good orders in January, but maybe not that weren't revenue.

I just wanted to clarify that and get a comment how the quarter looked.

I also wanted to see given that you have more -- you are expanding your channel business, if you have any kind of numbers that you can give us there on what might be direct versus channel at this point?

This is Dan.

The pattern this quarter was consistent with prior third quarters.

December was strong.

This typically is the most linear quarter.

In that we see strength in December and a falloff a little bit in January.

I don't know what you mean about held things back?

We saw the large growth in deferred revenues.

Bookings were pretty solid, but most of the expenses shows up as the deferred revenue. -- most of the excess shows up as deferred revenue.

You are asking me the same thing that the board is can -- me.

Don't you read the papers and the economies are soft, why do you think we can grow so well?

Well, we are doing it.

Year over year and sequential.

We are gaining share and momentum as Tom said.

As we look at the sales pipeline we are strong.

We are competitive in the pricing and competitive and the win rates.

We don't expect to see win rates shift at all, if anything, shift in our favor.

We look at all of the bottoms-up stuff that we have going, and conclude that we will see growth going forward.

I don't know what else to tell you besides that.

We're confident that we can take some share.

Let me add a couple of quick stories.

I was talking to some people on Wall Street and they explained to me there was an effect after 9-11 that perhaps we didn't understand which was they got reimbursed by the insurance companies on a dollar for dollar whatever they bought, but it had to be like, it had to be the same.

Of course, that wasn't us in many cases.

It was one of the largest main frame competitors.

So, for the last year, even if they wanted to use our stuff, they tended to have excess capacity.

Most of the terms they took out significant amount of dollars out by layoffs.

I have been told by a number of them now that their excess capacity has been used up, and they can no longer continue their reduction of dollars unless they simplify their environments.

So, we found a tremendous push now that we have to decrease our costs in a different way than we did before.

Secondarily, our partnership with oracle continues to pay dividends.

Not only do we have half a ped byte storage in Oracle, with LINUX, around the world, we are see seeing a push in major ways with large integrators to reduce costs.

A large company in Europe, a multibillion dollar company moved away from IBM to go with Oracle on a global basis.

Because of Oracle is putting a stake in the ground saying we are going to run our business with LINUX and NetApp is going to be the backbone, we're finding a tremendous push where I wouldn't have expected it.

So, there's the main issue, the main point I'm making is people are looking for all ways to find a way to manage the San Francisco for less money.

LINUX is going to deal with oracle.

Oracle is going to push that. (inaudible) is going to help people move over from locally attached disk to the network.

Much of the reduction they have done in the past, they have gone as far as they can go unless they take another step and simplify certain pieces.

NetApp is uniquely positioned to take advantage of that.

That's what we see.

You asked about indirect channel contribution.

It was up in the quarter.

It was up to just slightly under 50%, somewhere in the upper 40's.

That's directly correlated to the mix shift in Europe.

Europe is 50%, roughly, indirect and that alone accounts for most of it.

Thanks.

Your next question comes from Dan Raynard (ph) of Robert Baird.

My question is related to near store.

I'm wondering if you could -- it sounds like that's continued to be a strong product, and I think that you had mentioned when this got to be a 10% product, you would tell us.

So, I guess I'm going to ask, is this a 10% product, and/or do you expect the run rate of that product, you know, sort of exiting the April quarter.

I mean, on a quarterly basis to be at or around that level or maybe above that.

Thanks.

This is Dan.

Nearstore is just about at 10% of our product.

Revenues.

Excluding service.

It's coming right in the range.

We're not thinking about it as nearstore only, though.

Is part of the answer.

When -- typically when the nearstore product is sold in conjunction with other filers, and lots of software premiering as a complete -- for mirroring as a complete solution.

Nearstore as a standalone product is less interesting as a complete solution bundle for the customer.

10% is the nearstore product that doesn't include the associated poll of soft software so it could be higher.

It is definitely higher.

The number that I gave is you the nearstore box.

Even excludes the additional software to dot mirroring to it.

As an example, Dan, when people look at windows con sol consolidation, the key issue is not how I back it up, it's how I restore the information.

They have a window for what they can make for restore.

Nearstore is very, very popular now as a way of increasing the window.

You are backing it up from disk to tape speed.

As an integrated solution.

Windows consolidation is a solution.

Before, we were not thinking of it in that way.

You have it in the certain situations with agFA.

We are finding more unique ways that people are thinking of the data granularly.

They say that not all data is equal.

They are saying how can I move to a less expensive medium and get a disaster recovery scheme out of one -- nothing.

All of those things are happening with nearstore and it is dragging all of the product with it.

Lastly, reed to this, how do you -- who do you see in the field with the nearstore product?

There's EMC (inaudible) product with a niche, do you see them getting into that, or is it a discounted Clarion?

The only thing we're competing with is to a certain degree the newness of the offering.

We don't really have a head-on competitor against nearstore.

Now, it's tape alternative and CD alternatives and a variety of other things like that.

Here it is a new market space.

We're not competing Ed-up with other -- head up ATA devices frequently.

Very rare.

Thank you.

Your next question comes from Chris Rush (ph) of Wachovia Securities.

Good afternoon.

I know that you have commented on the competitive landscape.

With the introduction of the NS 600 from EMC, if that has had any change to the competitive dynamic vis-a-vis to EMC?

Did they introduce another mass box?

Pardon?

Did they introduce another mass box?

Apparently, yes.

No.

Okay.

It hasn't changed the competitive dynamic.

It's CX series, Clarion and Simms.

The NS didn't show up on the radar chart this quarter.

So, we still see solar are a now and there.

Relative to the EMC mass offerings, NS wasn't there.

You're just not seeing it competitively.

Nope.

OK.

Great.

Thank you.

Again, if you would like to ask a question, please press star, then the number 1 on your telephone keypad.

Your next question comes -- is a follow-up question from Andrew Ness of Bear Stearns.

Just a technical question if I could on the tax rate as you look beyond.

Do you think that you can keep it at 23%?

In terms of interest/other, is there anything unusual in there.

What's a good run rate for the number?

Thanks, Andy.

This will be the last question that we take.

You should model, going forward, you should model 23%.

We think it's the best representation of the tax rate that we expect to incur currently and into the foreseeable future.

On the interest/other?

I don't think you will see' a lot of change.

For conservative purpose, you might bring it down slightly.

Over time it's not going to change that much.

Is there anything unusual in there?

The hedging, foreign currency transaction that I mentioned, which was about 400K.

If the currencies stay where they are right now, it will be half of that next time.

Okay.

Thank you.

You bet.

At this time, there are no further questions.

(inaudible), I think we should go ahead and end the conference call.

Ladies and Gentlemen, I'd like to thank you again for joining us this afternoon.

We'll see you at this time next quarter.

Ladies and Gentlemen this concludes today's conference call.