NetApp Inc (NTAP) 2003 Q4 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to the Network Appliance fourth quarter and fiscal year end conference call.

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

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

If anyone should need assistance at any time during the conference please press the star followed by a zero and the operator will assist you.

As a reminder, this conditions is being recorded today, Tuesday, May 13th, 2003.

I would now like to turn the call over to Dan Warmenhoven.

and welcome to the earnings release conference call for the fourth 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 on the call are Tom Mendoza, President of Network Appliance and Steve Gomo, Senior Vice President of Finance and CFO.

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 and projections.

Factors that could cause projections to differ could be customer demand for products and services and any decline in general economic conditions.

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

Before we begin discussion of our fourth quarter results I would like to mention the share repurchase we announced today.

Network Appliance Board of Directors has approved a stock repurchase program, $150 million of outstanding common stock may be repurchased.

The duration of this repurchase program is open ended.

Shares will be repurchased on the open market at prices deemed appropriate by management.

The repurchase program demonstrates confidence in our ability to generate cash and one of the best uses of that cash is to invest it back into the company.

At this point I would like to turn the call over to Steve to review the financial portion of the press release, we issued today.

Following Steve's comments I'll share my own comments of the quarter.

Then we'll move to the financial aspect and move to a question-and-answer period.

My pleasure to introduce Steve Gomo.

Thanks, Dan.

Good afternoon, everyone.

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

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

As indicated in the press release, revenue for the quarter was $241.6 million, up 18% year over year from the 204.9 million dollars reported in the fourth quarter of last year.

Revenues increased 5.8% sequentially from the 228.5 million dollars reported in the third quarter resulting in our sixth consecutive quarter of sequential growth.

Revenue for the full year totaled $892.1 million up 12% from 2002.

Revenue from services, which includes hardware support, professional services, and educational services was about 10% of total revenue, down slightly from the 10.3% reported in Q3.

Service revenue for the full year was $89.8 million, up 31% year over year.

Add on software as a percentage of revenue was approximately 28%, a historical high for the company.

Software products were approximately 18% of revenue, and software subscription upgrades were approximately 10% of total revenue.

Addon software includes software products sold in addition to the base system.

At the point of clarification, the base system carries the core software value, including data on top, the waffle file system, SnapShot and first access protocol.

The addon software industry includes products such as SnapRestore, SnapMirror, SnapVault and any additional protocols that are purchased by the customer.

The software percentage we disclose will not in any way represent the total contribution of software to our revenue and will become less meaningful as various product structure changes create a mix shift between the basic system and addon software products.

North America contributed approximately 62% of total revenue, up from the 55% reported last quarter.

As expected, Europe declined to 26% of total revenue, down from 33% last quarter.

Icon contributed approximately 12% of revenue, about the same as last quarter.

Gross margin for the quarter was 61.4%, up slightly from the 61.3% reported last quarter.

Product gross margins strengthened by 6 tenths of percentage points of the prior quarter as a result of software mix and manufacturing cost management.

Services margin fell from last quarter as several investments were made in this area.

Pro forma operating expenses totaled $117.9 million, increasing $2.8 million from the $115.1 million reported last quarter and declining as a percentage o revenue to 48.8%, an improvement of 1.6 percentage points from the third quarter.

Operating expenses are now under 50% of revenue for the first time in nine quarters.

Other income was $2.7 million, down approximately 18% from the $3.3 million reported in Q3.

Pro forma pre-tax income for the quarter was $33 million or 13.7% of revenue, up 1.3 percentage points from the prior quarter.

The annual effective tax rate for the year was 23%.

Pro forma net income for the quarter was 25.5 million dollars or approximately 10.6 of revenue, up 6/10 of a percentage point from the prior quarter.

Pro forma earnings per share was seven cents based on a weighted average of approximately 352 million shares outstanding.

We reported a GAAP net income of 24.8 million dollars or 7 cents per share this quarter.

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

The difference between GAAP and pro forma this quarter includes amortization of intangible assets, stock compensation and net loss on investments.

Well, now, turning our attention to the balance sheet, cash and investments at the end of the quarter were $618.8 million, up $80 million from the previous quarter.

Cash generated from operations this quarter was $92.3 million.

Capital purchases of plant, property, and equipment was $15.4 million during the quarter, while depreciation and amortization was $13.3 million.

Days sales outstanding of accounts receivable were 57 days, down from the 67 days reported last quarter.

Shipment linearity was good during the quarter and collections were very strong.

Inventory turns for the quarter were 11.8 up from the 9.5 turns reported in the prior quarter.

A deferred revenue balance was $174.4 million up $18 million or 11.5% quarter over quarter, and up 63% from the $107.2 million reported a year ago.

Head count at the end of the quarter was approximately 2,345 employees, down approximately 30 from last quarter.

Well, now I'd like to make a few summary points for the quarter and for fiscal year 2003.

As we exit FY '03 we are growing revenues, we are clearly increasing our operating leverage, and we're making great progress towards returning to our target business model.

We've had good expense management during the quarter and over the course of the year.

Our balance sheet is extremely strong, and our ability to generate cash fro, operations has improved.

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

Thank you, Steve.

I am very pleased with our performance during this quarter, which as Steve mentioned represents our sixth consecutive quarter of revenue growth.

Our growth indicates we're taking share in the network storage market which is supported by a number of market share reports issued during the quarter by Meda Group, Garner Data Quest, and ISCSI.

Network Appliance is positioned as a market leader and Meda group recently released Meda Spectrum for enterprise mass, which we were specifically recognized for our ability to innovate and differentiate through technology development.

Garner Data Quest announced that NetApp was number one in NAS in 2002.

And IDC recognized NetApp as a market leader in NAS at 2002.

NetApp moved into the two the top four market share in NAS storage market, which combines NAS categories.

With respect to vertical mix, we saw somewhat predictable results, revenue from the U.S. federal business grew sequentially following a seasonally weak Q3.

Life sciences, high tech, and financial services saw sequential growth, while we saw some sequential declines in the energy, major manufacturing and telecommunications verticals.

We remained very pleased with the customer mix and exit the fiscal year with a well diversified business.

FAS900 did well, representing the majority of filing revenue as expected.

FAS900 was named best enterprised IT product of the year as part of the third annual eWEEK's excellence awards.

As the award judges noted "NetApp FAS900 Series Storage appliance successfully blends capabilities of NAS and sans into a single platform and may eliminate the SAN or NAS label spending debates that go on in most IT shops."

St. Louis based Emerson has chosen to standardize its enterprise storage infrastructure and has multiple NAS 900 clusters to maximize data availability between data centers in St. Louis and Chicago.

Deployment will enable multiple Emerson divisions spanning thousands of users to manage storage requirements through its Oracle and Windows based application.

Krispy Kreme chose NetApp to help them manage their growth.

Krispy Kreme is utilizing NetApp for replication and protection of the windows application data including Microsoft Sequel Server and for a consolidation of windows based home directors.

Another solid Windows consolidated win was Allstate Insurance.

Allstate chose NetApp for Window's for a server consolidation diaster recovery project at one of their primary data centers.

Allstate chose FAS900 Filers, SnapMirror, NetApp's virtual file manager software for simplifying management of storage infrastructure.

We continue to make good progress with SAN products, approximately 13% o filer and NearStore units shipped with SAN call enabled which is just up 10% in the prior quarter.

We also announced support for ISCSI protocol, which is available on F-800 and FAS900 Series Filer through a simple software upgrade.

ISCSI is especially appealing because it enables affordable network lock based storage for Windows and Linux server environments with simplicity, flexibility and price performance, our critical IT decision factors.

SAN customers during the quarter included [E.

Brawn Medical France, Brocade, Stewart, L'Oreal, Nationwide Insurance, and Solemn Better Jay].

Brocade chose Net App for unified storage in their data center using our storage architecture based on their silk worm SAN platform to address their Microsoft exchange requirements.

Our success in the SAN market is primarily due to our ability to run SAN and NAS simultaneously on unified storage platform, as well as the simplicity of our SAN implementation.

NearStore had another great quarter accounting for almost 10% of revenue.

We shipped 2 petabytes of NearStore during the quarter and have approximately 6 peda bytes in the enterprise.

During the quarter we announced NearStore based targeted industries regulated data requirements including financial services, healthcare, pharmaceuticals, and government.

The solution named SnapLock, a new software that provides long-term data retention using features including worm or Write Once Read Many capabilities.

NearStore continues to win awards from industry publication and this quarter Network Magazine named NetApp NearStore R1002003's best product of the year within the storage hardware category.

Biotech leader chose to deploy NetApp to drive the firm's tools for genomic research worldwide.

The decision includes FAS900 series filers and NearStore 150, as well as open system, SnapVault used to back up NetApp and nonNetApp storage, provide storage for HSM environment that includes VERITAS storage manager.

Revenue from NetCache was down from the previous quarter to a little over 6% of total revenue, compared to about 8% last quarter.

Caching and Internet access is clearly not growing at the same rate, it's becoming discretionary purchase.

We are the clear market leader in cache and will be well positioned when caching begin to resume their growth.

I'd like at this point to share a bit of news about a product we'll begin shipping in a few weeks, the newly introduced FAS 250 is our entry level unified storage appliance for the distributing enterprise supporting ISCSI and NAS protocols.

The FAS 250 integrates a filer head and storage enclosure into a single compact three-rack unit package and supports up to a tera byte of storage.

The product can be seamlessly upgraded to other enterprise appliances with no data migration and runs data on tap to ensure full software compatibility with the rest of our product line.

This product FAS 250 will range from $15,000 to over $30,000 based on storage capacity and the addon software content.

Initial customer feedback has been very positive.

And more information on this new product family will be coming later in the summer.

I'm also very pleased to announce Accenture Network has signed a formal alliance agreement after working together on joint sales activities, this is recognition of both companies of the value that NetApp product services provides, part of the business solution framework Accenture is doing.

Alliance with firms such as Accenture are powerful on your mutual customer base, enable us to build past success and continue our growth in fortune 1000 enterprises.

Oracle continues to be a significant partner and customer of Network Appliance.

Oracle and Network Appliance have over 1900 joint customers using Network Appliance storage.

Oracle has over 850 tera byte of NetApp storage in their own data center.

Other enterprise customers, supporting storage environment include Bank of America, Continental Airlines, Progen, Southwest Airlines and Texas Instruments.

Network Appliance and oracle maintain a joint center of excellence.

The key win coming out of that center during the quarter was at Home Depot, from significant data house project supporting a retail call center.

This deployment has been recognized with a finalist nomination for integrated solution magazines best small to medium enterprise disaster recovery solution.

In summary, this has been a terrific year for Network Appliance we shipped approximately 24 peda bytes of storage in fiscal year 2003, which represents 111% year over year growth from fiscal year 2002.

We continue to broaden our customer base and increased our penetration to the enterprise.

We announced our unified storage products and our entry into the SAN market and expanded our channel presence with partners including Forsythe, Data Link and Simmons.

We saw significant growth in our service business as it moved deeper into the enterprise and we significantly expanded our partners with other enterprise infrastructure providers.

This truly was the year of the partner.

Almost half the press releases we did during the year were partner related.

We saw revenue growth throughout the year and continued to take market share.

I'd like to thank our customers, our employees, our partners, and our suppliers for their support during fiscal year 2003.

Now I'd like to turn the call back over to Steve.

Thanks, Dan.

I'll now comment on our business outlook.

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

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

Actual results may differ materially from our statements or projections.

I'd like to start by describing our fiscal calendar for the upcoming year.

As you know, each calendar year consists of 52 weeks and 1 day.

Or 52 weeks and 2 days in a leap year.

Our fiscal years normally include four 13-week quarters, with the quarter always concluding on a Friday.

Every four or five years we have a 53-week fiscal year, consisting of a 14-week quarter and three 13-week quarters.

The extra week is intended to keep our fiscal quarter end relatively aligned with the end of the calendar month.

Fiscal year 2004 will be a 53-week year.

And the first fiscal quarter of 2004 will be a 14-week quarter.

Our last 14-week quarter was five years ago in Q1 of fiscal year 1999.

Moving onto the guidance for Q1, we continue to be extremely pleased with our execution.

The first quarter is typically challenging for us as we have our normal summer seasonality which includes territory and coverage changes that occur in our sales organization at the beginning of every new fiscal year.

In addition, our annual sales kickoff and annual sales club for our top performers are factored into our expectations.

As a result, we expect revenue for Q1 to grow sequentially by two to five percent.

This projection reflects year over year growth rates of 19 to 23%.

We're also mindful of the expense impact created by the 14-week quarter, and expect net income to grow slightly.

With Q4 pro forma earnings of 7 cents per share.

Q1, I'm sorry, Q1 pro forma earnings of 7 cents per share.

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

That concludes our remarks for today.

So at this point I'd like to open the conference to questions.

I'd like you to limit yourself to one question so we can address everyone in timely matter and limit the call to one hour.

Thank you very much.

Thank you, sir.

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

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

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

You will hear a three-tone prompt acknowledging your selection.

Your questions will be pulled in the order received.

If you're using speakerphone equipment, you will need to lift the handset before making your selection.

One moment, please, for our first question.

Our first question comes from Mark Kelleher with First Albany.

Please go ahead with your question.

Thanks.

Hi, guys.

I wanted to ask about the large sequential jump in long-term deferred revenue.

It seemed to jump considerably more than regular deferred revenue.

Can you explain the dynamics behind those two lines?

Yeah, I think so.

This is Steve.

I think what you're seeing there is our continued penetration into the enterprise.

I think this is a direct reflection of the type of customer we're doing business with and the kind of service package that they are purchasing from us.

It's a more robust, more complete package that's larger and longer in nature, and that's why the deferred revenue is reflected in the kind of growth that it is.

Next we have a question from Harry Blount with Lehman Brothers.

Please go ahead with your question.

Thanks.

Just wondering if you guys would comment on how the Hitachi relationship is going?

This is Dan.

Hello, Harry.

Hello.

The Hitachi relationship is off to a good start.

It hasn't really contributed anything material to revenues.

As you're probably aware they introduced their product only a few weeks ago.

We would expect to start generating measurable revenue in this upcoming quarter.

We've had a number of interactions in terms of customer engagement and so on.

The pipeline loose very good.

Our head of North American sales addressed their kickoff and it was very well received and I think we're ready to go.

This is Tom.

I was asked to address their leadership worldwide.

That went well.

From an engineering point of view, the product is extremely solid shape.

The channel conflict is low compared to what we expected and the engagement level is high.

This quarter we were able to capture at least two significant deals because they felt very comfortable because Hitachi was vendor of choice and data centers were choosing NetApp and having one architecture flow through their institution.

We don't want to overhype anything but we feel like it's gone extremely well.

I think the other thing we're happy about the highest point of both companies are focused on making it a success.

Our next question comes from Dan Renouard with R. W. Baird & Associates.

Please go ahead with your question.

Thanks.

I'm on a cell phone if it's not clear.

My question is around the ATA product.

Wondering if you could just talk about customer awareness of NearStore and just ATA in general and what you see looking forward to, I guess, the second half of calendar '03 and '04.

What do you think as far as interest levels and as far as where you see the mass market looking to potentially take this as a market opportunity?

Dan, this is Dan.

Let me start off, I'm going to turn it over to Tom.

First of all, I think the customer awareness is growing quite dramatically.

There's three or four distinct environments the customers are interested in.

One is really for a staging center for backup that is consolidated information before they go to tape, and providing an online backup as part of that.

Second is for mirroring, our business continuation.

I think they are starting to realize they shouldn't pay as much for the mirror as the primary storage.

The third is consolidation of remote office information for, again, data recovery business continuation, but now really focus more on distributed environment.

Then the last one which is the WORM technology, the Write Once Read Many, which is a way of satisfying regulatory requirement for retention of information for long periods.

They really have become very aware, not so much of the ATA technology as to the cost effectiveness of high capacity, low cost storage devices.

Most of the customers don't focus on ATA, they think of it as low cost rates and low cost secondary storage and they really have started to get it.

In fact, I've got to tell you, I think our sales force has done an excellent job of positioning it to the customers, and we're going to hand that also with recently announced products that allow us to be the secondary storage for nonNetApp environments which have now recently come to market.

Tom?

I was going to comment that a year ago one of the things we had to get our sales force away from was being an evangelical sales force, selling NAS as the only solution.

Today we can walk into an environment, doesn't matter what wire they want to go over, we can show them architecture top to bottom that shows them how t consolidate, share data, back up data with the same file system control and everything.

So I think the NearStore product line has allowed us to enter into accounts in big, big opportunities in ways we couldn't have before.

Secondarily, the key is what Dan just said.

With the software we're bringing to the market, which allows us to back up other people's storage in a very cost effective manner, again, it allows you to come in a nonconfrontational way, understand the business issue, allow them to reduce the cost of backing up and restoring information, also during disaster recovery.

It's allowed us to broaden our approach.

Secondarily, this is something that our partners are latching onto very quickly because this is an issue they are familiar with, hasn't been anything new to the market in a long time and the solutions are very, very clear.

So the messaging is becoming much more straightforward to large enterprise customers.

Our next question comes for John Roy with Merrill Lynch.

Please go ahead with your question.

Hi, guys.

Can you give us a little idea on what the pricing environment is like out there and how the general business environment is and what you're kind of planning on?

Hi, John.

This is Dan.

Hey, Dan.

I've gone through this before with many people wondering about pricing.

All can I say is I think over the last four to five years we've seen a pretty steady decline in terms of cost per mega byte, at about 40% per year.

That's driven as much by the disk capacity increases as it is by competitive issues or whatever.

We ship, as I said, 111% more bytes of storage this year than last year and revenues are up 12%.

Granted, that's kind of apples and oranges because we had different mixes in there of caches and services and softwares and all the rest.

But all in it does make sense.

It does.

We saw another year of 40% cost decline for cost.

Our gross margins during that five-year period have consistently stayed in the upper 50s, low 60s as costs per meg have come down.

I don't see the trend line moving very differently.

And, you know, the margin to me demonstrates that the price declines have been mapped to basically the decline in COGS from disk manufacturers.

And the general business environment?

I think spending overall this year is going to be pretty flat.

I think that's borne out by most of the CIO surveys I've seen, plus or minus a very small percent.

I mentioned in February, I was asked was there a war hang over.

My answer was no.

Is there a war resurgence, now that its over?

I don't think so.

Most CEO have been executing the plan they put together at the start of the calendar year.

I think there is a makeshift going on within.

There is potential the storage segment could be growing in terms of mix of their budget, as contrasted to some new application development or servers and so on.

But I don't think it's going to be really large.

I think it's going to be small shifts.

There was a clear mix away from direct attach network storage, which is where we're strongest.

I feel as though that segment is going to continue to do very well and we're going to continue to do very well in it.

This is Tom.

I think the modular approach we have allows us to offer storage in data sites or away from the center in a way they can afford it now because our argument has always been it's simpler, you can scale it from top to bottom with one operating system.

Now you can do it no matter what wire you want.

Sales call is very, very different.

At a high level people seem to get our message.

We're not having to explain it over and over again.

I think we're picking up velocity.

I think our numbers are showing that.

Thanks.

Our next question today comes from Paul Mansky with ThinkEquity Partners.

Please go ahead with your question.

Yeah, guys.

You've been alluding for the past two quarters now that the software breakout you give us is going to be less meaningful in the future, I guess it's due to some bundling solutions.

Clearly that didn't manifest itself this quarter.

When should we be thinking about seeing that actually reflecting in the results or breakout?

Actually you're starting to see changes in product structure.

If you look at NearStore, for instance, there's more services bundled in we would charge for separately on a filer.

As we move forward, I think you'll see different software capabilities bundled into the base system unit.

It will really accelerate, I think, over about the next year that we'll restructure our product base and addon software offerings.

Should we be thinking about this in the context of coupling more software with new products or adding what has historically been addon software to existing software lines?

Both.

You may find, for instance, at the low end as they come in the FAS 250, more things bundling back in, do mirroring back to the data center for no extra charge because it's part of the basic application.

You'll see different products have different integrated services.

I think the point here Steve is making is we sell very little software that's not directly attached to and part of our system.

The differentiation between what's in the base and what's in the addon is fairly arbitrary.

It's not as though we're selling software that runs on somebody else's server.

So this delineation is somewhat arbitrary.

We are, in fact, going to move it around.

One of the things you expect to see is you project that even forward say a couple of years, the concept of what is the system is going to change as we move to blade tape architect yours, SAN switches on the back end, variety of other architectural changes that cloud the relationship between the server and the storage.

You all of a sudden see system configurations and multiple processors on blades connected to large amounts of storage.

So the definition of what's a system is going to get very cloudy.

Those kind of configurations again will bundle a lot more software as part of the basic config.

Thank you.

Our next question comes from Robert Montague with RBC Capital Markets.

Please go ahead with your question.

Two questions.

Nice quarter.

First of all, could you give any more specific comments on short-term gross margin trends?

It was kind of a theme last quarter.

I'd love to get an update there.

Also, we clearly sensed that you've been penetrating the financial sect or mor effectively maybe the last quarter or two.

I wonder if you could give a little color in what you sense has been kind of the catalyst or tipping points to get that going.

Thanks.

This is Dan.

Let me comment on financial services.

It was up less than a full percentage point in the mix.

It's been over 10% of our revenue mix every quarter this fiscal year and has never peaked as high as 13.

So it stayed consistently at 10, 11, 12 kind of range.

So I'm not sure I can support your premise that it's accelerating.

However, that said, I would say that if you look at the list of customers in the financial services community that we now have, especially as contrasted to a year ago, that list that grown dramatically.

If you look at the type applications that are being deployed, you know, I think of the financial services community as kind of having a three-stage buying pattern.

The first stage is evaluation, the second stage of the trial deployment, they will give you one project and try it.

If the experience is positive, they will move you into mainstream.

I think we're starting to see mainstream adoption moving into database and others.

We're feeling really good about the progress we've made in financial services on a global basis, but it has not yet shown up in terms of percent of revenue changing dramatically from Q1 of this year to Q4.

Broad customer list, broad application base, we feel as though we're well positioned, lots of momentum.

I would expect to see that one of the growth contributors going forward.

Do you have a more specific question on gross margin?

Just any kind of guidance in terms of gross margin trends over the next fiscal year.

We've proven our aptitude at forecasting, we think it comes down as increased capacities and so on.

As you can see it actually went up a tenth over this quarter.

I still believe over time you should model for conservative purposes about a half a point decline per quarter.

What this is based on is increasing capacities in our system, global mix shift, a higher concentration of disks.

Our goal has been, and the challenge we give to the company, is find ways to add value by introducing new software products, which will, in fact, counterbalance that.

We have been successful on that path in the past and hopefully will be in the future.

But I think the more conservative model is trending down about a half a point per quarter.

Okay.

Thanks.

Next we have a question from Glenn Hanus with Needham & Company.

Yes, nice quarter.

Maybe you mentioned in your introduction, you talked about service investments and we've noted the service margin has been declining a little bit each of the last couple of quarters sequentially.

Can you explain the recent decline and what should we think about in terms of service margins going forward and what investments are you making and when should we kind of see some benefit from those?

Thank you.

Glen, this is Dan.

If you recall two quarters ago we peaked at 32%.

Right.

The explanation I gave then is it got high because we blew it.

We didn't hire enough people fast enough.

We plan to reinvest service infrastructure primarily in the form of professional services people.

The expectation you should have is somewhere in the mid to upper 20s in terms of service gross margins.

This quarter was a little lower than that.

You're going to see plus or minus 3 or 4 point swing around 26%.

I think this quarter we would be at the low end of that range.

It's too hard to predict exactly what it's going to be quarter after quarter.

We intend to aggressively build out a professional services organization.

We're going to back they will up with third parties and partners to compliment our own capabilities where necessary, and we are going to sell services to th customers that ask for them.

And you know, the gross margin to me is the dependent variable.

I'm not trying to manage, so it's going to swing wherever it's got to go based on building up the capacity and so on.

It's not what I would recommend you focus on.

Service right now is 10% of revenue and that gross margin swing is no particularly material a corporate sum.

Okay.

And could you venture a guess maybe sort of by the end of next fiscal year will services grow to a percentage of revenue to something like 15%.

Is that a decent number?

I don't think so.

I think it's more like 11 or 12.

If we're executing the way we'd like to, the product revenues and service revenues will grow roughly proportionately.

I think that's the way we ought to model it out, maybe 12% on the mix as opposed to a 10 but not a wild mix shift.

Okay.

Thank you.

Next we have a question from Laura Conigliaro with Goldman Sachs.

Please go ahead.

I have one question and then a clarification.

As far as a question is concerned, I guess I'm a little confused about the targets or the guidance for example, that you gave for next quarter considering how strong things seem to be, even though I know you did say it's a typically challenging quarter with territory and coverage changes and sales kickoff and all that.

If you take the extra week out of the quarter, I guess by my calculations, I get something like negative to slightly negative to flat growth.

And I'm wondering whether that really is kind of the new mantra for a first fiscal quarter, given kind of the normal seasonality, so that next year when you have the same number of weeks, we really should be thinking more in terms of flat to down for a July quarter.

And since you didn't mention the macroenvironment, it does sound like maybe that's a more typical pattern.

That's the first thing.

The second thing is I really would like clarification on your target growth margins for services, because at least I thought that you had been talking about target growth margins for services being in the lower 40s.

At least I thought I heard something a little bit different just now.

Well, since we just answered the service question, Laura, let me reiterate it.

I don't know where the 40 number came from, I said consistently as we penetrate enterprise customer they are demanding from us more services and we need to build that up to deliver.

I view the service model as an investment mode at the moment until we build sufficient capacity, primarily in the form of people, to give customers the support they are looking for.

Maybe long-term, three to five years out, you can expect service model with 40% gross margins.

In the near term I'm going to aggressively reinvest.

Throughout this fiscal year 2004, I would encourage model 26% range plus or minus a few fluctuation points per quarter.

We are going to just try to plow that right back in.

On the other question, the 14 weeks, let me start from the top.

First of all, our bookings traditionally drop from Q4 to Q1.

We see that every year.

Generally what happens, see, the revenues stay fairly flat but bookings always decline.

During the final push in the Q4 period, there's a lot of incentives going for sales reps to book everything in the funnel that they can.

That obviously leaves you in a position where the funnel has much less capacity in it starting the beginning of the next year.

That's also the period where we take two weeks out of the productivity period, the sales kickoff and sales club, as we mentioned, and it's also the time of year when we implement new sales programs and new territories and so on.

You add all that together, and you always get annually a down quarter in Q1 from a bookings perspective offset by a surge in the backlog in Q4 that spills over into Q1 and kind of linearizes the revenues.

We're shipping in Q1 a lot of what we booked in Q4, and that happens every year.

I expect this year will be very similar, independent of the 14 weeks.

We're going to, I think, see bookings go down quarter over quarter.

And therefore we gave you guidance we feel is appropriate on the revenue line.

I should point out this quarter bookings exceeded revenue by a significant amount and next quarter they are going to be very close to one to one.

We expect the bookings to come down.

Can I just follow up, Dan, does that imply, though, in a normal comparative week's period that we would be really looking at a more flat to down Q1 going forward.

You mean in the subsequent year, following year?

In revenues, yes.

No.

Because of the backlog carry over.

There's not a direct correlation between bookings and revenue.

They are linked as a function of time integral, but not in a given period.

So you see a surge in bookings in Q4 followed by a shipment of that converted to revenue to Q1.

So what we're talking about is bookings performance, not necessarily revenue performance in that little discussion I just had.

Okay.

I guess what I don't understand but I'll take it up off line is the whole issue of the extra week and why that doesn't add something, but we'll discuss it off line.

Next we have a question from Sabrina Ricci with Deutsche Banc.

Please go ahead with your question.

Hi, thank you.

My question relates to the new product that you mentioned, the FAS 250.

I assume these in line with the FAS 87 in terms -- the F87, that same product line.

I just want to find out, first of all, what's the competitive environment in that work group NAS arena.

And secondly how do you plan to sale this product?

Will be still be a direct sale, are you planning to leverage the channel?

How do you reach those small work group environments?

Thanks.

The FAS 250 is a significant departure from the F85, F87 design point, which those are basically specialized chassis using different drives and so on.

The FAS 250 is essentially an integrated filing processor into the disk shelf that we use as part of our high end systems.

Consequently the customer can usually upgrade from the 250 to the rest of the product line.

That's something he could not do with the F85 and F87.

This is truly an enterprise class filer, all the full data features are set of data on tap.

Going forward it will be the first of a family for the what we consider distributed price environment.

We're not really trying to target small and medium enterprise at this point.

It's still largely a product to sell to current channels, which our direct sales force system integrators such as Accenture I mentioned, Data Link Foresight.

In the near term certainly we expect it to flow through those channels.

As indicated, it's the start of a family of products we would expect to see that basic packaging strategy propagated through several iterations of product enhancements over the next few years.

And more specific on what the product contains will be more forthcoming when we actually make the formal announcement.

Thanks.

Does this mean you'll also still be selling 87 at a separate offering?

Absolutely.

The F87 is part of the product line and a number of customers that have a strong preference for it.

Great.

Thank you.

Next we have a question from Chris Russ with Wachovia Securities.

Please go ahead with your question.

Yeah, good afternoon.

About a year ago you introduced the direct access file system technology which is designed to allow NAS filers to support more mission critical transactions like database transactions, for instance.

Where does that stand currently?

Are you seeing much demand for your DAS enable solutions?

When we first started on the path of DAS, it was to have a data process architecture.

The concept behind it was to do memory mapped IO between storage system and application environment.

Obviously it didn't come about so we didn't see clusters we expected to see emerge in the industry.

It's still a piece of our product offering.

I wouldn't characterize it as being the only solution for mission critical database.

In fact, it really is an a performance enhancement because it reduces the overhead of the data transfer.

The overall reliability, integrity, data transaction are the same between NAS, SAN, and DAS.

This is just a reduced overhead version.

It contributed in the quarter.

We're still selling it.

It's a software feature.

But you see it wrapped into that software protocol number to the tune of probably about a million dollars.

Okay.

Thanks very much.

And our next question comes from Andrew McCullough with Credit Suisse First Boston.

Please go ahead with your question.

Thanks, guys.

Just two quick questions.

First on the international business how much benefit did you see from currency on the first quarter?

Are you comfortable with stain ability of DSO and inventory turn levels?

Thanks.

You're going to have to repeat the second part of your question.

But as far as the currency impact, the sequential growth rate was up about half a percentage point due to currency and revenue.

And the impact on operating profit was far less.

Then just on the balance sheet, do you see these DSO and inventory turn levels being sustainable?

Yeah.

Dan alluded to it earlier, there's some expectation we're going to see better linearity.

I think our inventory turns will stay about the same level.

Thanks.

And next we have a question from Shebly Seyrafi with A.G. Edwards.

Go ahead with your question.

Thanks very much.

Congratulations on the filer growth, 8% sequentially.

My question has to do with guidance in the context of products and geos if you take your guidance you'll be up 12% sequentially, 1/13, you'll be down 6 million sequentially apples to apples, that's down around 3% sequentially and I'm trying to figure out why.

You did very well in the filers but I'm getting your European business being down around 15% sequentially and your caching down 21% sequentially.

Should we expect that trend to persist going forward, and should we also expect filer strength to continue.

Thank you.

This is Dan.

I don't know how you did all that math, but I can tell you that's not the way I'm thinking about running the business.

I'm not sure what trajectory you're on.

I mentioned last quarter I was going to get to the question what's wrong with Europe.

I think that's the form we got it in.

We predicted Europe would be down.

They are in Q4, surge in Q3, come back in Q1.

Whatever interpolations you're trying to make about extrapolations I'm not sure how you got there.

I think you asked what Laura asked why is your run rate on 14 weeks.

The answer is bookings have nothing to do with revenue and that kind of correlation.

We're just not trying to manage the business for the week, but for the quarter, this has 14 weeks in this quarter.

We lose all those productive days for the sales organization in club and kickoff, the pipeline is less full, we end in July, we've given you all these reasons, but guess what?

It doesn't make any difference you're going to see 2 to 5% quarter on quarter growth in revenues.

We don't give you bookings information.

I don't know how you're doing your forecasting model without bookings.

I believe in the last fiscal model Europe was up 8% to 30% of revenues to 29% that grew sequentially.

That was actually a carryover from Q1.

It was largely driven by deals in the backlog plus one big deal from Deutsche Telecom, for $10 million in cash.

That's exactly what it was and we were very forthright about that.

Thank you.

Our next question comes from Bill Shope with JP Morgan.

Please go ahead with your question.

A quick question on channel opportunities.

You commented Dell cut up some opportunities in the channel.

Could you elaborate are you seeing any specific channel, partners coming up as as a result of EMC and Dell's tighter partnership.

This is Tom.

I would say a couple of things our channel opportunities overseas has really blossomed that's because we've been at it a long time.

I've been told by many of our biggest partners, we're the only thing making money for them.

A lot of the alternatives like EMC is too expensive and they are moving away from that and Dell is a competitor to them.

We're seeing a lot more emphasis on our products at the CEO level of many resells.

We're one of the companies also that are give them margin because we have a good structure.

They are making money on the products.

Domestically the overall success, we're proud of two for NetApp, our strategic account program has really blossomed into enormous wins, channel, that's where we focused in North America.

I think -- I can't tell you exactly why but I think it's a combination of you don't make money selling other people's products.

I think EMC with Dell in the face of the resellers is a difficult thing for the resellers.

Number three with the product we deliver, they can provide clear solutions to their customers top to bottom and make a good margin.

So we are seeing reinvestment at our resellers.

The other significant thing I would say, a year and a half ago we had to kind of push on people that wanted to talk to NetApp, a major partner, reseller, distributor, anywhere now, we don't push on them.

The conversation is very straightforward, people want to sell our products.

We're in an organized manner expanding our distribution.

I think it's going great.

One question on the new 250 product.

What type of margin profile does it have relative to the other products.

It's consistent with low end, F85, F87, it's all blended together.

No material difference really from the high end.

The interesting thing about our configurations is that the larger systems often have lower gross margin than smaller system because of the volume of disk they carry with them.

We have three components to the margin analysis, the core system, the processor and its associated software, the disk attached to it and the software that gets added onto it.

If you blend those together across any point in the product line, what you find is aggregate gross margin is pretty similar.

Okay.

Great.

Thank .

Our next question comes from Kevin Hunt with Thomas Weisel Partners.

Please go ahead with your question.

Yes, thanks.

I want to just clarify a little bit on the share buyback.

I don't remember you guys having done one in the past, but maybe you did.

If you did, can you clarify on how big that was, what you might have -- how long you took to do that?

And if you didn't do one, maybe any color you can give on plans going forward on the authorization you just did, if you're looking to be in the market soon.

If not, maybe why the timing of doing that right now?

One other thing you mentioned booked to bill above 1, was that above 1.1 or how above 1, I guess?

We've never done a share buyback in the past.

Steve, do you want to comment on how you intend to execute ?

Yeah.

I think the share buyback reflects the confidence we have in our ability to generate cash going forward, one.

Secondly, you know, we're not trying to time the market or anything.

We're going to proportion this out pretty much over the balance of the year, see how it goes.

Frankly our hidden intent here, if there is such a thing, is to really try and offset the dilution associated with the option program we have.

And the book to bill is better than one to one, no, I'm not going to clarify any further.

Okay.

Thanks.

Our next question comes from Joel Waggenfeld with Banc of America Securities.

Please go ahead with your question.

Thanks.

I was wondering if you could give detail around gross margin impact I think you said products management on the products side.

Was that more or less than what you anticipated and what's going to be going forward.

Can you comment on your plans for issuing options going forward relative to historical levels?

So as far as the gross margin is concerned the manufacturing performance came in just slightly better.

Kudos to the team for managing the overhead spending and the cost of the materials.

Probably it's minimal, probably a couple of points of 1/10 % contribution there.

The option going forward, I would look for a continuation of the program we had in the past, roughly 2 to 3% dilution level.

We have reduced from prior years the percent dilution granted.

You know, if you look at the proxy request, the question is in the 4.9% per year range.

We do not intend to make our request to shareholders this year to increase the pool size.

In fact, our consumption of shares granted from that pool this year I think will be under 3% for the first time in several years.

Thanks very much.

Next we have a follow-up question from Harley Blount of Lehman Brothers.

Please go ahead with your question.

Thanks.

Dan, one question I've asked in the past, would love to get more feedback on is competitive engagements and any changes in trends you've seen this quarter or over the last several quarters?

Not particularly.

In terms of frequency by vendor, if anything EMC moved up even more in the mix.

It varies a little bit by geography.

We see Hewlett Packard more frequently in Europe with some vendors.

Within vendor we saw mixed shift, in the EMC product line we saw I guess the new DMX, is that the name of the new Clarion family more frequently.

I didn't see any material shifts anywhere nor do I see a win rate.

If anything we saw stronger win rates against some other competitors I have not mentioned.

They seem to be weakening.

I think it's getting down to really the three or four market leaders now battling it out head to head and service vendors kind of retreating.

You see consistently in the mix EMC, Hewlett-Packard, Compaq, Hitachi to some degree and Network Appliance.

It seems to be fairly consistently that way.

Let me make a comment, something that isn't coming through in this call.

We definitely feel like we're winning.

We finished a sales kickoff, it's clear to our team on a global basis we're involved in bigger engagements, customer recognize NetApp as a major player, certainly true not even a year ago.

We don't have blocks to sell to people anymore.

They all need to do something different, in most cases they need to save money.

As a sales team I don't think we see the enthusiasm we've seen now for two years.

It has to do not that people's budgets are growing, they know the other alternatives and they don't think they are as good as ours.

Our message is getting our more consistently and broadly, we're engaged in a broader set of opportunities.

I thought the numbers would indicate that but I wasn't sure from the questions it is.

We are definitely beating the competition at a regular rate on bigger deals than we ever had before.

And just two other quick clarifications, you briefly mentioned Fed was up sequentially that fluctuated significantly the last few quarters.

Could you give us a little better sense of magnitude on that.

You also briefly commented strategic accounts continues to perform well but you haven't touched on that quite as much as you have in past calls.

First of all the federal business, to recap what happened in Q2, Q3, Q4, our quarter ended October fiscal year, so we saw a surge there.

In fact I think that was our largest single vertical at over 10%, even larger than financial services.

It dropped dramatically last quarter in the mix, it was a result of the continuing resolution with the Federal government we didn't have a budget during Q3, consequently no orders placed except for the Intel community, so we dropped down by a significant amount.

Our shipment to the Federal government that quarter dropped 50% quarter over quarter.

They bounced back this quarter.

The pent up demand that resulted from the continuing resolution being resolved by a formal budget put them back close to, you know, their normal range, which was closer to 7, 8%.

So you know, it's back where it should be in the mix.

The strategic accounts continue to do extremely well.

We are very pleased, as Tom said, with the success we've had in that program.

We've actually reduced the number of accounts from 33 to 30, and even in so doing the percent of revenues coming from strategic accounts continues to grow.

And it's well over 25% of our total business.

So I've got to tell you the feedback from the customers is extremely positive.

In fact, this is Tom again.

We've leveraged the success we've had and the number of programs we've rolled out for that set of customers to a broader set we're calling named accounts.

The idea is take our user sales force focus them on sales opportunity but deeper as opposed to geographic territory and really focus on the channel for a broader distribution, which is very enticing to the channel because it's one of the few places they don't see as much channel conflict.

But more importantly, what Dan just said the customers recognize that that improved focus is something they can take advantage of we can do a better job for them, handle them better on a global basis, and a lot of enthusiastic around their side and our side.

We've listened to large customers saying they loved us, loved the product, our sales force was more transactionally focused.

That was the feedback with we got a year, year and a half ago.

We made a concerted effort to change that and I think we've been very successful at it.

Thanks.

Next we have a follow-up question from Glenn Hanus with Needham & Company.

Please go ahead with your question, sir.

Yeah, hi.

I think one of the stories around out, you know, one of the challenges to you guys that's been thrown out there as well, the latest version of Microsoft has key features, SnapShots, replication, key differentiating aspects from you guys sort of in the marketplace, any thoughts on sort of improved functionality coming from the low end there at Microsoft bundled with Dell or whoever?

Some people say Window powered NAS is 75% of the function at 33% of the price.

Other things have been thrown out there.

Kind of comment on that and how you're raising the bar and how you view the threat there.

I think think people say 75 percent of the function and 33% of the price don't look at the data very well.

If you look at IBC reports and NAS market shares, dollars shipped and number of bytes and do the math, you'll find that Dell is about a 10% lower price per megabyte that Network Appliance, not 67%.

If you look at functionality differential I think you'll conclude Windows NAS is still not scalable, it's basically the NT technology.

And yes, they have added a snapshot capability but it is what I would consider to be the least robust method of snapshot.

It's a copy utility is really what it is.

It has no nesting capability and takes 100% overhead on the disk.

It's not at all comparable to what we offer in terms of nested snapshots and the ability to roll back complete file systems and so on.

What they have done, which I think is going to actually facilitate our integration to some environments is to start providing snapshot manager service on applications.

Heretofore we have had to provide services in conjunction with the exchange server or Sequel server to ensure that the application checkpoint was synchronized with the snapshot on the filer.

Now they are going to provide that trigger mechanism which then facilitates synchronized snapshot with application so you can do a rapid rollback.

We think instead of being more competitive what they are actually doing is providing more hooks which we can leverage more effectively to provide better solutions.

A tougher challenge was years ago all the people we mentioned said network NAS storage is not a market we don't want it, don't have it.

Second shift was yes we have it, you don't need it, because nobody tries to sell it except Network Appliance.

Now at least the great things is I walk into calls, we understand NAS storage is a big play and you're a big player.

We're going to buy some.

How do you compete?

That is an enormously better conversation than NetApp than having people say what we do doesn't make sense.

Now, you the market leader, what do you have to offer?

What we have to offer is a system that is very, very -- it's feature rich at the bottom end and price competitive.

It's the same features and scalability that goes all the way to the top end.

From an end user point of view, the ability to say I don't have to make the right choice up front, I can make one choice on size, I don't have to switch families and I can use all the software this company offers top to bottom is a simple way is an enormous benefit.

Typically my experience has been with Microsoft and competitive it's not an appliance, it's not simple, not fast, not scalable.

Regardless what vendor they ship it on compared to NetApp that's true today.

Let me give you one warning to go with that.

If you look at IDC going forward Microsoft and windows powered NAS are apparently gaining market share in the NAS market.

That's because of a reclassification.

If somebody has a Microsoft windows server running file and print service with it installed today it's classified as an NP server.

If it's with Windows NAS it's reclassified as a NAS appliance.

You'll see NAS market showing enormous growth and Microsoft share grow accordingly when it's nothing more than a simple upgrade from NT, OS to Windows powered NAS, exactly the same technology underneath.

Are you guys seeing NS 600 from EMC yet ?

Is that looking better than the 4800 used to ?

That wouldn't be hard, but, no, we haven't seen it.

Thank you very much.

There are no further questions at this time, gentlemen.

Do you have any closing remarks?

Thank you all very much for joining us today and we look forward to seeing you at this time next quarter.

Thank you all.

Ladies and gentlemen, this concludes the Network Appliance fourth quarter and fiscal year end conference call.

If you wish to hear a replay of today's conference, please dial 1-800-405-2236 and use the pass code 534799.

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