NetApp Inc (NTAP) 2004 Q2 法說會逐字稿

Good afternoon and welcome to the Network Appliance second quarter earnings release conference call. At this time, all participants are in a listen-only mode. Following today's presentation instructions will be given for the question-and-answer session. If you need assistance please press star zero. As a reminder this conference is being recorded today, Tuesday, November 18, 2003. I would now like to turn the conference over to Dan Warmenhoven, Chief Executive Officer, please go ahead, sir.

Thank you. Good afternoon and welcome to the Network Appliance earnings release conference call for the second quarter of fiscal year 2004. This is Dan Warmenhoven, and 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 and will be available for replay on the website at www.netapp.com. With me today are Tom Mendoza, President of Network Appliance; and Steve Gomo, our Senior Vice President of Finance and Chief Financial Officer. In the course of today's conference call we may make forward-looking statements and projections that involve risks and uncertainties. Actual results may differ materially from our statements or projections.

Factors that could cause actual results to differ from our projections include, but are not limited to customer demand for product 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 accessible through our website. All of which factors are incorporated by reference into today's discussion. At this point I'd like to turn the call over to Steve who will review the financial portion of the press release we issued earlier today. Following Steve's comments I will share my own comments on events during the quarter. And then we'll move to a financial outlook and conclude with a question-and-answer period. I'd like to introduce Steve Gomo.

Thanks, Dan and good afternoon everyone. Our press release today is available on the Business Wire, and our website. I'd now like to provide some commentary about our results for the second quarter of fiscal year 2004. Once again, this quarter we experienced very strong revenue growth. As indicated in the press release, revenue for the quarter was $275.6 million, up 28% year-over-year from the second quarter of last year. Revenues increased 6% sequentially from the $260.5 million reported in the first quarter, resulting in our 8th consecutive quarter of sequential growth. Revenue from services which includes hardware support, professional services, and educational services, was about 9.4% of total revenue, about the same as the 9.5% we reported in quarter 1.

North America contributed approximately 59% of total revenue, up slightly from the 58% reported in Q1. Europe had a strong quarter and contributed 29% of total revenue, up from the 26% reported in the prior quarter. Asia-Pacific contributed approximately 12%, down from the 16% reported in Q1. Software as a percentage of total revenue, was approximately 29%, about two percentage points higher than last quarter. Add-on software products were approximately 19% of total revenue, and software subscription upgrades were approximately 10% of revenue. Pro forma gross margin for the quarter was 60.4%, just slightly report below that reported last quarter.

Pro forma gross margin for products strengthened buy 700 basis points from last quarter, and was slightly higher than the average of the last three-quarters. Service margins finished at 13.9% for the quarter, that's as a percent of service revenue and that's a decline of 7.8 percentage points. This decline translates to about $2 million unfavorable impact in Q2. Of the $2 million, about $500,000 reflects the continuation of our investment in our service organization. These investments include additional professional support engineers, increased support center activities, and global partnership programs. About $1 million reflects an increase in stocking of parts associated with new products and components, as well as, an increase in the related logistics costs to move these parts out to the depots. The remainder comes from several minor operating variances in the service organization.

Pro forma operating expenses totaled $126.4 million increasing $3.2 million from the $123.2 million reported last quarter. Expressed as a percent of revenue, operating expenses were reduced to 45.9%, an improvement of 1.4 percentage points from the first quarter. This is the fourth consecutive quarter of improvement in the pro forma operating expense structure, even as we continue to make collective strategic investments across the company which will benefit us over the long run. Pro forma operating profit benefited directly from improved -- from the improvement in operating leverage and finished the quarter at 14.5%, an increase of 1.3 percentage points from last quarter. This marks the fourth consecutive quarter of improvement in this area. Other income was $1.6 million, down from the $3.0 million we reported in Q1.

The decrease is primarily the result of a transaction related to currency hedging that is not expected to reoccur next quarter. Pro forma pre-tax income for the quarter was $41.6 million, or 15.1% of revenue, up 8/10ths of a percentage point from the prior quarter. The effective pro forma tax rate for the quarter was 19.2%. During the quarter, we received a favorable tax ruling in the Netherlands, that dates back to FY2001. This ruling provides for retroactive benefits dating back to FY2001, as well as, future tax rate benefits. Our pro forma results include only the benefit associated with the current fiscal year. As our GAAP results show we will also receive a substantial tax refund that relates to prior years. Going forward, we expect our pro forma tax rate to be 21%.

Pro forma net income for the quarter was $33.6 million, or 12.2% of revenue, up 1.2 percentage points from the prior quarter. Pro forma net earnings per share was 9 cents based on a weighted average of approximately 365 million shares outstanding. Pro forma EPS would have been 9 cents, even without the benefit of the favorable tax rate change. This quarter we reported a GAAP net income of $48.4 million, or 13 cents per share. We have provided a reconciliation between pro forma and GAAP net income in the consolidated -- in the condensed consolidated statement of income of our press release, and it's also available on the investor relations section of our website at investors.NetApp.com. Turning attention to the balance sheet, cash and investments at the end of the quarter were $722 million, up $72 million from the previous quarter.

Capital purchases of plant, property, and equipment were $9.7 million during the quarter, while depreciation was $13.5 million. Two quarters ago, we announced the stock repurchase program under which up to $150 million of outstanding common stock may be repurchased. We repurchased approximately 491,000 shares of outstanding common stock during the quarter, at an average price of $20.44, for a total of $10 million. Day sales outstanding of accounts receivable were 53 days, down from 54 reported last quarter. We have focussed our attention to improve our performance in this area, and while we still have a ways to go, we're pleased with the progress that we're making. Inventory turns for the second quarter were 12.1, up from the 10.6 in the prior quarter.

The deferred revenue balance is $209.1 million, up $19.8 million or 10.5% quarter-over-quarter, and up 60% from the $130.2 million reported a year ago. Head count at the end of the quarter was 2,430 employees.

In closing, this quarter was very representative of the progress that we're making on many fronts. Revenue growth was very strong, which has allowed us to make selective strategic investments, particularly in our service organization. We continue significant progress towards our target business model as gross margins remained at expected levels, operating expenses declined as a percent of revenue, operating leverage improved for the fourth quarter the in a row, and our cash balance reach an all-time record high. I'm extremely pleased with these results. At this point I'd like to turn the call back over to Dan.

Thank you, Steve. I'm also very pleased with the strong performance during the quarter which represents our 6th consecutive quarter of accelerating year-over-year growth. We achieved a significant milestone this quarter with regard to capacity, shipping 11 1/2 petabytes of storage. This is the first time we've shipped more than 10 petabytes of storage in a single quarter. We also received a couple awards during the quarter, the FAS 250 was named as the best product in the online hardware and management software category, this is the second year that NetApp has been honored with FAS 900, winning the special award for innovation in 2002. The NetApp FAS 900 series was granted the innovative technology award for 2003 in the storage category, by IDG's Computer World, one of the leading IT magazines in the world; and this award is the latest accolade in a series of successes Network Appliance has achieved for the FAS 900 series.

We announced a number of new products during the quarter, the newly announced FAS 270 and FAS 270C are the newest members of the FAS 200 series, and are designed for unified mass, iSCSI and/or fiber channel SAN environments providing enterprise class reliability, availability, scalability, and powerful performance; with a very attractive price starting under $10,000. We extended our support for fiber channel, including Linux, HPUX, and AIX servers and complementing perviously SAN support for Sun Solaris and Microsoft Windows. This support broadens the NetApp SAN footprint giving customers even more flexibility and choice on how to deploy NetApp FAS systems throughout their enterprise infrastructures. We announced that our SnapLock compliance regulated data solution is now available on NetApp FAS servers, in addition to the near store platform; and introduced SnapLock Enterprise a new version of our SnapLock software.

SnapLock Enterprise is designed to protect important information that must remain unchanged for long periods of time, and is specifically intended for use with non-regulated data such as seismic surveys, automobile collision reports, or customer records that should not be changed, but do not need to meet government regulatory guidelines. We also announced SnapManager 3.0 for Microsoft Exchange, which supports Microsoft Exchange Server 2003 and Exchange 2000. SnapManager 3.0 for Microsoft Exchange is a comprehensive data management solution for hosting and automating backup and restoration of Microsoft Exchange-based storage groups. And enables near instantaneous hot backups and near online restores; delivering a high level of reliability, availability, and scalability at a low cost of ownership. SnapManager is integrated with Microsoft Multipath IO, also known as MPIO for resiliency and fiber channel SAN environments when deployed with NetApp clustered storage, and is also integrated with Microsoft's volume shadow copy service or VSS.

Microsoft VSS provides a standard way to integrate Exchange 2003 backup and recovery functionality, with NetApp data management software, including SnapShot and SnapRestore. Integrating NetApp's simplicity into Microsoft's new data management interfaces enables us to provide our customers with an industry leading standard space storage solution for Microsoft application servers. Significant customers during the quarter include Apache Corporation, an oil and gas exploration and development company, DHL International, National Instrument, the National Oceanographic and Atmospheric Administration's National Weather Service, RR Donnelly, Xceed, Xerox and Yahoo! Japan. NetApp was also chosen by Magellan Health for a multi-terabyte windows file server consolidation project involving NetApp FAS 900 series storage systems.

In addition, Magellan also chose to employ Near Store for a back up initiative in their corporate data center. Network Appliance was chosen because we were able to demonstrate the simplicity and ease of use of our windows server consolidation solutions. For backup, the importance of integrated SnapShot, the condition of SnapMirror for remote replication offered key functionality benefits for Magellan, and provided a path for future open storage development. The U.S. Department of State chose NetApp filers and open system SnapVault for distributed deployment supporting Microsoft Exchange at 29 U.S. embassies and consolates across Europe.

SAN customers during the quarter included the Antwerp Port Authority, Bacardi, Constellation Energy, Edgemont IT, and English-Welsh-Scottish Railway. Network Appliance demonstrated a joint ISCSI interoperability solution at the SAP Microsoft Congress 2003. The completely integrated data management solution for SAP and windows environments included NetApp SnapManager for Microsoft SQL Server. The software streamlines database storage management and delivers the highest levels of availability, scalability, reliability for my SAP environments, an extremely high return on investment. Coupled with NetApp storage systems, the solution offers comprehensive data management for hosting and automating, backup and restore.

1-800-Contacts, the world's largest contact lens store, has deployed a NetApp iSCSI SAN solution to simplify it's network storage, lower it's storage TCO and implement a disaster recovery and business continuous solution. By leveraging its existing gigabit ethernet network and integrating a NetApp iSCSI SAN storage solution, 1-800-Contacts was also able to more efficiently store and manage the large amounts of data generated from processing as many as 10,000 orders a day by more than 300 call center agents and 90 shipping agents; using Microsoft SQL server-based applications to meet the company's high standards response time. Customer acceptance of iSCSI target licenses for NetApp filers continues to be outstanding, and over 50% of the FAS 250 units in the field that report usage statistics back to us have enabled the iSCSI protocol.

These customers are clearly moving iSCSI into production environments, and we are leading the market in making this new technology available to enterprise customers. Near Store had another great quarter accounting for 11% of revenue, orders were even stronger than revenue and shipments are off to a great start this quarter. Significant Near Store customers included The College Board, Bronson Healthcare Group based in Michigan, and they chose the regulatory compliance storage solution. Bronson's solution consists of NetApp SnapLock software, a NetApp Near Store system and F800 series system, all of which are being deployed to help the community owned healthcare system address HIPAA legislation regarding the secure electric transfer of healthcare information.

Regarding the conference call announcing our acquisition of Spinnaker a few weeks ago. We discussed our plans to architect a tiered storage model that becomes the facilitator for information life cycle management or ILM. As companies strive to optimize the class of storage for their data objects, the applications needed to make that happen depend critically on meta data for each object exposed within the file system, and a set of open API's and interfaces which enable transparent migration of their data between storage devices. NetApp is unique in that we provide a common file system and simple management API's across all of our storage platforms, which enables easy integration with the major enterprise content management or ECM applications. Our architecture enables customers to select best in class CCM applications for their data center environments, knowing they're not locked into a particular solution.

In support of this approach we announced a number of partnerships and customer deployments during the quarter. Certified and tested applications from NetApp partners enable customer organizations to safely comply with the growing number of regulations requiring the retention and management of e-mail information, database data, and other corporate records. Such regulations include SEC rule 17A-4 for securities broker and dealers, the U.S. Department of Defense 5015.2STD, HIPAA for healthcare companies, Sarbanes-Oxley and 21 CFR part 11 for pharmaceutical companies.

Application partners that are currently shipping solutions that support SnapLock compliance, include COIA Technologies, Documentum, Educom TS, Inc., Enigma Data Systems, Filenet, KBS, Princeton Softech, Ilumen, Axis One, and Legato. Application partners committed to supporting SnapLock compliance include Filetech, Tower Technology, Comval Systems, Opentech, LaserFiche Document and Imaging, and Optika; essentially the complete list of players in the industry. NetApp, KVS, MDY Advanced Technologies, and Decru announced a joint solution to achieve US Department of Defense 5015.2STD certification for electronic records management applications.

KVS has integrated it's enterprise bulk e-mail archiving software with NetApp's enterprise storage solutions, MDY file surf records management software, and Decru data fort stored security appliances. The DOD 5015.2STD certification is a records management application with extremely rigorous requirements for systematic control of the creation, classification, maintenance, use, reproduction and deletion of records. By meeting these requirements, this joint solution delivers a highly secure records management solution that enables government and business users to better manage information storage; while meeting the US Department of Defense's strict data protection and shredding regulations, designed to increase national security and minimize legal and intelligence risks.

In summary, this was another great quarter for Network Appliance. We announced or acquisition of Spinnaker Networks and unveiled our vision for the storage grid and information life cycle management. We continued to expand our enterprise customer base, and made great progress in expanding our partnerships to enable open ILM. Our business continues to be healthy, and our business model is back on track. Before I turn the call back over to Steve for the guidance, I'd like to invite everyone to join our analyst day on December 3 in Santa Clara. If you need registration information, please contact Billy in our investor relations department. Now I'd like to turn the call back over to Steve for guidance.

Thanks, Dan. I'll now comment on our business outlook. This outlook is based on our current business expectations, and reflects our pro forma presentation. Again, I'll remind you that we're making forward-looking statements and projections that involve risks and uncertainties. Actual results may differ materially from our statements or projections.

We expect our momentum in the marketplace to continue. And project third quarter revenue to grow sequentially by 3 to 7%. This projection reflects year-over-year growth rates of 24 to 29%. We expect net income to grow, with Q3 pro forma earnings of 10 cents to 11 cents per share, depending on the revenue levels that are achieved. Dan, I'll turn the call back over to you.

Thank you, it concludes our remarks for today, so at this point I'd like to open the conference call for questions. I'd like to ask you limit yourself to one question each so we can address everyone in a timely manner and keep the call to an hour. Thank you.

Thank you, sir. Ladies and gentlemen, at this time we'll begin the question-and-answer session. If you have a question, please press the star followed by the 1 on your push button phone. If you would like to decline from the polling process, press the star followed by the 2. If you are using speaker equipment, you will need to lift the handset before pressing the numbers. One moment, please, for the first question. Our first question comes from Robert Montague with RBC Capital Markets. Please go ahead.

Good afternoon. Thank you. I wonder if you could provide a little more color on the one-time aspects of the service investment parts and head count, and just where you see that trend going in a go-forward quarterly basis; and also any comment you can make on your hedging experience in the quarter and what you see for this quarter as well. Thank you.

Thank you, Steve Gomo here. As I mentioned during the quarter we continue to invest fairly significantly in our service organization; and particularly in the areas of professional service support engineers, increased support center activities, and global partnership programs. I would expect to see that trend continue and, in fact, there may be a slight pickup even in the rate at which we're investing in our professional support engineers. We may add a few more heads next quarter than this quarter. I would also expect to see as we go forward some continuation of the stocking, the part stocking that we incurred as we have had a relatively large number of new products and new components for existing products that have to be stocked into the depots. A lot of that occurred last quarter, but some of that will continue going forward. So looking forward, I would not expect to see a very material different performance in our service margin.

This is Dan. Just as a comment, many companies choose to keep the service spares on the balance sheet as an asset. We fully expense everything we put in the depots at the time it leaves our facility. That's probably the most conservative possible treatment you could have, but that does show then periodic fluctuations as a result of new products or other consumption. The other question was?

Similar question on the hedging.

The hedging was a one-time event. We overhedged the balance sheet position, it was a balance sheet hedge, we overhedged it in the second month of the quarter. That should not happen again going forward.

Okay.

Our next question comes from Harry Blount with Lehman Brothers. Please go ahead.

Thanks, hi guys. Similar type of questioning on the gross margin side of the equation. You also experienced a significant improvement in the product gross margins. I wanted to understand what happened in the quarter and how we should think about that on a go-forward basis.

Hi, Harry, Steve here. Couple of things to think about here. I think first you saw the software, the add-on software, pick up a little bit this quarter, about two percentage points from last quarter, that is significant and did help move the needle. In addition we've had a very strong program managed by the the field to manage our discounts, and keep our discounts in equilibrium, if you will. That program has done extremely well during the first half of the year, that was a big part of the results you see.

In terms of what we should expect going forward, should we continue to expect this type of product margin performance on a go-forward basis?

Yeah. I would probably, in my conservative nature, back off a little bit from what you saw. Dan has a smile on his face over here, but I would encourage you to think about it down maybe a little bit; but we still plan to keep it above the 60% mark.

And just to clarify further, in terms of how's the channel mix going to impact the distribution mix going to impact that?

It depends on how successful we are in the channel and how fast that success occurs. But to the extent that the channel were to exceed our expectations clearly that would have an unfavorable effect on our gross margin, a favorable effect on our operating expense structure, and should leave our operating profit in a neutral position relative to our business model.

Great, thanks.

Our next question comes from Glenn Hanus with Needham & Company. Please go ahead.

Hi guys. Maybe January quarter sometimes a little dicey for you, maybe talk about the kind of linearity expectations for the January quarter and comment generally on what you're seeing sort of IT budgeting-wise, and the environment, and people's willingness to start to deploy some resources in your area a little bit more?

Glenn, we're waiting with anxious anticipation, as I'm sure you are as well as. We're not quite sure what to expect. Normal seasonality would be that we see a better than linear performance through December and then a very soft January. January is characterized by a lot of customers that don't have their budgets finalized yet, and aren't ready to make capital purchase commitments. We actually put a big full-court press on the field to get most of the bookings in before the end of the calendar year, and to take advantage of whatever year-end budget flush is there.

One of the by-products that I should point out, is because more of our customers seem to have their fiscal and calendar years aligned in Europe, this is the time of year we normally see Europe surge in terms of revenue mix. I would expect that to occur this time as well. Of course we'll set ourselves up for the question in Q4 as to why is Europe soft. We go through this every year. We don't know what to expect. We're not getting any real signs of year-end budget flush, we are getting indications that next year's butts will increase capital spending particularly on storage. We are getting commentary from our customers that feel as though that they are in need of a refresh cycle, and whatever excess capacity they did have is now fully consumed.

I think our momentum is, you know, really strong in those accounts, and that we're pretty optimistic. But you know, it may not all come home in January. Part of the issue is a lot of corporations don't get final budgets approved and release the funds during calendar January. So we'll have to see how it plays out this time. Tom, do you want to add some more?

I would say that last quarter, I would think was one of the best Q2's we've ever had from the following point of view from a global performance, we have momentum everywhere in the word, very, very clear. All three geos are feeling a large increase in moment full, specifically high in their enterprise-type accounts. I would say a year ago we were just starting to get the enterprise in Asia, we're definitely getting it now. As we enter this quarter, I think the sales teams are feeling -- by the way, last quarter was probably was one of our -- last two quarters have been very linear for us. Our sales teams are optimistic.

One of the things that does work our way is that at the December, the quarter closed for all our competitors, most of them, so everyone gets in a buying mood and then they go home and take the month off and we work hard in January. I understand what Dan's saying, it's much harder to get the money in January, we're probably the only guys asking for it, too. At the end of our quarter, our guys know it. We've done well in this quarter historically. The one time this quarter really fell off for everybody was 2001 where everyone's budget just stopped, and we didn't see that coming.

Right now, I think my experience has been that people are much more comfortable in their spending patterns, down from where they used to be but they don't sit there and discuss it and mull it over for four or five months. I would expect when we start the year people will get back to business fairly quickly this time.

Thank you.

Our next question comes from Laura Gieman with Robert W. Baird & Co. Please go ahead.

I was wondering if you could talk about when and if, I guess, you expect to use serial ATA in Near Store, and then sort of related to that, do you think that customers have been waiting for serial A to become available before purchasing Near Store-type products?

I don't think they're going to wait. In fact customers are very happy with the Near Store that they have. In fact as Steve mentioned we saw near the end of the quarter, a real uptick in the bookings and that should reflect itself in terms of product shipments this quarter. Relative to serial ATA, customers aren't waiting for it, we think it offers some advantages from a technology viewpoint, but the customers don't care. As I said, we don't care either, ultimately the low end serial technology, serial ATA, serial SCSI, or just cheap fiber channel, the idea is fat, slow, cheap disk drives and we'll plug in whatever is in the industry. We're not really necessarily hung up and waiting on serial ATA.

Let me make a comment at this time, there's no doubt that the Near-Store product has been the most successful product since I've been here. From a salesperson's point of view, it is pulling us into more high end deals than anything we've ever known. The reason is, I was at the Gartner Group speaking this past year, and they said that last year 50% of the high end accounts said they were going to go disk to disk back up with a year. This year was 50%. We're feeling a tremendous surge toward people looking at data consolidation of all types, How do I consolidate or how much I can consolidate is very much filtered or gated by their confidence in their backup plan and their restore plan.

With Near Store we're finding people consolidating more putting Near-Store in and then using it as a disaster recovery device. And the fact that it's all one file system, so they can manage it simply is getting tremendous mindshare in large companies. So I think if you had to say what's the one thing that's allowing us to surge right now, I think it's the combination of people are moving forward on their data consolidation projects; and in all cases Near Store is -- in some cases it gets them on the front end, they decide to consolidate because of Near Store but in all cases they're adding it.

Thanks.

Our next question comes from Laura Conigliaro with Goldman Sachs. Please go ahead.

Yes, thank you. A couple things. First of all given the drop-off in Asia can you discuss the pattern of demand in the quarter, especially as it relates to Asia, particularly with and without Australia? And also going forward in the January quarter, without the large impact on the federal side, what would you expect the main drivers to be in the quarter?

It's Dan. Just trying to go back through some of the specifics here so I can get the data to answer your question. Asia Pacific in particular normally runs about let's say 10 to 12% of revenue. Last quarter, is when they really had the abnormal quarter and really spiked. I think they went to 16, as I recall.

Right.

And in particular, what we call South Asia was down a little bit from Q1 to Q2. I think that's really driven by some fairly large deals in Q1, like Australian Southern Communications Company, which I think we referenced that call. It was kind of a non-recurring piece of the business. We actually saw a strength in Japan, Japan was up quarter-over-quarter. And a little bit of softness in North Asia but not really material, most of the short fall was in what we call South Asia. What was the other question? What we see going forward in the quarter? I personally think -- pardon me?

The drivers, particularly assuming the absence of federal.

Federal actually wasn't that big this quarter. It was up 10 percent quarter-over-quarter, it's a little bit more than the corporate average, but not a huge driver. It was probably an extra million or so on the revenue line, that's really about it. If they were at the norm, right, at 6%, they would have been $1 million less. So it wasn't that big a huge driver.

I really think that the driver this quarter is going to be Europe. I don't have any particular insight into that, just based on historical patterns. Like I said in my comments a moment ago for some reason, their customer base seems to have much closer alignment in fiscal and calendar, so they see a little bit of end of the year buying surge, particularly see that in Europe, the major manufacturers, automotive companies and so on. I expect that to recur. We'll have to wait and see.

Okay.

Our next question comes from Omar Al-Midani with Soundview. Please go ahead.

Good afternoon. Just a quick follow up here on the gross margins. In Q1, you did get a negative impact about a half a point, I think that was due to a Oracle ERP rollout. Can you just tell us if you saw the reversal of that effect this quarter, adjusting for this, maybe your margins would have been down a half a point? And also usually you provide some color on the impact of Near Store on margins, if you could talk about that as well, please.

This is Steve Gomo. There was no reversal or credit made to cost of sales. What we said last quarter, the quarter had some unfavorable charges in it, in the first quarter. We told you to expect that some of those would go away, that's what we told you to expect the margin to hold where it was. The fact that the gross margin is stronger on the products than we had anticipated, is a reflection, as I mentioned, of the program that we had for discounts, et cetera. The big change, I think, from the first quarter was the service margin. Products margins, I think, were very, very strong and we're very, very pleased with the product margin performance.

On a sequential basis, in order to compare apples to apples, wouldn't you have to adjust for that 50 basis points?

No, you wouldn't.

Okay.

I think that was amortization that kicked in, it wasn't really one time.

It was the amortization from the costs associated with the implementation of the Oracle program, which was a one-time impact then but we have it again in this quarter.

Understood. Thank you.

Our next question comes from Bill Shope with JP Morgan. Please go ahead.

A few quick questions. Can you give us an update on the activity you're seeing throughout the Arrow and Avenet partnership and also last quarter you noted that the HDS pipeline was fairly strong. Are you continuing to see momentum with this partnership? Also obviously your discounting efforts, or your reduction in discounting efforts helped the hardware gross margins. Are you seeing any change in the overall pricing environment when you go in front of competitors or really is it just the product gross margin just a sign of your product strength right now?

This is Dan. A lot of the program that Steve referred to was trying to retrain both our sales force and customers in terms of what they should expect. If you recall, there was a fairly significant increase in discount activity during the downturn, and we wanted to get some discipline back into the process; and I think we have done that. Nothing overly dramatic, but enough so that it shows up a little bit in the firming up of gross margins, and a slight decline in the discounts. Arrow and Avenet actually I don't have access at my fingertips to the actual numbers, but they did extremely well in the quarter. I was very pleased by the transition.

If you recall, we consolidated a number of our second tier resellers under Arrow and Avenet, and my recollection is they did somewhere in the range of about 15% of the revenue for the quarter; in aggregate, the two of them. And that exceeded the plan we had for them. So it was an extremely successful transition of our smaller indirect partners under Arrow and Avenet. It was extremely well-executed, I think. They really stepped up and did an excellent job of establishing relationships with the resellers, and executing our new product training to those resellers, which is part of what we're looking for them to do. The HDS relationship is doing fine, it's still early and it's not particularly material. It generated a couple percent of revenue, nothing earth shattering.

Thank you.

Our next question comes from Peter Labe with Nutmeg Securities.

Thanks. Just two questions, one, I know EMC introduced some competitive product, and I infer from your results that they were practically invisible in the market. Is that a fair observation? And secondly, I wondered if iSCSI was developing along the lines you anticipated, better than, not as good as; or what do you see ahead?

Peter, this is Dan. Are you referring to EMC's technology product?

Yes.

We really haven't encountered it honestly. We see every once in a while that product from what do you call it, windhill packagers, right, the PC manufacturers, but it is really not very prevalent in our competitive mix. I don't think we've encountered it yet from EMC. When we see a mass product from EMC, it's typically the Solara or the NF600, the Clarion equivalent. We do extremely well, I should add, against those. I just don't think -- I personally think that the positioning of the Microsoft technology is such a market point that we would generally not compete.

They try to bring those at price points under 5K, IVOhm has upgrades for existing NT servers, a large percentage of those NT servers are doing nothing but file and prints, the natural migration path for them, we don't necessarily compete in those environments. On the iSCSI, it exceeded my expectations. It's been more rapidly deployed, I think, in some of our customers than I expected, 50% of the systems being active, iSCSI, I find a little bit stunning. It's brand new, and until we get a full endorsement from Microsoft, it probably isn't going to take off.

Okay. Thanks a lot.

Our next question comes from Mark Su with C.E. Unterberg Please go ahead.

Thank you. Can you quantify the total number of new customers this quarter or maybe the percentage of revenue from new customers?

No I can't. In fact, you know, we really changed our strategy, we don't have the visibility of the new customers that we had a while back. We have really focused our direct sales organization on expanding our presence in, let's say, the top 200 or so what we consider the premier enterprise accounts. And we have really tried to focus our channel partners on going after, you know, other than our named accounts. So it is really difficult to track new customer penetration at this point, it's not particularly material from the way we're thinking about the business going forward. We think there's far more growth opportunity by selling our products to customers we already have than there is in trying to secure major positions and new accounts.

Got it. As you try to drive deeper into your existing accounts are you finding that the deal sizes may be getting larger?

You know, the question is what do you mean by deal? Because the transaction size stays about the same. What you find is the total size of the opportunity over time is clearly much more significant. But you know, when you look at per-transaction basis, it's one system ordered at a time. So it's really kind of a design-win stage you go through, those are larger, then the deployment stage, it's hard to track how those are connected to each other.

This is Tom, what is clear is that on a global basis, the engagement level we're having with big, big firms or major enterprise is completely different than it was a year ago and probably six months ago. Number 1, our partnership with Oracle is spectacularly good for us. I was the keynote -- I'm going to be a keynote speaker in Japan, Dan was in France, I was in the United States before that. Our sales force is engaging with Oracle very aggressively around the world. I was told in Japan they said the market is now accepting that the way to drop cost around Linux is with Oracle and NetApp that's what's happening in the market.

Secondarily, Veritas, has been enormously helpful in the last couple months. I expect the work that we've been doing together is going to pay big, big dividends in the future. They're a fantastic partner for us. NetApp has got more push now than anytime since I've been here. When we go into major accounts, it's no longer trying to get an appointment with the CIO, your question was are you getting bigger transactions. No one's looking at us for point solutions any longer.

When they engage NetApp, it's to look at the whole realm of data consolidation, data recovery, disaster recovery and how do I get to the extended view of my enterprise and take cost out. That's what's driving our growth. And I would tell you that big, big partners are now helping us in a way it's never happened before.

I had to really always -- almost fainted in Paris when I was there, I heard EMC endorse Nass for database environments after five years of steadfastedly insisting in the market that it would not work, I was blown away. It's that kind of capitulation on the part of some of our competitors, they finally found out this really does work, I think to the kind of result that Tom's talking about. We are in the forefront, we're benefitting from it.

Got it. Sounds good. Thank you and good luck.

Our next question customs from Shelby Seyrafi with Merrill Lynch. Please go ahead.

Yes, thank you very much. Nice quarter, Dan, Steve. Can you give me some metrics like your top verticals, the cash percentage of revenue and your distributor breakout? Thank you.

Yeah, we'll dig up some numbers for you. I do not have the vertical breakdown, although from an application viewpoint, it's really interesting, both database and windows were up, which I would conclude UNIX has to be down, although we didn't break it down separately. The strongest verticals, although I don't have specific numbers for you, the strongest verticals continue to be the -- first of all, tech sector continues to lead the second largest major manufacturers, financial services is also over 15%. Those are kind of the high runners. What was the second question? The cash as a percent of revenue? Was that --

Yes.

Could you repeat the second question?

Cash as a percentage of revenue and your distributor breakout.

Oh, I was thinking like cash on the balance sheet, pardon me. Net cash was about flat with last quarter, right around 6%. In fact, from product mix it looked just like last quarter, virtually flat lined in terms of percentages. The third piece was?

The distributor breakout, OEMs and indirect?

Total direct was 53%, up a little bit. So the total indirect obviously was 47%.

Thank you.

Our next question comes from Kaushik Roy with Susquehanna.

Thank you. What's driving the growth in software, more specifically what's driving growth in the add-on software? What was the book to build?

The book to build was pretty good, I'm not going to tell you what it was. If you look at the deferred revenue component, you can see it grew by $20 million bucks. Show that essentially was all bookings over revenue, right? We've got packed way on the deferred revenue line. The software mix is really driven by the Snap products in general. Excuse me, and is really -- Snap alone has moved up quite nicely in the mix. That is a combination of SnapRestore, SnapMirror, SnapLock, a whole family of them. It really is a reflection of just exactly what Tom said, we rarely sell a Near Store by itself.

We either sell a Near Store as a DR target, and, therefore, it's SnapMirrored or we sell a Near Store for remote backup along with 250s, in which case it carries again SnapMirror license. You sell Near Store for compliance, it's got SnapLock. We sell it, you know, as a back up centralization, so we sell SnapVault or open system SnapVault. It's really that combination. I think it doesn't show in the Near Store product category so much, but it is used in conjunction with all of our other systems quite extensively.

This is Tom. About a year ago we said we have to think more broadly about how we add value in a non-NetApp world. Obviously if people buy all NetApp stuff, we have fantastic solutions. But how do we add more value. SnapVault is a product that allows people to go-- so disk to disk is taken off, but if you have to have a disk to disk strategy with each of your vendors, that kind of kills the whole idea of simplicity. SnapVault is an extraordinarily elegant product that allows you to back up other people's stuff to our Near Store family. What we're finding is a tremendous acceptance in big companies of starting with our 100, SnapVaulting other vendors to our stuff along with NetApp, and it increases our penetration very simply. It's a very nonthreatening way of trying to help solve a very obvious business problem. How do I get away from tape, but I own all this stuff already; and I want to migrate to newer stuff how do I get there? SnapVault is a tremendous product.

Great. If I may ask one more question. So what part of your revenue growth is coming from, say, new markets and what part do you think is coming from gaining marker share from competitors?

I'll let you try to do the analysis. I know I'm growing at 28%, I don't think the market's growing that fast. The last I looked, there's not another competitor growing at that kind of rate. You come to your own conclusions. But I got to tell you, I don't think it's new market so much as it is -- the market overall, I view as IDC, Data Quest, they have a pretty good read, it's moving about 2% or 3% a year.

The fact of the matter was when the recession hit, we knew there was an opportunity because in the enterprise, the biggest challenge NetApp had before the recession was guys who had all the money they wanted don't switch with what they had worked. What we said back then is now everyone was looking to say I must use something different because I have to save money. We have now got foot holds in more enterprise accounts by far than we ever expected a year ago.

Today people universally are thinking I have to do something different because they're not getting more money in IT, they have equal or more things to do. And they're moving much more rapidly toward broader deployment. And they really want to focus on can you really safe me money, real ROI, meaning does it cost less when you leave then when you got here. We have a fantastic solution for that. We're -- we've been pounding on the same markets harder for the last two years, the results are speaking for themselves about how we're doing.

Great. Thank you.

Our next question comes from Tom Mancino with Pacific Equity Growth. Please go ahead.

This is for Dan Warmenhoven. You introduced the Linux AIX and HPUX protocols for the SAN functionality this quarter. Can you share with us the reaction to it and what you've learned about the SAN ecosystem with these introductions? Thanks.

Tom, what we actually introduced was the server attach kits for those three types of servers. HBAs and all the rest of the certified drivers, et cetera. We thought when we introduced the SAN piece a year ago, with Windows and Solaris we thought it would be far easier to get the other three concluded. If you recall my earlier comments our SAN products struggled because we couldn't handle a lot of multi-vendor environments. That issue is now gone. And I think, even though it's fairly recent, I think we're seeing a pick up in the funnel. Customers like the technology. The SAN product is very solid, but if they couldn't use it in their operation with all the rest of their server operations they couldn't move forward with it. That obstacle is removed.

Our next question comes from Chris Russ with Wachovia Securities. Please go ahead.

Wondering if you would comment on the unit pricing for Near Store sort of price per megabyte. I think the R150 was about a penny. Is it still at that level, at or above or maybe below?

I'd prefer not to tell my competitors what we're selling it at, but that's not a bad zone.

EMC has talked about annualized unit price declines 30% to 40%. Would you be in agreement with that?

I have said for years, I don't think it's up to us, the system vendors to make that determination, it's up to the drive manufacturers. And I'll point out that the historical decline that we've got accelerated in 2001 and 2002, is because a very rapid succession of basically doubling of drive densities from 9 to 18 to 36 to 73 in an incredibly short period; that's what drove down the cost per meg. You'll notice my margins stayed the same, even though we came down in cost per meg. It's a function of what the drives do. I happen to think we're hitting a flat spot, unlike the rapid succession that occurred in the early 2000's we're going to see a much slower progression through the higher drive densities. And, therefore, I don't think it's necessarily coming down 30, 40% per year. I have a feeling we're going to find it flatten off.

You're talking about slowing in the increase in aerial density?

Right. In terms of especially customer preference on high performer drives. Essentially if you do the historical analysis, every time you get to a particular density point, you have a price performance trade-off against the next lower form factor of drives. That is if I put too much information under one spindle, one head, then I essentially impact my overall performance. The question is at what price? That's what drove the transition from eight to five and five to 3 1/2 and we're at that point again.

I think you might start seeing smaller drive form factors hit the market. And you know, we're shipping 144gig high performance drives right now, and many customers say they see a negative impact on that from their performance. They prefer 73. Even though they're cheaper. So at that point you say I'd rather go with a 73gig, half the power, half the form factor, stick more on your shelf. The economics are in a different crossover point at this point.

Finally, research and development was flattish quarter to quarter, I'm wondering are you getting greater productivity out of the R&D staff or are you transitioning some resources abroad to India, for instance or --

Steve Gomo here. Basically, it's hard to tell quarter-to-quarter what's going on. So much of R&D quarter to quarter movement and expending is due to project life cycle. Projects coming in getting started don't cost as much as the ones at the end of their R&D life. In the sense that that's where you incur all your project expenses and project materials and all the testing, et cetera. You should understand that we continue to add people to engineering in R&D, both here in the states but significantly in India as well. So I would characterize it as head count increase, but spending has been relatively flat quarter-to-quarter.

Our next question comes from Brett Bracelin with Pacific Crest Securities. Please go ahead.

Thank you. I had a follow-up on the software side of the business. Now that add-on software is roughly 19% of the mix, more than a $200 million revenue run rate, what are your long-term expectations for kind of the add-on software from either a mixed perspective or a pipeline revenue perspective?

This is Steve Gomo here. So as we've said, I don't really have a target for that. One might expect it to increase. On the other hand, it depends how much functionality is in the base operating system and file system. You know, so I think you're going to see probably it hover around where it is, maybe increase a little bit over the intermediate term.

This is Dan, you should understand we're not trying to execute the same strategy as some of other guys on the market. All of our software is targeted to add value to our systems. What you're asking is nothing more than a question of how we choose to package that offering as it goes to market. What we make embedded and optional.

ISCSI for instance, should that be add-on feature at separate price or a native feature in the system? We'll make those decisions in terms of what we think is best in the business. We're not trying to manage 2% of revenue reflected in the software. Do not judge us by the other templates used in the industry.

I guess the trend would be you saw obviously an acceleration in that business, the question would be will you continue to see an acceleration in that business or not?

You I think it's a function of whether or not people continue to use SnapLock and SnapVault and all the other stuff we talked about. A lot of the issues right now with compliance, business continuation, back up, et cetera. That could be temporary. In a year or two, it could be on to a different issue. Who knows. I don't think it's necessarily going to increase that much more. I'm in the same frame of mind as Steve. We've had a mix level now where I don't think there's a lot of upside potential to it.

Lastly, on the competitive front, if you're not seeing public companies out there, could you comment on any private companies that are around to if at all?

I just bought one, but no we don't see a lot of anybody from the private sector at all. We hardly even saw Spinnaker. There aren't very many private companies getting any traction anywhere. It's a very tough market for somebody that doesn't have a big reference base and a big balance sheet to gain any mind share with customers at this point.

The toughest part for new entrants now is getting the partnerships necessary to really commit to an enterprise and give them what they need.

Great. Thank you.

Our next question comes from Andy McCollough with Credit Suisse First Boston.

Thanks. Tom you hinted at the Veritas partnership strengthening after EMC acquistion of Legato. How do you view the Documentum partnership evolving? Is there any company who we should to see you work more closely with in what does seem to be a much more fragmented content management market?

This is a very interesting question, this is Dan. We're kind of in a wait and see mode relative to what EMC ultimately does with Documentum. I've had several discussions and I'm optimistic that we may be able to evolve to a model where we can continue to have a close relationship with them, even under the EMC umbrella. If so, it would have to look a lot like what we have with IBM. We compete with IBM in the product areas and they're our biggest channel in IGS and DB2, web sphere, some of the other apps like Lotus are clearly certified and we actually do great marketing with them.

Documentum is obviously a very significant force in the document management aspect of the market. We would like to have a partnership with them, and then the question is do their new owners promote that or encourage it or do they go the other way? So we stand ready to partner with them in the marketplace. We certainly have a number of joint customers, we want to make sure that they are well taken care of. And I'm optimistic we can find a way to have that persist beyond the acquisition.

This is Tom. I do think -- I agree with what Dan just said, our view is that you have to be open on all this stuff, meaning you have to apply open interfaces and work with all these vendors to get them certified, and so from an end users point of view, you get to pick best of breed from his application source and he gets to have an open environment where he's not locked in. The strategy where you buy software companies, it's better because we own it, it been tried a long time ago, Digital did that, IBM did that. I don't think that's a brand-new strategy.

Veritas is working closer with NetApp. We were working pretty well together anyway but I mean, things are lining up the way we would like them to line up. They are the -- clearly the dominant backup vendor both for us and in the enterprise no matter where you go. Globally. So Number 1, Number 2, we've had some joint projects that our engineers have worked on together over the last six to 12 months, which I think will add value around a lot of the products we've announced recently and will be announcing. I think the partnership will get stronger.

The same thing has happened with Filenet. We had a great relationship with Filenet and Documentum. Uh-uh. Uhm-hmm, and after the announcement the Filenet relationship got even better.

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

A couple of quick things. What is the head count? You mentioned services was going up. Can you give us what the head count is in services? And the second thing was just on the Near Store, you said you really didn't see much change in your normal competitive environment. What are you seeing on the Near Store front, is that just like a green-field opportunity or are you seeing competition there?

We don't give out head count by function. I guess to answer your question effectively is I can but I won't. 2430 was the total. And you'll just have to be satisfied with that. The answer on the Near Stores, I think this is a multi-part opportunity. You know, I don't think of it as greenfield because the customers are solving their problems with other solutions but typically they weren't necessarily disk. There was a lot of tape usage and other things. I think there are five areas I can see how customers think of as separate distinct areas, although kind of overlap.

Backup remote offices, that's what I referenced selling the 250s, so they become a centralized backup recovery point for many remote offices. A backups consolidation center for their data center before they write stuff to tape so it's an online recovery facility. NetApp primary storage and through open system SnapVault or other vendor storage. There is the compliance component, the SnapLocks and so on. There's a reference component, large, you know, volumes of infrequently used data that they want to have online. And the last one that's kind of the newest one I've seen, which is what I'll call soft compliance, using kind of SnapLock as I referred to in the conference call script could be things like, automobile insurance, photographs, things like that.

There's no regulatory issue for them but they also want to make sure that once they've captured the images and so on they can not be modified. We've seen people use it for human resource performance evaluations, once they're closed and signed, they're locked down. So there's a variety of applications. I don't think it's greenfield though because there are other ways of solving those problems. Now they've got a more cost-effective way of doing it with a higher degree of automation, a higher degree of variability, and doing it all online.

The other thing is the fact that it's the same file system as our standard filer line, has caused a lot of people to think what is the precise performance requirement and reliability requirements do I need for each app. The reason say that Dan pointed out before, in some apps you may want more drives that are very high performance because time to market is everything. But we are seeing more of a tiered structure where for a certain app, not just backup, I may want to run this app on a Near Store because they don't have the same requirements.

The key thing that differentiates this, I've seen the light bulb go on in many a CIO's mind or team's mind. If I can manage this all with one operating system, not talking about different families with disparate operating systems, we're talking about I operate the entire environment very, very simply. This makes me -- allows me to put it at the right price point where I need it. I think that's what's driving Near Store into their mind as a key part of this strategy. Not some point product with a new file system, it's the same file system as our current products and they can use it where they want, and they can deploy low-end, high-end or medium with our regular filers around it. That's very powerful.

Thanks.

There are no further questions. Please continue with any closing remarks you may have.

I'd like to thank you all very much for joining us today and certainly we look forward to seeing you around this time next quarter. Thank you again.

Ladies and gentlemen, this concludes the Network Appliance second quarter earnings release conference call. If you'd like to listen to a replay you may dial 1-800-405-2236 or you may dial 303-590-3000 and enter the access number of 556284. Once again if you would like to listen to a replay of today's conference you may dial 1-800-405-2236, or you may detail 303-590-3000 and enter the access number of 556284. Thank you for participating, you may now disconnect.