NetApp Inc (NTAP) 2004 Q3 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to the Network Appliance Q3 fiscal year 2004 quarterly conference.

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. (OPERATOR INSTRUCTIONS).

As a reminder, this conference is being recorded today, Tuesday, February 17, 2004.

I would now like to turn the conference over to Mr. Dan Warmenhoven, the Chief Executive Officer.

Please go ahead, sir.

Good afternoon, and welcome, everyone, and thank you for taking the time to join us today.

With me on today's call 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 will make forward-looking statements and projections that involve risks and uncertainty.

Actual results may differ materially from our statements or projections.

Factors that could cause actual results to differ from our projections include, but are not limited to, 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 accessible through our Website, all of which factors are incorporated by reference in today's discussion.

I would also like to remind you that today's conference call is being webcast live over the Internet, and will also be available for replay on our Website at www.NetApp.com, along with our earnings press release and a reconciliation between GAAP and pro forma numbers.

At this point, I'll turn the call over to Steve Gomo for a review of this quarter's financial results.

Following Steve's comments, I'll share my own comments on events during the quarter.

Than we will move to our financial outlook and conclude with a question-and-answer period.

So at this point, I'd like to turn the call over to Steve.

Thanks, Dan, and good afternoon, everyone.

Our press release is available both on Business Wire and on our Website.

I would now like to provide some commentary about our results for the third quarter and fiscal year 2004.

Please note that all members are GAAP, unless stated otherwise.

Once again this quarter, we experienced very strong revenue growth, up 30 percent from the third quarter of last year, revenues finished at $297.3 million.

Revenues increased 8 percent sequentially from the $275.6 million reported in the second quarter, resulting in our ninth consecutive quarter of sequential growth.

Favorable foreign currency impact contributed about 5 percentage points of growth to the year-over-year growth, and just under 2 points to the sequential growth numbers.

Revenue from services, which includes hardware support, professional services and educational services, was not quite 5 percent of revenue, similar to the 9.4 reported in Q2.

North America contributed approximately 55 percent of total revenue and, as expected, based upon historical trends, Europe was seasonally strong, contributing 34 percent of total revenue, up from the 29 percent reported in the prior quarter.

Asia-Pacific contributed approximately 11 percent, down slightly from the 12 percent reported in Q2.

Add-on software and software subscription upgrades accounted for approximately 31 percent of total revenue, about 2 percentage points higher than last quarter.

Every add-on software product across the board experienced increases in revenue this quarter.

Keep in mind that this figure does not include the base software and file system that is bundled with our hardware sales.

Add-on software products were approximately 21 percent of total revenue, and software subscription upgrades were approximately 10 percent of total revenue.

Pro forma gross margin for the quarter was 60.7 percent, up 3 basis points from last quarter.

Pro forma product margins for the quarter went up slightly, to 65.3 percent from last quarter's 65.2 percent, and service margins finished the quarter at 16.3 percent of service revenue, an increase of 2.4 percentage points compared to last quarter.

Pro forma operating expenses totaled $132.7 million, increasing $6.3 million from the $126.4 million reported last quarter.

Sales commissions associated with strong revenue levels and project-related expenses in R&D were the largest contributors to the increase.

Expressed as a percentage of revenue, pro forma operating expenses were down to 44.6 percent, an improvement of 1.3 percentage points from the second quarter.

This is the fifth consecutive quarter of improvement in the pro forma operating expense structure.

Pro forma operating profit benefited directly from the improvement in operating leverage again this quarter, and finished the quarter at 16.0 percent, an increase of 1.5 percentage points from last quarter.

Pro forma other income was $3 million, up from the $1.6 million reported in Q2.

Pro forma pretax income for the quarter was $50.7 million, or 17.1 percent of revenue, up 2 points from the prior quarter.

The effective pro forma tax rate for the quarter was 21 percent.

Pro forma net income for the quarter was $40.1 million, or 13.5 percent of revenue, up 1.3 percentage points from the prior quarter.

Pro forma net earnings per share was 11 cents, based on a weighted average of approximately 366 million shares outstanding.

This quarter, we reported a GAAP net income of $40.2 million, or 11 cents per share.

We have provided a reconciliation between pro forma and GAAP net income in the condensed consolidated statements of income of our press release, and is available on the investor section of our Website.

Well, turning our attention now to the balance sheet, cash and investments at the end of the quarter were $778 million, up $56 million from the previous quarter.

Capital purchases of plant, property and equipment were $13.6 million during the quarter, while depreciation was $13 million.

Days sales outstanding of accounts receivables were 59 days, up from the 53 days reported last quarter.

While bookings were extremely linear throughout the quarter, shipments were impacted by some product transitions, which concentrated new product shipments in January.

I expect DSO to return to the low 50's next quarter.

Inventory turns for the third quarter were 12.3 times, up slightly from the 12.1 times reported in the prior quarter.

The deferred revenue balance is $236.8 million, up $27.7 million or 13.3 percent quarter over quarter, and up 51 percent from the $156.4 million reported a year ago.

Now, three quarters ago, we announced the stock repurchase program allowing for the purchase of up to $150 million worth of stock.

Due to the Spinnaker acquisition, we made no repurchases this quarter.

We plan to resume the program upon completion of the acquisition.

Headcount at the end of the quarter was 2,549 employees, up 119 people from last quarter.

In summary, strong growth and improved operating leverage allowed NetApp to achieve new records in both revenues and net profits this quarter.

The balance sheet is solid, and cash levels are at an all-time high.

More importantly, however, this quarter marked a significant milestone for NetApp, as we have now returned to our targeted business model.

Going forward, our focus will be on topline growth and maintaining profitability within the bounds of our model.

I am extremely pleased with these results.

And now, at this point, I'd like to turn the call back over to Dan.

Thank you, Steve.

I am also very pleased with our record execution this quarter.

We continue to post the strongest organic growth rates in the industry, demonstrating the market's demand for more simple, innovative and cost-effective storage and data management solutions.

Our focus on simplicity, innovation and growth are the driving forces behind everything we do here at Network Appliance.

NetApp's vision of offering simple, open, unified storage resonates well with customers for several reasons.

First, by simplifying the process of managing data for customers, we help them reduce the amount they spend on man hours necessary to oversee their data, reducing their total cost of ownership.

As an example, recently, a large European customer configured 96 terabytes of NetApp R200 and put it into production in just four hours.

Second, we allow enterprises to get better leverage from their IT investments, because our products simply plug and play into their existing software and hardware environment.

Third, our unified approach, in which we offer the same underlying operating software across all of our products, gives customers unprecedented flexibility, as their heterogeneous needs grow.

And lastly, we offer the best performance in the industry.

Notably, we are the only vendor to submit benchmark specs with real world customer-usage situations like RAID-DP, our recently announced dual-parity RAID, turned on, and we still outperform the competition.

Our innovative approach to storage has spurred our growth in the enterprise market.

In fact, enterprise deployments account for the majority of our business today.

Companies like Bloomberg, Dasso (ph), Kimberly-Clark, Nielsen and Northrop Grumman exemplify the broad enterprise applicability and demand for NetApp solutions.

The new product introductions we have made in areas like the data protection and consolidation area have been a big hit with companies like Citadel, First American Bank and Hela (ph).

In addition, we're finding valuable partners like Oracle, SAP and Veritas increasingly working with us in major accounts.

In the data protection area, our recently introduced NearStore R200 product provides economical secondary storage that is simple to manage, easy to support and easily integrated into existing IT infrastructures.

NearStore has turned out to be one of the fastest-growing product lines in our history.

A good example of our enterprise traction here is with Cisco, who continued to build out its NetApp storage infrastructure this quarter by adding over 300 terabytes of NearStore R200 to support the rearchitecture of their connected desktop backup environment.

Combining our NearStore solution with our newly enhanced SnapVault allows enterprise customers to back up tens of terabytes of online data, with little or no impact on primary storage performance, while at the same time greatly reducing backup times and associated management overhead.

The combination of these two products enables customers to efficiently store data from multiple, local and remote heterogeneous storage systems.

Our products and solutions help customers better protect their most valuable data, while at the same time improving uptime, dramatically reducing time to recovery and reducing management costs.

Companies like Canon, Deutsche Telekom and Merck are examples of new SnapVault customers, and GE, Intel and Oracle each returned to purchase additional licenses for their existing SnapVault deployments.

And just last month, Forrester Research published a study showing an 81 percent ROI with just a 20-month cash payback period on our SnapVault backup and recovery solution.

Regulatory compliance also continues to be a strong driver of our business.

Customers are looking for simple, easy-to-deploy and cost-effective solutions to the compliance-driven business initiatives.

Our new SnapLock software enables customers to meet the data permits requirements of regulations like SEC Reg 17a-4.

In this quarter, SnapLock's license software license revenue more than doubled, and accounted for over 500 terabytes of worm, or Write Once Read Many storage.

Customers like Dresdner, First American Bank and Millennium Partners all chose SnapLock for compliance initiatives this quarter.

We have also significantly enhanced our ability to serve the enterprise database, ERP and technical application markets with the launch of our new high-performance, highly scalable FAS980 and FAS980c products.

These systems run on NetApp's universal Data ONTAP operating system, allowing customers to scale quickly and reliably, and at the same time deploy mission-critical applications on the simple, easy-to-manage, high-performance platform.

We announced the FAS980 product line in December, and it will begin shipping in the next few weeks.

Overall, our filer unit sales were very strong, growing over 25 percent quarter over quarter.

Our newly-introduced FAS270 had the fastest unit sales ramp in our history, resulting in over 100 percent growth in the number of entry-level systems shipped.

On the SAN front, we have made strong inroads, with hundreds of accounts in production and block mode.

Our iSCSI offering has really taken off for us.

We were the first vendor to offer an iSCSI solution, and according to IDC, we have nearly 50 percent market share in terms of revenue, and over 63 percent of terabytes shipped.

The best news on this front is that Microsoft has gotten behind the use of iSCSI with their SQL Server and Exchange products, and just last week, Microsoft issued statements of support for these environments.

Overall, our Windows business grew even faster than our overall business, and Windows has proven to be a strong driver of the growth of our block storage solutions.

Our SnapDrive unit sales more than doubled this quarter, and our SnapManager license revenue doubled year over year, both driven by Windows application deployments.

Overall, our SAN business continues to grow at a nice clip, tracking to plan, and we are very pleased with the uptake of our iSCSI solutions.

In the NetApps (ph) arena, NetApp continued to lead the market, achieving over 43 percent share of the standalone network attached storage market, according to the latest Gartner research.

IDC also ranked us number one in both factory revenue and terabytes shipped.

A terrific example this quarter is Volvo.

Volvo recently chose our filers and NearStore products for a global consolidation project, in which NetApp storage and data management software will be used for home directories after moving their network operating system from Novell to Windows 2003.

Going forward, we will continue to grow our existing business and product lines, layering in additional capabilities to address new, high-potential markets like grid computing.

Along this front, our pending acquisition of Spinnaker Networks, which is anticipated to close tomorrow, will ultimately allow us to deliver a single system capable of scaling to over 500 clustered storage nodes that have a total capacity of over 11 petabytes.

Initially, we will target markets with customers that use large-scale Linux farms for performance-sensitive applications in verticals like energy, high tech entertainment and federal.

We will approach the Spinnaker technology integration in two phases.

The first phase will focus on hardware integration, which we expect to complete later this calendar year.

Please keep in mind, though, that we will be taking orders and shipping upgradable systems until that time, and we will not recognize revenue on any Spinnaker products until the first hardware integration is complete.

The second phase will focus on software integration, so that our WAFL file system and Spinnaker's global namespace and clustering technologies will converge within the next two years.

We are very excited about these additional capabilities that Spinnaker will bring, further increasing our ability to help make our customers successful.

It's another great example of our focused innovation to spur our future growth.

In summary, this was another great quarter for Network Appliance.

We are attacking a large and growing market with a unified product set, offering complete compatibility across all of our product lines.

We have made great progress in expanding our partner ecosystem, allowing our customers to pursue an open, best-of-breed approach to ILM, and we continue to expand our enterprise customer base by cost-effectively solving their business challenges.

We are beginning to see our investments in professional services pay off, with customers like BMW, Southwest Airlines and Telstra initiating professional service engagements this quarter.

We have just concluded a very strong quarter.

We expect to continue to grow and capture market share with the innovation and nimble execution that have gotten us to where we are today.

We have achieved our target business model, exceeding our previous record revenue quarter, which was Q3 FY '01, exactly three years ago.

And I am proud to say we have a great team of motivated people who have made NetApp one of Fortune's Top 50 Best Places to Work for the second year in a row -- people who are committed to taking this Company to the next level.

Now, I will turn the call back over to Steve to discuss our financial targets.

Thanks, Dan.

I will now comment on our business outlook.

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

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

Actual results may differ materially from our statements or projections.

We expect our momentum in the marketplace to continue, and project fourth-quarter revenue to grow sequentially by 7 to 9 percent.

This projection reflects year-over-year growth rates of 32 to 34 percent.

And, as Dan mentioned, there will be no Spinnaker revenue recognized in Q4, so our projections reflect our expectations for organic growth.

We also expect net income to grow despite a partial penny dilution from Spinnaker expenses and, depending on the revenue levels achieved, we're targeting Q4 pro forma earnings of 11 to 12 cents per share.

GAAP earnings should come in modestly below these levels, although GAAP earnings targets cannot be determined until the Spinnaker deal closes and the total purchase value is calculated.

With that, I will turn the call back over to Dan for a wrap-up.

Thank you, Steve.

That concludes our remarks for today.

In closing, I would like to thank the NetApp team for their continued enthusiasm and dedicated efforts.

We're very proud of our record achievements this quarter, and expect to continue to outpace the rest of the industry.

At this point, I will open the conference for questions.

We ask that you limit yourself to one question, so that we may address everyone in a timely manner, and also honor your request to keep the call to one hour.

Operator?

(OPERATOR INSTRUCTIONS).

Dan Renouard, Robert Baird.

Thanks.

I'm wondering if you could give us an update on RAID-DP, if you can update us and quantify uptake of that offering, and any potential margin impact going forward?

I have no specific data on RAID-DP utilization.

It's embedded in the basic system, and it's up to the customer whether they want to turn it on or not.

My guess is it will not have any effect on margins whatsoever.

In general, the way most customers will choose to deploy it is to increase the size of their RAID groups, and then use two RAID disks.

A typical configuration today is about seven data drives and one parity drive.

We expect that to go to 14 and 2, which is roughly a breakeven.

So I don't think we're going to see any change in the gross margins as a result.

It should be a wash.

More of a topline benefit?

Yes.

It really helps us on the competitive front.

It increases data availability.

It's a very unique capability.

And, actually, this one is incredibly unique, relative to anything else that's ever been proposed in the industry, because it has a very negligible performance impact.

It's essentially free from a COGS viewpoint, and it's free from a performance viewpoint.

And the data protection it delivers is better than a fully mirrored configuration.

One of the things that it also allows is customers to be more comfortable migrating some apps over to ATA drives that they might not have before, because they have more protection than they did before.

So, as we look at the continuum of what we are offering people, from -- you know, you use the right type of storage for the right job.

ATA drives are being used more than we expected for things like data mining and others.

But specifically because of this feature, I think you'll see much more locally attached storage move to a network, because they can protect it at a low cost.

Anecdotally, can you talk about customers doing this?

Or is it too early to --

I think I'll have to hold that one for next quarter.

Harry Blount, Lehman Brothers.

A quick question on the operating margin.

Obviously, Steve, you said in your prepared comments you've already hit your target operating margin, actually the upper end of your target operating margin.

I was wondering if you're going to be able to hold to that 15 to 16 percent range, as that was kind of for the full year '05, or if you're going to continue to be bumping up or even exceeding the high end of that range going forward.

The way I would look at this, Harry, is that we hit the model a quarter early.

Yes, I fully expect to stay within the bounds of the model that we talked about at the analyst day -- that is, the 15 to 16 percent.

And I would expect our focus, as we said during that meeting, to continue to be the topline growth now.

So, just in terms of the OpEx, you had indicated previously that you expected to spend a lot of the incremental profitability on R&D and services, yet I did notice the services gross margin also improved this quarter.

Where do you expect the bulk of that investment to go incrementally, going forward?

I think that you could expect our investment profile to stay somewhat the same.

First and foremost is to enhance our service and support capabilities, to make sure that they are capable of providing the kind of service that an enterprise customer would expect, one.

Secondly, we're going to make sure we have plenty of sales capacity in place, because there's a large demand for the products, and we don't want to run out of sales runway there.

And finally, the engine of our product growth, obviously, is R&D; we're going to make sure that that is adequately funding to provide the kind of products that are going to ultimately generate the kind of growth we need.

Laura Conigliaro, Goldman Sachs.

A couple of things.

First of all, when you first gave those 25 percent growth targets for FY '05 at your analyst meeting, that was considerably before we started to see some growth changes in various vertical markets.

We have now seen changes in a number of verticals, but in particular in the Internet in the last couple of months.

That is, acceleration in spending, and yet you have kept that 25 percent number intact.

To what extent is this kind of spending acceleration, whether it is the Internet vertical or other verticals like communications and elsewhere?

Would that be upside, potentially, to the extent that you started to capture it in a model?

And in addition, is it reasonable to assume that, since you are now in a position where you have built some of the infrastructure that you wanted to in service gross margin, that we could be looking at something on the order of about 20 percent growth margin for service, all in, for FY '05?

Wow, Laura, that's a lot of questions there.

A lot?

That's two!

Let me start at the top.

I think that, if you think about our 25 percent growth rate, if you adjust for currency, that's pretty much what we delivered this quarter.

And I think 25 percent growth is a good basis going forward.

Clearly, if there are opportunities in the market where we can grow faster, we're going to take advantage of it.

That's the whole point of concentrating on the top line.

However, I think that there's a lot of uncertainty out there today in the market, in our segment in general, but also in the economy.

We have an election coming up, and I am not one to say that things are all robust and rosy at this point.

There are verticals that are picking up, some more than others.

I would like to attribute, I think, our growth, however, to the fact that we are taking share in those verticals.

We will see if the verticals pick up next year.

Right now, I think the appropriate way to look at this is that we will deliver the 25 percent; and if there is opportunities to do better, we will.

On the Internet in particular, this represents sales to what we consider to be pure Internet companies like Yahoo! and eBay and others.

That was basically flat as a percent of revenue; it really didn't move appreciably in the mix.

So, if there has been increased spending there, it certainly has not yet shown up in our mix.

Precisely.

I think it's just now beginning to start, because it's just now beginning to be reflected in Company comments.

If that does, in fact, materialize, yes;

I would hope that we would benefit from it, but it's too early to tell.

What about the second question, which you forgot?

Oh, the service gross margins for next year?

Yes, I think 20 is a pretty reasonable kind of estimate.

Obviously, it's about 16 now, this past quarter, as I recall.

And I would think -- I'm sorry, excuse, me it was 12.2, pardon me, for this quarter.

16.3. (multiple speakers).

16.3 for the quarter and 17 for the year.

And it looks like that should probably continue to improve somewhat, as we go through next year.

Does it average out to 20?

Well, let's say high teens, anyway.

Laura, this is Steve.

I think that Dan is correct, in that our first priority here is to make sure that we have the right resources in place to support all the customers we now have to support.

Once that is done, we're going to go ahead and let the service margin grow a little bit.

But until then, our first priority of service has to be to invest, and fill out our service offerings and service capability to meet the needs of those enterprise customers.

I think we could get to 20 percent next year, but I think the first thing we have to do is make sure we have the right resources in play.

Glenn Hanus, Needham & Co.

Maybe just following up on that last question on gross margin, I know, Dan, your internal focus on keeping the gross margin above that 60 percent mark -- what is your confidence level, kind of going through '05 and keeping product gross margin relatively flat going forward, and kind of keeping that above 60 overall?

And the second question would be related to the sort of Microsoft-based attempts and attacking your market.

While most of my checks indicate not a big threat there, I do sometimes pick up the thought that they can sometimes slow down sales cycles.

Can you comment on that?

First of all, on the gross margins, I would continue to advise that you show a slight degradation in the gross margins quarter after quarter.

You probably heard the comment at the analyst day about my maniacal obsession on 60.

But maniacal obsessions don't necessarily turn into reality.

The reality in the marketplace is continued pressure on pricing, and we have been fortunate enough to keep the mix of software moving up, which offsets the decline in system gross margins.

And we have got some downward pressures because of channel mix increases.

Indirect channels now are 50 percent.

Low-end systems have a slightly lower gross margin.

The NearStore has a slightly lower gross margin, et cetera.

So it is much more dependent now than ever on the mix of software going forward, and it is very, very difficult to predict.

So I would still advise you to model a slight degradation in sequential quarters in the gross margin line.

On the Microsoft question, we very rarely compete head-on with Microsoft.

We very rarely see the Windows storage server positioned as an alternative to our solutions.

However, the type of competition we do get with Microsoft is around the applications, the suitability of NAS for certain environments or iSCSI.

The reason I highlighted the SQL Server and Exchange endorsements from Microsoft, which occurred just last week, is that that that really eradicates some of the FUD and uncertainty that was in the customer's mind about our iSCSI solutions as suitable for the Microsoft environments.

And I think that is going to really accelerate customer accepts.

So you really don't see any slowing on your sales cycles, as people evaluate Microsoft's stuff at all, and maybe stay with you, but --?

No, I would just say the opposite.

In fact, that's why I pointed out that Windows as a percent of revenue moved up this quarter.

As we get the larger and larger footprint and installed base, more and more references, customers are having a higher degree of confidence that it's going to work right.

And as you look at the Microsoft Website, the iSCSI endorsements at the operating system level, at the application level, the licensing we have of their technology for SIPs, and I think the customers are feeling very confident.

I was going to say that I think it's actually way easier now than it ever has been since I've been at NetApp, as far as working those issues in major enterprises.

I think the support of companies like Accenture, IGS and others has helped us a lot in this.

We had a number of big deployments go out in the last two years that have been tremendously successful now, and people are writing papers about it.

So I spend most of my time facing customers; whereas I used to spend quite a bit of time on NAS10 (ph), that is completely gone.

I can't remember the last time somebody wanted to have a technology debate, given the fact that we can do both.

Secondarily, I can't remember the last time anybody accused us of having an inferior NAS products to anybody in the market.

I think that debate is over in almost everybody's mind.

And, finally, on the Microsoft fit (ph), I think so many people now have used it within each industry, it's very easy to point them toward other success stories.

Our sales force, for two consecutive quarters now, throughout the world, on a consistent basis, has overachieved their goals.

It's almost amazing to me that they are performing better right now -- sales cycles are probably as short or shorter than they were in the boom, and the reason is the pipelines are much larger, the activity levels are very, very high.

And I think the proficiency of our sales force is high.

We have had very little turnover, compared to other companies, I believe.

So the combination of events, I believe, is allowing us to (technical difficulty) the acceleration that we have.

Well, thank you, and congratulations on your quarter.

Chris Russ, Wachovia Securities.

Congratulations, great quarter.

A question on the NearStore -- it looks like a very strong quarter for ATA disk space backup.

I think last quarter, you indicated NearStore was about 11 percent of revenue.

I was just wondering if that has ticked up this quarter?

It's roughly about the same.

We also pulled some interesting numbers on total storage shipped.

Our total storage was up 19 percent.

ATA storage was up 19 percent quarter over quarter, so it's going roughly proportionately.

Incidentally, I expect to see, going forward, that that number will pick up in the mix -- that the NearStore and ATA will be an increasing part of the mix going forward.

Is there a unit pricing issue?

In other words, where is the price per megabyte currently for NearStore?

I don't have that number off the top of my head, but it's certainly under a penny.

You know, the most recent NearStore -- I think it's about a half a cent, actually; it's approaching half a cent.

The most recent NearStore introduction, the R200, we changed the product configuration quite a bit.

In the prior releases, you could have only a 12 or 24 terabyte fixed capacity system.

The new one, the R200, scales from 8 terabytes to 96 terabytes in increments of 8 terabytes, which is one shelf.

So it's got a very different kind of structure to it; it's going to be a little difficult for us to figure out exactly what's going on, as we go through that transition, for about another quarter.

The NearStore is sold standalone.

We have SnapVault, which means we can back up other people's stuff to our stuff.

But in general, the amazing thing that is happening in this market is people are looking at it more holistically.

They're looking at I need to consolidate my storage.

If I want to consolidate more, I need to come back from disk.

That's happening at a much faster rate than people seem to expect.

The Gartner Group last year, where I had the opportunity to talk -- Nick Allen said a year ago that 15 percent of his clients said they were going to disk-to-disk.

This year it's 50 percent.

Well, our disk-to-disk, given that it's the same file system, is extremely attractive as a package.

So you go to file it in NearStore, and, as Southwest Airlines has said before, they get disaster recovery for free.

I think expensive to expensive is over, except for a very, very small amount of applications.

Expensive or mainline storage to inexpensive storage, used for recovery and for disaster recovery, and with the same file system, is an enormous advantage over anybody else.

That is what people are talking to about, and big, big opportunities.

They're talking to our partners, they are talking to us.

So data recovery really is what we are selling, as opposed to any -- we never get in with NearStore product-featured, dollar per megabyte, almost never.

It's really the overall application and the ability to manage that in a simple fashion that is driving us above everybody else.

I'd add one more application to Tom's list there, and that is the deployment of 250's and 270's in the regional offices with NearStore as a mirror to all of those in a centralized data center.

The end into one (ph) backup and centralized data management has been a big winner.

And just finally, the percentage of filers that shipped with iSCSI capability enabled?

I think that was 26 percent last quarter.

Was that flat, or did that tick up? iSCSI is obviously a big driver for you guys.

It was roughly about the same.

Let me confirm the number here, but it was reasonably flat.

Shebly Seyrafi, Merrill Lynch.

Great quarter.

Maybe you can provide us with some metrics like the filing and caching breakdown, the terabytes shipped for NearStore and x-NearStore, i.e., total.

And my question really is, how high can software grow, as a percentage of revenues?

You are now at 31 percent.

Can it grow to as much as, say, 35 percent, 40 percent?

Where do you see it topping out finally?

Just a couple ones that we will rattle off real quick -- net cash was just about 7 percent of revenue, NearStore was right around 11, which we just talked about a second ago.

So that means all the rest was basically filers, other than service.

The question of the software mix -- I don't have a particular target, and I don't have a particular forecast, either.

We're trying to continue to offer more value, and, as Tom said, bundle things together -- NearStores along with SnapLocks and SnapVaults and open system SnapVaults and all the rest, which kind of keeps that mix marching up.

But I don't have a particular target in mind.

We're just going to continue to try to find ways to add more software value add into the mix as we go.

Again, there was a tremendous amount of software value added to the base system.

I would not want to give the wrong impression here that that 31 percent is all the software in our products.

We have a huge amount of software, in terms of the operating system, the ONTAP operating system, WAFL, the first protocol, Snap capabilities that are buried in there.

And over time, we will take some of the existing add-on software, and bundle it into the base system, and make it just part of the fundamental product that you buy.

So I think it's somewhat misleading to look at our software add-on capability and software content the way you would look at an EMC.

These are very, very different companies.

What about terabyte metrics, total and for NearStore?

Terabyte metrics.

It was up about 19 percent in the mix.

Last quarter, it was just a little over 3, and obviously, that makes this quarter somewhere in the range of about 3.8.

Bill Shope, J.P. Morgan.

On your iSCSI sales, are you seeing these sales particularly pushing in environments where the storage was server-attached previously?

Or are they pushing out other network-attached storage technologies?

And then, on the add-on software attach rate, is that typically higher for your NearStore products than it is for the other hardware products?

In other words, is NearStore -- is that primarily one of the key drivers behind this fast growth in add-on software?

First of all, on the iSCSI one, I guess the answer to your question is both.

A number of customers have stayed with direct attached storage because the alternative of going to SAN is too expensive.

The SAN attachments, by the time you added HBAs, switch ports, management software, et cetera, typically made it very prohibitive to attach a server that might cost a few thousand dollars. iSCSI provides a wonderful alternative to that, so customers who had a desire to move the network storage found it cost prohibitive, and now with iSCSI, find that they can proceed the way they want.

And let's not forget also that for several years now, we have been shipping block storage over Ethernet transparently, if you will, in an early form of iSCSI that was embedded in our SnapDrive.

So customers have got a lot more confidence with it now that it is endorsed by Microsoft.

On the NearStore question, this is a very complex question.

NearStore does not, by itself, carry a higher percentage of software than any other thing in the product line, not materially.

However, what we find is more solution bundles that are combinations of, as Tom said, filers in NearStore, our entry-level systems in NearStore, et cetera.

And as a package, a complete solution set, the software content there is, in fact, higher.

But it doesn't necessarily run just in NearStore; right?

So, for instance, you buy a bunch of 270's, let's say, with the SnapMirror capability -- those are mirrored back to a single NearStore.

But each 270 carries its own mirror license.

So it's spread across the product line in such a way that customers can use all of the building blocks in a toolkit to craft an optimal data management solution for their environment, and that does require more software.

Kaushik Roy, Susquehanna.

Congratulations.

Nice quarter.

I have two questions.

One, can you comment on the pricing and the competitive environment?

EMC for the first time in its history is making some progress in the NAS with the NS600 and the G (ph).

And then IBM has come out with their EIX gateway.

How does that impact you?

That's my first question.

I don't know anybody who looks at EMC's new product and puts it up against ours and thinks it's competitive, period.

I don't know how many NetApp killers they have had, but why don't we just number them like Roman numerals at this point?

The fact of the matter is they are not simple.

When they put it up against ours, they are not that performing (ph).

And if people benchmark them both, we're going to win; they can price however they want.

So that is not forcing us to do anything on the pricing front.

IBM already pulled their first product;

I don't know what their new one is.

Outside of IBM environments, no one would look at it.

So we feel extraordinarily -- we could not be in a stronger position on the NAS front than we are now.

The other guys have missed so many times -- there's only so many times you come back to the same movie expecting a different ending.

So we feel very, very strong about the fact that we can fight these guys.

And I just -- I am involved in virtually all transactions that are in this way.

People don't come to us and say, boy, the products are equal; what are you going to do next?

Their biggest problem is their products are not equal.

And my second question is, on services revenue, which grew 9 percent, are you focusing more or hiring in professional services, or is the growth tied with the hardware support?

I guess, for modeling purposes, should we assume that there is a high correlation with the product growth?

Or can it grow more than the product growth?

The emphasis obviously is on professional services.

We have hired a number of professional services people in the field over the last several quarters.

We expect to continue to do that.

Our customers are asking us for more sophisticated services, and I think you should see a disproportionate percentage of the service revenue growth going there.

Omar Al-Midani, Soundview.

I was wondering if you could provide some more details surrounding the forces on gross margins.

EMC this quarter got a benefit from more favorable component prices.

I am assuming a lot of that had to do with more favorable hard disk drive prices.

I am wondering if you benefited from that at all this quarter and also, you know, whether you can talk a little bit about whether there is other factors in there that may have either hurt or benefited your gross margins?

And then I have a quick follow-on.

We have seen the same reduction in drive costs that we will have seen over the past several quarters.

It's a straight, flat line heading downward at the same rate.

So there is no change in the rate of price declines in the components we have seen, one.

Secondly and probably more importantly, I think the improvement in margin owes itself to a couple of other forces having to do with, a, the software mix, because software does have -- the add-on software and the subscription software has no cost of sales associated with it, as you are aware, and also the fact that the product configurations were such that they tended to be toward the higher end of the margin spectrum.

So those were the primary drivers behind the performance.

So then a quick follow-up on that, because usually you talk about the product mix as being a drag on margins.

And your low end is better than the rest of your products.

But I guess you're saying now, it's small enough in the mix that, overall, you got a positive boost from the product mix.

Is that correct?

I think you have to also look at the fact that, as Dan and Tom just mentioned, that many of the environments we go into with the low-end products -- people are buying the low-end products as part of the solution.

With software components that may SnapMirror something back to a NearStore for recovery or for backup or for whatever the case may be.

And that solution set is richer than a standalone individual low-end product would be.

Kevin Hunt, Thomas Weisel Partners.

A question for Dan.

You're actually on the tape saying you're going to have 25 percent growth in fiscal '05, and that's going to be -- and acquisitions will be part of that strategy.

I wonder if you could comment on that?

And then, if that is the case, maybe what areas we should be looking for in terms of acquisitions?

And then for Dan, I a question, too, a follow-up on the competitive environment.

Maybe you could give us -- when you guys do lose a deal, why you would lose a deal?

If you listen to that interview very carefully, you will hear that what I said is we guided, as in the past tense, meaning the December analyst meeting, the analyst community, to 25 percent year-over-year growth.

That was a statement of history.

It had nothing to do with going forward.

This other comment I made on acquisitions was we're always interested in, I think I said, broadening our product solution set.

I think Spinnaker is a good indication of the profile of what we'd be looking for -- very advanced technology that helps us move our solution set forward, but we're not necessarily trying to buy a revenue stream.

Spinnaker's revenue was fairly de minimus, relative to our own and in fact, as we just pointed out, in Q4, there will be no Spinnaker revenue at all.

So we're not trying to actually buy a market share or a revenue stream; we're trying to buy technology to help us solve customer problems better.

So the growth by acquisition is not the way to look at it.

The other question you had when we lose, why do we lose?

I'm going to turn that one over to Tom.

The interesting thing about NetApp, if you have been following us over the years, is that our win percentage has always been very, very high.

The growth of the Company has come over the years by meeting new folks.

The fact of the matter is, when you are a young company emerging, most of the people don't know who we are.

So the fun part of what is going on now is the enterprise has a big problem that they need to solve a different way, meaning the don't have the money they used to have.

I think it's like, if you go back to when the Depression happened in the 20's, when people got money after that, they didn't go back to being stupid.

I hope that these people are going to go back to being stupid either.

And they are going to go with what is the most cost-effective way.

So the primary thing that excites me about what's going on is that we get to find new people all the time.

I had the opportunity to be the keynote speaker at Oracle's World in Tokyo in front of 1,000 people in December and January, in front of their leaders' conference.

Their 300 largest prospects, 900 people in the room.

They asked me to be the keynote there.

I must have had half that room say, you know, we had not looked at you for these type of applications.

We're going to now.

These are big-time enterprise guys.

So why would we lose?

The vast majority of the time, it's because we're not engaged; we are not there yet.

And that's fine, because that is just more opportunity.

There are a very small percentage of times -- and the other thing that is interesting about NetApp is, think about our world.

We come in, something else is already installed.

We have to prove to them we are better than that.

That's usually how we win, and we still win a high percentage of times.

So where we lose, typically, is people have an existing environment they are happy with, they have the money they need, they don't need to do stuff that's different, they keep buying what they were going to.

If they are looking to say I need to do something different, and I'm willing to engage and see, can someone do this better, our hit rate is extremely high.

Brent Bracelin, Pacific Crest.

First question would be, was there any kind of material change in the average deal size in the quarter, particularly given the emphasis on cost solutions, selling to large enterprises?

Question two would be, given the acceleration and kind of the low-end filer space, you mentioned the FAS270 was up 100 percent.

Are you taking share in the low end?

Could you provide a little more color on why you are seeing acceleration there?

And then the third question is, clearly, it looks like there has been another acceleration here with the indirect channel expansion.

Where do you see that going?

You said it's a 50/50 mix today.

Two years from now, do you anticipate that being a 60/40 mix?

Just give us a little color there, as where you see some of the growth coming from, indirect.

The driver on the low end was really the introduction of the new FAS270, which is the low-end system that allows us to really offer a low-end SAN, if you will.

We introduced the 250 as a companion product about a quarter earlier.

It grew about 40 percent in units, but the FAS270, in its first quarter of shipments, had over 300 units.

Low end in SAN is not low low end; this is not single-digit kind of thousands of dollars.

The ASPs in those areas are measured between 20 and 40 K, so these are one to four-terabyte kinds of systems, high functionality, et cetera.

So, depending on how you categorize low end, it's lower than we have typically gone, but I would not say it's low end yet.

Most of the time, the market analysts view low end as under 15 K or even under 12 K, or something like that.

So we're kind of low-mid.

Based on the success you're seeing there, do you plan on moving further downstream?

Yes, we'd like to.

We think we can keep driving those product lines down even further, and have plans to do so over time.

It's important to understand that our view of the low end is the edge of the enterprise.

It's not just standalone systems and small companies.

And the fact of the matter is here's what I see happening; it's kind of interesting.

People have used SAN as data center, network attached storage as distributed.

Now, with Linux Blade technology, you now have network attached storage in the data center.

Whereby SCSI, you have staying outside the data center.

The thing that we have to offer people is one consistent file system across those four, and you heard us say iSCSI is starting to go up.

That's usually where it is after you have distributed SAN.

And so when I was talking before, I talked about the fact that we are seeing more solution-oriented sales, where the edge is bought at the price point Dan just talked about, they mirror it back using our SnapMirror to where their people are, they take the backup off of those remote sites, feed (ph) it more as a black box, and they take dollars out from having to back that stuff up.

That's kind of how the sale goes, as opposed to someone saying, I need some low-end servers, what do you have?

We don't -- very rarely -- I can't remember being in that conversation.

It's tied to a bigger problem.

On the channel question, it's really difficult to forecast.

Let me kind of give you some color on it, though.

We do believe the bulk of our growth will come from large enterprise accounts.

Now, historically, that has always been serviced through the direct sales organization.

But increasingly, major system integrators like IBM global services and Accenture, Fujitsu Siemens in Europe, Lockheed Martin in the federal sector or Northrop Grumman -- all those are becoming major players for us into those customer sets.

Those are classified as indirect, so the bottom line is the enterprise business continues to grow.

It's difficult to predict what will be the exact channel mix, because of the increasing involvement of the system integrators.

And I guess the last unanswered question would be average deal size.

Is there a change or shift that you're seeing there?

You know, it's slight, but I've got to tell you, we have thousands and thousands of transactions, a lot of which have to do with just adding a shelf or whatever, adding a feature, adding of piece of software.

And so, if you look at average deal size, it doesn't move very much.

I can tell you that we have seen some of the largest wins this past quarter.

I think the second-largest PO in the history of the Company came in this past quarter.

So deal size overall is kind of moving up, but if you look at it on the average, based on purchase order value, it doesn't move much at all.

Harry Blount, Lehman Brothers.

Dan, you had indicated that you were still on track in terms of your SAN market share.

And I think, if memory serves, you had indicated your kind of overall plan is about 1 percent market-share gains per year.

So is that kind of the game plan you were talking about, in terms of on track?

Yes, it's a little more aggressive than that, but that's pretty close.

By the time we exit three years from now, fiscal year 2007 or so, we would like to be getting near the 5 percent range.

So a point this quarter, point to point a quarter, and then increase that every year.

And we are right on track.

A couple of other quick things.

I noticed in the press release that you had Microsoft's called (ph) on a lot of your other boxes, but I did not see the 980/980c.

That's because they have not shipped yet.

They can't get certified until they ship, and the shipments of the 980/980c will occur within the next couple of weeks.

And then, last couple of questions are more housekeeping-related.

You've indicated a couple times Windows moving up as a percentage of revenue.

I was wondering if you might be able to comment on where that percentages is today, and also what your cluster is, as a percentage of revenue.

And then a question for Steve on the guidance of 7 to 9 percent -- what are you baking in for currency on that?

Of the systems eligible for clustering, about 60 percent were shipped with that, which I think is an all-time high.

Now, remember, a lot of the low-end systems do not ship with clustering, so they are removed from that.

These are cluster-eligible.

Around 60 percent.

Now, the Microsoft piece is, Windows as a percent of revenue is right up around 20 percent, which is their all-time high.

That's pure Windows; that does not include multi-protocol systems.

And it is up faster than the growth of the Company as a whole.

So, if you look at multi-protocol and everything else in there, the total Windows business, you could argue it's 45 to 50 percent of the business.

Did I get all your questions?

Yes, and then the one I had for Steve?

Harry, if we were good at predicting currency, nobody at this table would be at this table today.

But since we are not, and we don't try to be, we don't plan any currency increase next quarter.

We just take the known currency exchange rates at the point of the forecast.

And we try to have a hedging program, obviously, that's adjusted monthly to lock that in.

I actually did have one last question.

Dan, I think you said your filer units were up 25 percent sequentially.

I was wondering what your overall units were up sequentially.

24 percent.

Ladies and gentlemen, at this time, we have no further questions.

I would like to turn the conference back to management for any closing comments.

Please go ahead.

Ladies and gentlemen, thank you very much for joining us today.

We look forward to having you join us this time next quarter.

Thanks again, and have a great day.

Ladies and gentlemen, that does include the Network Appliance Q3 fiscal year 2004 quarterly conference.

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