NetApp Inc (NTAP) 2005 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the Network Appliance Third Quarter Fiscal Year 2005 Earnings Conference Call. My name is Carlo and I will be your coordinator for today's presentation.

At this time, all participants are in a listen-only mode. We will be facilitating a question and answer session towards the end of today's prepared remarks. If at any time during this call you require assistance, feel free to press "star" "zero" and a coordinator will be happy to assist you.

I would now like to turn the presentation over to your host for today's call Mr. Dan Warmenhoven, Chief Executive Officer. Please proceed, sir.

Thank you. Good afternoon and welcome everyone and thank you for joining us today. With me on today's call are Tom Mendoza, President of Network Appliances, Steve Gomo, our Executive 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 risk and uncertainty, including statements regarding our forecasted operating results and metrics, forecasted market share gains, anticipated technological and product developments, and our outlook for continuing growth. 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 are also accessible through our website, all of which factors are incorporated by reference into today's discussion.

I'd also like to remind you today's conference call is being web cast live over the Internet and will also be available for replay on our website at www.netapp.com. Along with the earnings release, the reconciliation between GAAP and pro forma numbers and other financial and fiscal information presented during the call.

Now I'll turn the call over to Steve to review this quarter's financial results, then I'll share my own thoughts on the quarter and I will wind up with our financial outlook and conclude with the questions and answer period.

At this point, I'll turn the call over to Steve.

Thanks, Dan. Good afternoon, everyone. I'd like to start by saying how pleased we are with our third-quarter performance, again demonstrating the effectiveness of our business model. This quarter's strong performance was reflected in the income statement, the balance sheet, and cash flow.

I'll now walk through some commentary about these results. Please note that all the numbers are GAAP, unless stated otherwise. For our third quarter, revenue was $412.7 million, up 39% over third quarter of last year, and an increase of 10% sequentially. Foreign currency effect contributed a favorable two points to both the sequential and year-over-year growth rate.

Product revenues of $367.9 million grew 9% sequentially, finishing 37% higher than last year. We saw strong increases in all of our filer unit volume, particularly at the high end. Add-on software and software subscription upgrades increased more than we planned, accounting for almost 35% of total revenue.

Remember that this figure excludes software that is bundled with our systems, including the Data ONTAP operating system, our WAFL file system, the first protocol, and Snapshot. This figure is a combined total of add-on software products which were 24% of total revenue and software subscription upgrades that were nearly 11% of total revenue.

Revenue from services, which includes hardware support, professional services, and educational services, was about 11% of total revenue, up 58% over Q3 of last year, and up 17% over last quarter. The growth in services was driven primarily by a dramatic increase in our professional services business, which grew almost 27% sequentially from last quarter.

Turning now to margin, pro forma gross margins finished strong at 61.3% compared to 61.8% reported last quarter. Pro forma product gross margins finished the quarter at a more typical 65.7%, compared to 67.1% last quarter, which you'll recall was higher than normal due to a few one-time events.

Product margins also reflected increased discontent as storage capacity shipped increased significantly this quarter. We shipped almost 27 million -- excuse me 27 petabytes, which is a 23% sequential increase over last quarter.

Service margins were the standout this quarter, as they increased significantly to 25.3%, a favorable sequential increase of over 9 percentage points. Clearly, the investments we've made in our professional services organization, over the past 18 months are beginning to pay-off.

The major contributors to the improvement in service gross margins were the volume effects of service revenue growth and a back-ended hiring pattern in professional services. Professional services headcount finished the quarter, slightly under our plan.

We are projecting services margin, going forward, in the low 20's. We will continue to invest in professional services as our strategy is working. It's undoubtedly a growth driver for both product and services revenue at NetApp.

Moving on to expenses, pro forma operating expenses totaled $180.9 million, an increase of approximately 9% from the $166.2 million reported in quarter two. This quarter's results included about $2.5 million of expenses, which were not expected to repeat next quarter, such as the write-off of a leased field sales office, some consulting fees, and a few smaller non-recurring items. Pro forma operating expenses represented 43.8% of total revenue, roughly in line with our 44% target for OpEx spending.

Pro forma operating profit for the quarter finished at about the same level as last quarter at 17.5%. Pro forma other income was $5.5 million for the quarter compared with $6.2 million reported last quarter. You may recall that last quarter's results included a $1.3 million of interest on a tax refund. Pro forma pre-tax income for the quarter was $77.6 million or 18.8% of revenue. The effective pro forma tax rate remains at 19%.

Pro forma net income for the quarter was $62.8 million or 15.2% of revenue. And pro forma net earnings were 16 cents per share based on a weighted average of approximately 386 million shares outstanding. GAAP net income was $60.1 million, also 16 cents per share. The reconciliation between pro forma and GAAP financial results is provided in our press release and is a separate reconciliation table both of which are posted on the investor section of our website at netapp.com.

Our balance sheet is strong as ever with cash and investments increasing approximately $185 million to 1.1 billion. Deferred revenue was up $50.5 million to $390.3 million, a 15% sequential increase, and up 65% from the $236.8 million reported a year ago. In addition, in another true measure of the value of our business, we generated a record $148.5 million in cash from operations this quarter. Capital purchases totaled $16.9 million and depreciation amortization was $15.9 million.

As part of our stock repurchase program, we purchased about 1.5 million shares of outstanding common stock at an average price of $32.62, for a total of almost $50 million. We have approximately $81 million remaining in our buyback authorization.

Accounts receivable day sales outstanding were down slightly to 52 days versus 53 days last quarter. Inventory turns favorably increased to 16.8 times, compared to 16.3 times in the second quarter. Compared to one year ago, inventory turns have improved 37%.

Our employee headcount at the end of the quarter was 3,519 employees, an increase of 264 employees from last quarter. So, on summarizing the quarter from a financial perspective, we are effectively executing our operating plan and our investments in growth are visibly paying off. This was certainly highlighted by our professional services performance this quarter.

Now, before I share the outlook for Q4, I'll turn the call back over to Dan.

Thank you, Steve. As you can see from our results, NetApp had another very strong quarter, looking at it from a macro perspective; data protection appears to be one of the biggest drivers of our recent success, fueling demand for compliance solutions, disk-to-disk backup and business continuity solutions.

Microsoft Windows and Exchange continue to drive our growth in the iSCSI business and we're seeing LINUX began to drive demand for more storage-grid style deployments. And with these macro drivers, the decisions are made some time ago about our operating model and internal investments are now paying off.

Our professional services organization is a great example. We invested heavily in that group over the past 18 months to hire professional service of engineers who are now beginning to contribute both to services revenue, as well as to driving increase product revenue. While that investment had depressed our service margins over the past year or so, that trend is now reversing as these people become effective. And has had -- is directly resulted in the kind of service margin improvement we reported today.

NetApp has always been known for innovation and we're very pleased with how our investment in broadening our product family has also paid off. Our filer business experienced growth across every product line this quarter.

Our high-end FAS980 was the strongest performer with over 60% increase in units sold. Overall our high-end products, which include the FAS960, FAS980 and our NearStore family accounted for well over half of filer revenue this quarter.

The number of FAS200 units shipped grew over 15% over last quarter, bringing our low-end product line to almost half our total units shipped. In the mid range, units shipped of our FAS920 and FAS940 increased by 25%. Our product management and engineering teams have clearly done an outstanding job of producing innovative products, which meet customer needs and are therefore experiencing strong uptick in the marketplace.

NearStore contribution, including the hardware and related software and services increased to 19% of total revenues this quarter. This is a 23% sequential increase, and over 120% year-over-year growth.

Total ATA storage has increased over 50 petabytes shipped, since inception. With our robust RAID dual parity capability, which protects customers against double disk drive failures making less reliable ATA drives, appear to perform as reliably as server class drives, we see ATA going well beyond narrowline applications and becoming prevalent in primary storage environments as well, bridging the gap between primary and secondary storage in tiers in the enterprise. We expect this to have a significant impact on overall storage economics, further driving down costs for our customers, even as we increase storage capacity and functionality.

Our Fibre Channel SAN and iSCSI business had another record quarter with block-based storage now included in 24% of our business. Both SAN and iSCSI grew this quarter; with SAN coming on particularly well accounting for 15% of business and the iSCSI protocol was included in 14% of our business.

The overlap included both SAN and iSCSI, and the majority of the rest of our block-based business also included NAS along with other protocols. This is one of the many reasons customers continue to buy NetApp, because we're the only vendor to offer the ability to run multiple protocols concurrently out of a single system.

This quarter the Mayo Clinic purchased a large scale Fibre Channel SAN clustered filer to support the Windows home directories complemented with FAS250's and FAS270's in their storage systems they've previously purchased for patient records and disks indefinitely. This is one of the examples of our channel success because our partner custom storage was the lead on each of the Mayo Clinic purchases of NetApp systems. The majority of our SAN-iSCSI business was done through our channel partners.

Our iSCSI growth also coincides with the momentum we're gaining at our Windows business and our Microsoft relationship, because the majority of these deployments are from Microsoft Exchange and Microsoft Sequel Server environments. This quarter NetApp kicked off our first outbound marketing campaign with Microsoft and conducted several joint exchange seminars with Microsoft and KVS around the country. These are already generating a lot of quality leads for us, and so we continue to be very optimistic about the future of this business.

By the way, we're also very happy to see new competitors finally entering the iSCSI market. Not only does it lend additional validation that this is a very important segment, but it also gives customers a choice. We believe that this will accelerate the adoption of iSCSI now that customers have two leading vendors to choose from. Many customers wait until they have choices before committing to a new technology, and now there are two leading vendors in the market, we are confident they will choose NetApp in increasing numbers.

We are the industry leader in iSCSI and Ethernet-based storage, and we're still the only vendor who offers unified capability. Our competition may now offer iSCSI, but they cannot run iSCSI and SAN and NAS concurrently on one system. And this is a strong advantage for us, especially in Microsoft environments where customers can deploy a single unified storage solution from NetApp to consolidate both their exchange on a sequel data storage, the iSCSI, on the same network and storage systems that supports end-user home via NAS.

The strong performance of our SAN and iSCSI business exemplifies that the strength of our unification (ph) storage continues to accelerate. As we discussed this quarter -- last quarter, excuse me, since so many of our systems are now sold in multiple connection types, we believe the market has recognized that NetApp offers infrastructure solutions which allows customers to run virtually all protocols on any of our systems.

Reaping the benefits of our R&D investments in the past few years to create unified storage, and this puts us in a very strong position of leverage. The SAN business is growing and taking market share, and our NAS business continues to grow and take market share right along with it. The key differentiator is we offer one common operating system across all our products and connection protocols. We look forward to further stimulating the growth of the SAN-iSCSI business in the coming quarter.

The latest version of our operating system Data ONTAP 7G became generally available this quarter. 7G is the next major step in our storage grid effort with virtualization capabilities to allow customers to significantly increase their storage utilization rates, at the same time decrease the time needed for administrators to maintain the system.

Offering the new standard in storage virtualization technology, FlexVol, one of our key new software features enables the creation of virtualized flexible data containers which eliminate performance and utilization trade-offs, essentially separating data management from the physical disks.

Synopsis is a terrific example of a customer planning their infrastructure for good computing. This quarter they purchased a wide range of NetApp filers from our low end FAS270s to our high end FAS980s, as well as near store are 200s to fulfill the data protection and grid storage needs, supporting both their technical applications as well as their SAP, ERP environment worldwide.

Our net cash products contribute about 4.5% of revenue this quarter, and while this remains a small percentage of our business, it is a very profitable segment for us, and it often opens the door for filer sales and new customer opportunities. Customers this quarter include, Deutsche Telecom, Eli Lilly, Ford, and the US Army Recruiting Command who purchased NetCache to support their goarmy.com website.

Looking at our business from a geographic perspective, we again our typical seasonal trend. This quarter's profile was almost exactly the same mix as we saw in Q3 of last year. North America accounted for 55% of the business this quarter, Europe contributed a seasonally strong 34%, and Asia-Pac contributed 11% this quarter.

Our channel mix also returned to a more typical profile for Network Appliance with approximately 50% of our business coming from direct, and 50% through indirect channels, which was down from a record high of 55% last quarter. The combination of the two-tiered distribution partners Arrow and Avnet increased to a total of over 9% of the business this quarter.

Our investments and developing partner programs and relationships continue to expand our opportunities in revenue. We have developed a robust and friendly model with our channel, working to provide them with good margins and easy to do business with practices. Relatively few new partnerships with influential companies like Microsoft and SAP are just beginning to return benefits to us, reminiscent of the early days of our valuable Oracle partnerships.

For system integrators like Accenture, IBM, Global Services and Fujitsu, Siemens continue to develop practices around our system as well as resellers like Datalink, Northrop Grumman and Proactive Scandinavia.

To recap the quarter, Network Appliance demonstrated our strategic decisions continue to be the right ones for growth and taking shares in storage market. With the strength of our product margins are clearly doing well in competitive situations, we were not particularly impacted by the constrained supply from the disk drive manufacturers.

At this point, I will turn the call back over to Steve to discuss our financial targets.

Thanks Dan. Our business outlook is based on our current business expectations and reflects our pro forma presentation.

Again, I'll remind you that we are making forward-looking statements and projections that involve risk and uncertainty. Actual results may differ materially from our statements or projections.

We expect our success in the marketplace to continue and project fourth quarter revenue to grow sequentially by 6 to 9%. This projection reflects year-over-year growth rates of 30 to 33%, compared to a very strong Q4 one year ago. We expect Q4 pro forma earnings to be -- per share to be 16 cents to 17 cents per share. GAAP earnings per share should finish at 16 cents.

Full-year FY '05 expectations for revenue are, therefore, $1.584 billion to 1.596 billion, or 35 to 36% year-over-year growth. This implies FY '05 pro forma earnings per share of 60 to 62 cents per share. Projected FY '05 earnings per share should finish GAAP earnings per share should finish in the range of 57 to 59 cents. We expect total shares outstanding to end at the end of Q4 to be roughly at the same level as this quarter. I'm turning the call back over to Dan now to wrap up.

Thanks, Steve. As you can see, Network Appliance position continues to capitalize on the strongest growth segments of the storage market. We believe in growth and data protection, windows, and unified SAN, NAS, and iSCSI with a long-term phenomena just beginning to gather steam. We will continue to innovate new technologies like Data ONTAP 7G to bring new and more effective ways of sales storage challenges for the market. Internally, we remained focused on acquiring scale with infrastructure to handle our future growth.

We will continue investing in targeted areas of the business to fill that growth. You can expect to see more people add particularly in professional services and sales, this quarter. With some changes made to streamline and the marketing organization, you can also anticipate, we will be rolling out focused marketing programs to increase the effectiveness and velocity of sales, services, and alliances.

Before I open the call for questions, I'd like to thank everyone on the NetApp team for their efforts and helping us to achieve another great quarter.

At this point I'll open the call; I'd ask that you please limit yourself to one question so that we can address everyone in a timely manner and also on your request to keep the call to one hour.

Operator, please take the first call.

Thank you, sir. Ladies and gentlemen, at this time, if you wish to ask a question, please press "star" "one" on your touchtone telephone. Again, "star" "one" for any questions. One moment please. Your first question is from the line of Shebly Seyrafi with Merrill Lynch.

Yes. Thank you. And congratulations on a great quarter. Maybe you can help us out with the operating expense expectation forecast for Q4. You mentioned that some one-time expenses will not recur. Should we expect double digit, say, a sequential growth maybe over 200 million for the quarter? Thanks.

Well, I don't think that we're going to get that granular simply, but that's probably on the very high side. So no, I would not be looking for that kind of rapid growth.

Okay. Thanks.

Your next question is from the line of Bill Shope with JP Morgan.

Okay. Great, thanks. There's been some charter about pricing potentially getting incrementally more aggressive at least in the high-end of the market. Are you seeing any of this or is it still really localized in the high-end subsystems based?

We didn't see any significant change at all. And if you look at gross margins, I think that speaks to it. Pricing and competition have always been -- shall I say, fairly aggressive throughout the industry. I mean, this is a highly competitive sector. But we don't see any significant change relative to the prior quarter.

Okay. Thanks.

Your next question is from the line of Ben Reitzes with UBS.

Yes, good afternoon. Thank you. Dan, could you just touch on your long-term goals again for next fiscal year, as well as, FY '07 for 2.8 to 3 billion? And then if I may, can you just, Steve, recap services gross margin, what we should look for going forward. I think you -- if I heard you correctly, you said it should go down sequentially by about five points but I want to confirm that?

Yes, can I ask you to kind of clarify the question? I mean, you obviously have the numbers of what - you're obviously looking for color behind it. I can't you give me a sense of what --

In which part, the services or the long term?

Probably a long term.

Well, I just see some stuff on the tape here about you talking about your long-term goals that nothing has changed, etcetera. I just want to confirm that that is correct that about your targets for growth 35% all the way through '06 and '07?

Yes, that's correct. I mean, Yes, we think, we can sustain that kind of growth rate. Certainly the market is available. And we have a stretch goal -- I think, I mentioned at the analysts conference, which we held on December 1st and trying to get to 35% compatible, which takes us right to the $3 billion mark that's a little higher than the official guidance, we gave you. But we think, it's possibly within our grasp. I mean, you should interpret these comments as being exactly the same as the ones we made in the December meeting. We're not moving off that a bit.

And we think the market conditions are right for us. You can see the struggle that companies like Hewlett Packard have significant share going through and that represents an opportunity for us and we think the product line we have is as competitive as ever. So we're not backing off one notch.

Yes, just add to Dan's comment there before I hit the service question, if you looked at the high end of our guidance on the year-over-year, I think, you'll find it's probably 36.5% -- 34.4% to be precise. Like Dan said, we're not changing the guidance at all. Okay.

Talking about service here, yes, we did say that we expect to see service come back down a little bit, service margins come back down a little bit in the fourth quarter and the reason for that down is the fact that we expect higher income pickup now.

We saw slowdown during the holiday period, which we probably should have anticipated better that slowdown pushed most of the hirers to the backend of the quarter and also caused us to fall a little bit short in this past quarter. Going forward, we expect to get back on our ramp and that's why we expect the service margins to fall to the low 20's.

Thank you.

Your next question is from the line of from the line of Keith Bachman with Banc of America.

Hi, guys. Thanks for the question. In terms of the growth trajectory, I just want to see if you could offer more color out over the next quarter or two on either a geographic basis or on the direct versus indirect side? Thanks.

Well, this quarter comes out like a traditional Q4. You will see North America spike in the mix. Europe will fall off a little bit. And Asia-PAC will pickup one or two points. You look historically and Europe drops to right around 29 or 30% typically and Asia-PAC about somewhere around -- 12 or 13% and North America has a big surge. I don't have any reason to believe that will not be the case this quarter.

On direct?

On the direct percent, direct? Yes, let me comment on the why 55% indirect last quarter and only 50% this quarter. We saw some softness in quarter in two areas dominated by indirect channel. One was the US federal business and which very soft. Last quarter, remember, was the end of the US government fiscal years, so that kind of surged up and that was largely indirect.

And this quarter they came back to a more typical profile in the mix. And the second was Japan, which was almost all indirect, and they had a fairly soft quarter, as well. We'd expect them to come back this quarter. So you should probably expect the indirect mix to go up a little bit as those two kind of come back maybe 52% indirect.

Thank you.

Sir, your next question is from the line of Richard Chu with SG Cowen.

Yes, hi. Good afternoon. Could you, Dan, you mentioned that your ATA and NearStore petabytes cumulatively were 50 petabytes. That sounds like the (inaudible) is correct. It sounds like the increment slowed a little bit in the third quarter. Could you talk about that a little bit?

Well, the increment didn't slow at all. It was 25% higher than the prior quarter. It was over 12 petabytes shipped this quarter.

Okay. I mean, it could be something else. I'll follow-up on that. And do you have -- of the total headcount additions, 260-plus, how much of that, roughly speaking, was in the even though backend loaded was in the services area?

There was about 64 including about 20 contractors that were in the headcount increase.

Thank you.

Professional services.

Sir, your next question is from the line of Harry Blount with Lehman Brothers.

Hi, guys. I wanted to ask a quick question about coming back to, Dan, your comments on Japan. I know you guys in the last 12 months or so have significantly enhanced the number of relationships over there with NTT and others. Can you maybe give some longer-term color on how long that going take to ramp or what some of the impediments have been short term?

I just think we've seen a typical seasonality. They just go slow in January. The typical end of the fiscal year in Japan is April or March -- March, I guess. Anyway, they seem to really surge in our Q4, but they're always soft in our Q3. I don't see anything particularly long-term about them being soft this quarter. That is more normal seasonality. Longer term, we think we're going to increase the amount of direct touch we have. We wanted to do the business indirect, but we've decided to change our strategy to the point we have much more direct end user involvement high touch model, especially, with the larger accounts there.

And I believe that' going to probably have increasing effect, I mean, there is a number of large account there already that are NetApp customers and we don't have much of a relationship with, but as the relationship builds, I think, their confidence will build and therefore the business volumes will build.

Several of the major automotive manufactures, bank, NTT DoCoMo, you go through the list, and I think as we expand beyond the customer base we already have, that's more of a market development kind of function and typically you find those sales cycles being 12 to 24 months depending on the nature of the account before they really start producing significant revenue. Tom, you want to comment?

I would say two things. The major resellers we have over there most probably for get to, as an OEM and TTC are also ramping, new investments fairly dramatic over the last nine months with NetApp. And we are ramping our investments both on, as Dan said in the high touch and also in supporting those large, large channel vendors who have literally 2,000 sales people a piece. We're starting to address a large -- broader group of those sales people which broadens the opportunity.

And as Dan said, we have move more in enterprise sales and we've dominated in the engineering markets over there for a long time, but we're getting far more enterprise-oriented sale cycles, which are bigger transactions and longer sales cycle. It's a little hard to predict by month, but I actually go there quite a bit, and I think, our business is very, very healthy there and we are increasing our investment because of it.

Great. Thanks.

Your next question is from Joel Wagonfeld with First Albany.

Thank you. I was wondering if you could just remind me on longer-term your expectations for the mix of product versus services revenue, and services margins at more of a steady state, say, a year or two out.

Yes, Joel. This is Steve Gomo here. I think in our December meeting we talked about our model next year having services that around 11% of total revenue. And we expect that to actually play out that way.

And the margins there?

Margins would be in the low to mid 20.

Low to mid 20. Okay. Thanks. And then can you give us any more clarity on any verticals beyond the federal government comments that you made?

You know, tech was, again, top of the list. I mean, although it was down a little on percentage, it was still number one vertical for us. Right behind it was financial services, Telcos, the federal government sector which was, I think, like 13, 14% of revenue last quarter was down to 7% this quarter and that's a just reflection of the comment I made about the end of the federal buying year was last September, which caused a spike. Behind federal was the energy sector, oil and gas, manufacturing sector, and on down the list.

Thank you.

Your next question is from Tom Curlin with RBC Capital Market.

Hi. Could you talk about the upgrade cycle opportunity for the new OS and related to that, have you taken any actions to raise pricing significantly on maintenance for your existing installed base? Thank you.

No. We have not changed the maintenance pricing, although we do have some new service packages, which turn out to be incredibly popular. The support edge premium service, which includes both the warranty -- I'm sorry -- the hardware maintenance, the software upgrades, global advisor services, which look at the performance and behavior of the systems and it turns out to be price neutral, but it's a nice, simple bundle to put in front of a customer. And we have seen a significant penetration of that.

Is that -- so these are services that are incremental to the type of maintenance you've provided historically?

No. It's a combination. Typically it was a Chinese vendor if your customers could pick what they wanted for hardware support or they could pick what they wanted for software support whether they not wanted any Global Advisor and professional services, etcetera, etcetera. This wraps it together in one easy bundle for them and it is price neutral just an easier way to present it to an enterprise customer as a complete solution.

All right. Thank you.

Your next question is from the line of Dan Renouard with Robert Baird.

Hi. Thanks. Can you comment on large deal this quarter versus last and maybe defined as $10 million up or however else you want to define large deals? Thanks.

I don't think we had any of $10 million up this quarter. That would be very rare. Yes, probably yahoo we've had a couple of, but that's a large number for us from a single customer.

We had some large transactions as Dan mentioned on the conference call, Synopsis decided whether there were going to move away from another competitor and go completely with NetApp. We had dominated the account for a long time, but another competitor didn't do as well as they come back to us in a full way, so that was a significant order. As Yahoo continues to expand their presence with NetApp to a dramatic fashion. We are now in many, many petabytes in Yahoo as most people know. But which say this, as I looked over the major account penetration, we have a strategic account program here. And it's been very, very successful this year as we continue to see larger and larger numbers as the big accounts we focused on. We have 25 that we really focus on and another subset of 100 that we put to program into it, too. And that is continuing to be a growing part of our business as we forecasted it would.

Your next comes from the line of Aaron Rakers with AG Edward.

Hi, guys. Nice quarter. A couple of questions. First, if you can talk a little bit about again about the near store and the potential for cannibalization. As I look at my number, it looks like the pure filer revenue was sequentially essentially flat. And then also if you can provide some update on the integration of the Spinnaker stuff? Thanks.

While we do the math on the filer mix, let me comment on the Spinnaker one. It's going very, very well. They are on track for being able to release that system on schedule near the end of this fiscal year -- I'm sorry -- calendar year. And it's coming along from my viewpoint extremely well.

Also, I want to point out the 7G. I got a question, I think, a minute ago that I didn't quite answer on 7G adoption. We have about 700 systems, which is about probably on the order of 7% of our install base, I think, if I did the math right, now running 7G. About 75% of those are running the new FlexVol technology, which is optional. I mean you can install 7G without activating FlexVol.

The question that one, though, was about revenue opportunities, that really doesn't represent the revenue opportunity because most customers buy software subscription therefore entitled to the upgrade for free. What it does leverages, however, is the opportunity for some more database, value-added software in the form of FlexClone, which was specifically developed to help customers in database deployments be able to do more effective testing of their environments before they roll them into production. And they replicate production databases into a test world very, very quickly. On the filer revenue, Steve?

Filer revenues were roughly flat. That's up nominally a little bit. Units were up dramatically. And filers represented around 73% to 74% of the total business this quarter.

Let me give you a little color on how we view NearStore. We have a large customer of 700 terabytes and they came to see me last year and they said, we bought 700 terabytes in nine years, we are going to buy 700 terabytes this year, are you interested in why? I was almost afraid to ask why, but I did ask.

And the reason was 64 bit processors -- this is a chip company -- they went from 10,000 UNIX machines to 20,000 LINUX machines and by telling their story they're all primary storage with NetApp before filer, as you are calling it, they went to 40% to NearStore. So what happened is, within the envelope of their budget, they got tremendous more computing and they were able to use a lot more storage.

And the reason was with our RAID parity protection, they felt it was good enough now for many of the data mining apps. So two things are happening that I see. Number one, people are taking things that were on the net direct connect and they are pulling it together and NearStore is giving us incremental opportunities. Number two; it only cannibalization, only is relevant, if we get much lower margin on our ATA family. We don't, so our sales force, isn't out there trying to push a higher priced product. They are trying to solve the customer's need with the broadest array and bring more direct storage to us.

Dan pointed out the Hewlett Packard issues and other companies issue, Sun and others. We feel like we can move more and more storage to the ATA platform and give the right availability and recovery with ATA and our filer family better than anybody else.

As I said in my remarks in the opening of this call, we expect NearStore to move more and more into production style environments because of the RAID-DP capability. Essentially what you will get to I believe -- and I as a customer is equivalent reliability between our systems with server class drives and our systems with ATA drives. And then they have a price performance choice to make. If they want high performance, they have to pay a higher price than the server drives. And if they can live with lower performance, slower response times, then they can achieve that at much lower price point, like Tom was saying. So I don't view it as cannibalization, I just say that's the, the best fit for the application requirement.

And remember the one big advantage is regardless of what they choose, they get the same file system, so they don't have to manage different families. With any other computer company or any our storage vendor, they have to pick correctly up front or they have a major upgrade because the families aren't compatible. In our particular line they pick the right performance, capacity, and recovery aspects that they need and they match the product to it.

Okay. Thanks, guys.

And the next question is from the line of Andy McCullough with CSFB.

Thanks guys. Just on distribution mix, do you see any margin impact with shifts between direct and indirect sales? And then secondly, Tom, you've talked in the past about NetApp being under distributed, and I guess, are you content with your current stable of indirect partners? Are you going to be looking to build this network out through 2005?

I'll take the first part of the question on the margins. There is not a material difference that we see today. So, could that change overtime? Yes. But as of today, right now in our current business model, we are not seeing a material difference in margin there is. Tom.

I'm not content with anything, if you know me very well, but anyway, be that as it may. On our distribution strategy, we've been -- last year has been tremendous for us from a channel point of view. Number one is a lot of big channel partners bet with us and saw tremendous amount of profit coming into the Company. It's very, very clear because our margins have stayed up that we can have our partners make more money selling our stuff than they can with anybody else. Number two; we have had some tremendously large opportunities like Fujitsu Siemens, like computer center in London, like CGC in Japan that have really increased the revenues dramatically this year. So, they are putting more and more investment on it.

So, we view it as a tremendous upside opportunity for going-forward, as far as getting more and more distribution. It's becoming -- as the word spreads that you can make money here, the alternatives are not many. So, we are putting a lot more resource into our side of marketing for the channel, getting the assistant views of channel, and also putting more people in channel support because what they really need is technical folks to go with them, technical folks help them out. They don't need sales support. We've been growing that fairly dramatically over the last six months. So, you'll see more than ever the focus on growing out the channel at NetApp over the next year to two years.

Thanks.

Your next question is from line of Kaushik Roy with Susquehanna.

Thanks. Can you comment on your expectations for product margins for Q4 and are you seeing abnormal pricing pressure on disk drives?

Well, I'll take the -- this is Steve Gomo here. I'll take the first part of the question on product margins for Q4. I would not look for a material change in the level of product gross margin performance in Q4. Should be right around where it is today.

This is Dan. On the disk drive question, my personal forecast we don't see any price decline, but we're not going to see any premiums paid either. As you probably know, this is a very unusual time from a disk drive supply viewpoint. Both of our major suppliers are basically discontinuing the former generation of disk drives and are in the process of ramping up new production on the new generation of disk drives which leaves -- I cannot remember any time when the two of them went through the same change concurrently or simultaneously. That's actually a very temporary situation as they ramp up their supply. I think you'll see that the price is going to stabilize very quickly. I don't expect to see any declines in price, but I also don't expect to have any premiums.

Okay. Thank you.

Your next question is from the line of Mark Kelleher with Adams, Harkness.

Thanks. Dan, could you talk about the competitive situation out there? Who is giving you the most trouble, and do you see any new developments from the EMC-Cisco agreement?

On the EMC-Cisco and the answer is absolutely not. Yes, while that may seem to have a lot of speculative interest from a lot of people, it is, we think, fairly minimal in terms of the impact on the marketplace and the customers. It is really aimed at finding complimentary product for Actona, which has got a very small market share.

So, coming back to the bigger question about competitors, you know, EMC continues to be our primary competitor. We see them in terms of frequency of engagement more than anybody else. Second place, as you might guess, is Hewlett-Packard, although I must say they seem to have a declining strength from a product viewpoint with this getting a little old and tired. So generally often gets down to be just us and EMC. I mean there is a smattering of others in there, but EMC is by far the most frequent competitor.

We have had a number of very large accounts in the last year move our way, and primarily because they want a second vendor. In many cases, they have, for whatever reason, been a one-vendor shop and I don't think many people think that's very intelligent over time. You don't get the best competitive pricing if you do that. And the Intra Day (ph), a CIO of a very, very large company overseas said to me, that when they decided that they are going to go to second vendor that was the first decision.

The thing he said is, there's only two companies in storage innovating, EMC and NetApp. And we can all argue over who does a better job at that, but the fact of the matter is the other guys are trying to figure out how to catch one of other. Well, when you are the second company and the other guys are in a lot of them, there is a tremendously positive reinforcement when you go into a company. They want two and they already have EMC, who would they select besides NetApp? What they said is, I might well get the two innovators on my floor, let them look at my business, and whichever one solves whichever problem the best I will give them the business. That's happening to us as a trend. I said that about two or three quarters ago and it continues to happen everywhere.

So, I don't always have to argue, you got to take them out to us in, we are a complimentary second vendor and we drive a different way of looking at the business problem and help drive cost out.

Okay. Great. Thanks.

And I should point out that we also probably have the only product line in the industry that goes head to head against every one of the EMC's products. Our 980s up against the DMXs. You know, our Mid-range Solutions against the CLARiiONs. Obviously, there is Celerra, which was mass, right. There is Centera, who is head up against our NearStore. I don't think you can find another vendor in the industry who has got that breadth. And so it really is us against the EMC because we are the only ones that can weave together a complete solution for all the different environments.

And sir, we have a question from the line of Brian Freed with Morgan Keegan.

Thanks, guys. I know you don't have to report options expense until later in the year, but could you comment on the impact of options in the quarter and also just your view on the positives and negatives of options and option expense?

Well, is that a politically charged question? So the easy part is to say that if you look back historically, over the last several quarters, option expensing would have erased about not quite two-thirds, call it 60% of our earnings. I think we could debate the prose and cons of option expensing for a long time, Dan, unless you have any comments. I'm going to pass on that.

Well, we have been very clear. We think that there is a significant benefit in terms of the allocation of options to all employees. Every employee in the company has one. The most significant options are granted at the time they're hired. We think that has a tremendous unifying force both in terms of them placing their primary emphasis on what's the best thing for the company and the shareholders. And we will do whatever FASB mandates, right, but until that time we're going to just keep it as a footnote, which is all it's really required at this time.

I need -- this is Steve Gomo. I need to clarify something. I said before that filer revenue was flattish. It's actually up 8%. And it just serves me right for trying to read something upside down.

Your next question is from the line of Kevin Hunt with Thomas Weisel Partners.

Thank you. I wonder if you could comment on your relationship with Veritas and any changes you might see given their merger that they have got going on? And also it's follow-up for Tom, if you could give us a comment on your outlook for Notre Dame football under Charlie Weis?

I am having lunch on March 30th, I'll give you a report after that you call me, but first of all, the relationship with Veritas is very, very strong, the three strongest partnerships there Oracle, Veritas, and SAP, with SAP being an emerging strength.

I mentioned before that we did 100 new SAP installations in Germany alone last year and I believe you will see that start -- that we just talked about Synopsis, but the US is a big, fertile ground for that for us. But Veritas specifically, their group around KVS and their compliance group have been focused on NetApp big time. We've won a number of big compliance deals on the street, where they like our SnapVault and SnapLock products.

One of the things, they asked us to do was to integrate that in with net backups, so you could have one view of the data. That is being done by Veritas. That's very, very exciting because they get the same way of doing what they today -- say, because this handles both structure data and unstructured data. As you know if you have an issue on the street, they don't just come and ask for premail, they want everything.

So what if we can lock it down, if you back it up and what if we could manage the net backup because they -- Veritas is the most popular on the street? We're working closely together both as sales, engineering, and marketing organizations to push primarily, I would say, and to compliance and backup. Number two, since Symantec bought them, and Symantec made it very very clearly and in fact recently, I listened to some of John Thompson's statements that NetApp is one of their key strategic partners for the same reason as it was for Veritas, common enemy.

And I think at the end of the day, EMC's strategy in a wrap to the market is, if you buy everything from us, it is better that way, that's what IBM did in the 80's, people want to open systems. We believe you don't want to buy everything from one vendor. You want to buy the best of breed and the partnerships have to pull us off with the customers, so they can drive cost out while utilizing best of breeds. Veritas and NetApp or Veritas, Symantec and NetApp are very committed to working together and do that.

Okay. Thanks.

Sure.

This is Dan. Let me add one thing there. We feel we have a distribution agreement already in place with Symantec. We saw lot more of high-risk gain product in conjunction with filers or caches through the Internet access or for a lot of these exchange environments. And John Thompson is a good friend of a lot of ours, so it was a natural extension.

We have a question from the line of Clay Sumner with FBR.

Thanks very much. Steve, can you just talk about why G&A expense grew faster than sales this quarter and did you guys issue stock for anything other than option exercises? Thanks.

So the G&A grew for a variety of reasons. Most of them having to do with a number of unusual things. As you know, there were a lot of option exercises at the company this past quarter and the employer portion of Medicare was quite large and accounted for about 700K worth of admin expense.

In addition, we had the -- a number of small things -- these are part of the nonrecurring items that I mentioned earlier. The contributions to the second harvest food bank, the contributions to the Tsunami relief fund, some audit expenses and audit fees associated with the Sarbanes-Oxley activities that are going on. All of those were adding up to about $2 million in increased expenses. And the second question, as far as any stock options, stocks being issued aside from options, the answer is no.

Thank you very much.

You are wondering why the share counts are up so much?

Yes.

I think its just calculation based on the treasury methods, based on the price of stock.

Right.

So the options outstanding, right, already issued and granted at a fixed price are very -- the share counts based on the current price of the stock. It's a probabilistic thing, right?

Right. But the basic count went up as well, so I was just checking that.

Okay.

Sir, our next question is from line of Glenn Hanus with Needham & Company.

Just wondering on the whole disk drive transition, as you look here for this quarter, is any of your guidance 438 -- I can still add 438 to 450 for the quarter, are you being at all conservative on that guidance because of disk drives?

No, disk drives had nothing to do with it. I mentioned we don't see any pricing pressure. We don't see any particular supply issues for this quarter either. The supply team has -- the supply chain team has done a terrific job of securing supply, and we think we are adequately covered for the quarter. I don't think the assertion behind your question is correct either. We didn't lower anything.

No, I didn't mean to imply that you did. I was just wondering if drives were somehow perhaps an issue, but I understand now that they are not.

Okay, it's fine.

And if I could, just any general comment you can make maybe contrast today versus, say, three months ago on just what your sensing out there in terms of IT spending, storage spending, just sort of the tone and the environment that you are sensing?

I don't see any particular change. And let me recap this quarter a little bit because it was pretty typical of Q3. November and December are really strong. We see a little bit of a rush especially in Europe for year-end budget flush, whatever, and January is really weak. I don't know if any tech company that has a really good January, right, as companies come back from the holidays and try to get their budgets and plans together for the upcoming year. However, as we exited January, things felt like they were really pretty solid. And pipelines looked really good, things like that. I don't see any significant change from last year.

And I think it's going to continue to be strong. The themes are the same. A lot still around several consolidation, especially around exchange, where customers are looking a move to exchange 2003. A lot around the business continuity issues, the vast recovery data protection, compliance, re-engineering backup, a lot around distributed enterprise and all mirroring of information back and forth to regional branches offices and things of that nature. So both thematically and quantatively it feels very, very consistent with what we saw in the fall.

Thank you.

Our next question is from the line of Bill Fearnley with FTN Midwest Securities.

Yes. Thanks. Just a follow-up question here on the indirect channels. Could you folks compare your traction with SI's versus VARs in the quarter and your expectations in near term as well? Thanks.

I don't have that data in front of me. I haven't broken it down to that level of granularity here.

But in terms of trend versus expectations, can you give us more color there?

I thing the SI's are coming on with extremely well. We just had one of the biggest ones with 25 of their top architects because they really wanted to understand how they could help architect savings for their customers. And we have been trying to get them here by a year ago and now all of the sudden they came here and asking us to put the session on. We did a session last quarter. I think we may have talked about, we brought, I think, 13 different major SI's together and talked to them about what we can do better as a program. And they just liked the fact that we -- that they can make a lot of money doing what we're doing and we can lower the cost of their customers and they can work with us.

So we're seeing -- we put more investment in that over the last six months and it's very, very clear we have a much higher mind share with them. We no longer kind of beating on them to get mind share. It's a matter of picking which practices we want to go after and each of its has do that to develop a practice whether it be compliance, whether it be data recovery, however they are going about it, some with data consolidation, but in general, they have a practice, then they're pushing into their customer bases. And we are becoming a lot more adept, I think, at setting our organization up in a way that's easier for them to deal with.

So, I really like the way our global systems integrators programs feeling, both from the way the customers are talking to me about it and the way we are structured internally. I spend quite a bit of my time on this, personal time as well as some of the other sales execs, and the feedback has been very, very positive. Our reseller program has done very, very well. The two-tiered structure that Dan mentioned before has been fabulously successful.

We are delighted with the people that we chose and the way they have taken the kind of lot of workflow off of our back we used to do, and were focused more on the big geographic and also national resellers, helping them figure out how to add value. But I can tell you the investments in NetApp, if you turn that question around, it say, how are your investments going with NetApp versus others? The investments on both those fronts from those people, is increasing.

Thanks.

Your next question is from the line of Naveen Bobba with Bear Stearns.

It's been answered. Thank you and nice results.

Is there a question?

Go ahead, Naveen.

Hello?

It's been answered, Dan. Thank you.

And the next question, sir, is from the line Andrew Neff with Bear Stearns.

Andy?

Yes. Hang on a sec, I just - you're answering all the questions, we are very happy on these answers.

Okay. Thank you.

And sir, we have a question from the line of Les Santiago with Piper Jaffray.

Yes. Thank you. Given the way your add-on software contribution is progressing and your product margins are progressing, could you remind us, again, why you see gross margins heading down to 59% in fiscal year '06?

And you talked about software contribution moderating, but have you changed the stance at all, I mean, given the current performance of the software business?

No. I just think we are approaching the mixed limit, right. In fact, I thought it was 34 last quarter, but at some point the percentage of revenue comes from software is going to just flatten off, in fact, it's going to oscillate, probably, up and down a little bit by couple of percent per quarter. And I think we are in that kind of zone already; I just don't see it going up dramatically. And consequently, as the systems get larger, you get more discount and etcetera; you just expect those margins to go down little bit. And it's just conservative guidance.

Okay.

I mean, we go through this all the time, right. We have been -- I think it's only prudent to assume gross margins are going to decline about half a point a quarter, and then model it that way. And then we do everything in our power to try to make sure that doesn't happen.

But if you sit back at a macro level and say, what's the trend line look like? The answers got to be that sort of some new contribution in terms of software or whatever, a new breakthrough in terms of cost reductions, you're going to see the gross margins decline half a point a quarter.

Les, you saw the growth rate of the service business this past quarter, and while we are not projecting that to increase at the same rate each quarter going forward type of thing, nonetheless, I mean, to the extent that service exceeds our expectations and grows faster, even though the margin is improving, vis-…-vis in the past several months, you are going to see a drag on gross margin.

Got it. Okay. And then, if I could follow-up with one quick one, the competitive landscape, you talked about EMC, Cisco -- wide area file services, I mean, do you not see that as an important need for customers at this point? You know given...

No. We don't see that as an important need for customers at this point; very few customers can be particularly interested. It's a very small and very nascent kind of area. The assumption is that you don't need a local storage and that you're going to rely totally on network access.

And the two assumptions that most customers are willing to make that employee home directories -- employees prefer to have them stored locally for access and security. And to say you are only going to be able to access the information when the network is up is a second kind of risk that customers aren't willing to take, especially for branch office environments, where the links are often not redundant. So, there is a very small customer community that's interested in piling it. They're doing it primarily to try to simplify the operations management. It's not even a cost reduction.

And, we just see it as a very small niche kind of solution. We have looked at doing distributed file systems through our caching system, in fact, we have them deployed for NFS some of the engineering environments of our larger tech customers in particular, but we have never found a market demand for the equivalent sets, which is the Windows-based technology.

Okay. That's great. Thank you.

Sir, we have a question from a line of Clay Sumner with FBR.

Yes. Thanks. And Steve, one more. Last quarter, you said product cost deficiencies that led to, I think, about 200 basis points or a little over that of product gross margin upside last quarter. And then, you said you thought that was sustainable and you plowed that back into pricing to try to take some more share, and did you actually do that on the pricing front that you get the share increases that you expected?

Yes. Steve Gomo here. Yes, we did a little bit. Remember, some of it we said was going to go away. We had a purchased part price variance of about four-tenth of a point last quarter that we took the benefit of, but it didn't repeat again this quarter. We have a constant program to continue to improve the pricing of our products, keep them right at the market at a thing, keep them very competitive.

And then, finally, last quarter, we didn't have the disk rich content behind the heads that we did this time. As I mentioned in the call earlier, the disk content was much higher this quarter we shipped a lot more petabytes between -- behind the heads and the lower gross margins accompanied that a little bit. So all of that played into the change in that product gross margin.

Do you think this quarter's disk richness was an anomaly or would you expect similar results next quarter?

It's Dan. It seems to oscillate. It is very difficult to predict. It goes up and down. I think, two quarters ago if somebody us asks how come your disk ships were flat? Why wasn't it up 24% this quarter? I don't know. I mean its just mix and it varies all over. And I want to add one thing to what Steve just said.

The specific pricing action we took was SAN bundles for the channel, which were very, very successful. We put together an easy to configure, lower cost bundle and we thought that would accelerate the business due to channel, you saw the Arrow and Avnet percent of revenue mix move up, and most of SAN business -- SAN moved up very nicely. And I've made a comment that was all primarily indirect. So the pricing action we took, I think, did yield share, and it did not hurt the margins.

Great. Thanks. And nice quarter.

Thanks.

And sir, we have a follow-up question from Dan Renouard with R Baird.

Hi. Thanks. Just a quick one, Steve. I wonder if you could help -- you mentioned share count being flat, and obviously, there's a tie here to your share price. Are you assuming that the stock is where it closed yesterday or what just basic assumptions are you making around assuming that the share count stays flat? Thanks.

All right. Dan, I am just looking at the profile of the option pool and what's out there. And, basically, if you look at that profile, once you get above this -- the $30, there's not a lot more they're going to get uncovered by the treasury method. So, it really slows down at this point. So that's why we're projecting what we are. It's -- at this point, I won't say that it's stock price independent because that's not quite true, but the stock price has a lot less impact on the amount of shares outstanding than it did, when we were looking at moving from 24 to 30.

Great. Thanks, Steve.

Yes.

Okay. I assume that's the last question. I want to thank you all for joining us today. We're pretty satisfied with the quarter we just put up. And obviously that quarter of 10% sequential growth is one we're very proud of. All the various metrics in there were absolutely spot on from our advantage point. And there we're looking forward to another good quarter going forward. So, we look forward to see you all here for the conference call -- I should point out that next quarter's conference call, we may, in fact be a week later than normal. That because of various requirements associated with year end audit and so on. We are considering having a little more time before we go out.

So, we'll keep you posted on specifics, as we get closer to the date. But again, I want to thank you all for joining us today. See you next quarter.

Ladies and gentlemen, we thank you for your participation in today's conference. This concludes your presentation.

And you may now disconnect.