NetApp Inc (NTAP) 2006 Q1 法說會逐字稿

Good day, ladies and gentlemen, thank you for standing by. And welcome to the Network Appliance first quarter fiscal year 2006 conference call. (OPERATOR INSTRUCTIONS). I would now like to turn the presentation over to your host for today's conference, Tara Calhoun, Senior Director of Investor Relations. Please proceed, ma'am.

Good afternoon and welcome everyone. Thank you for joining us today. With me on today's call is Dan Warmenhoven, our CEO; Tom Mendoza, our President; Steve Gomo, our CFO; and Suresh Vasudevan, our Senior Vice President of Product Management.

In the course of today's conference call we will make forward-looking statements and projections that involve risks and uncertainties including statements regarding our forecasted operating results and metrics, sales transfer of products, hiring activities, potential benefits to be derived from our pending acquisition of Decru, and anticipated benefits from our relationships with IBM and other industry partners. Actual results may differ materially from our statements or projections.

These factors (technical difficulty) cause actual results to differ from our projections include, but are not limited to, customer demand for products and services, increased competition, any decline in general economic conditions, and foreign currency exchange rate fluctuations. 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 be available for replay on our website at www.NetApp.com along with our earnings release, the reconciliation between GAAP and non-GAAP numbers, and other financial and statistical information presented during the call.

At this point I will turn the call over to Steve to review this quarter's financials. And then Dan will share his (technical difficulty) thoughts on the quarter. We will line up with our financial outlook and (technical difficulty).

Good afternoon everyone. As we discussed in our preliminary earnings call on August 4, NetApp experienced a revenue and earnings shortfall relative to the expectations we had set at the end of last quarter. However, we believe our business fundamentals remain intact. Let me walk you through some commentary about our final results to illustrate. Please note that all numbers are GAAP unless stated otherwise.

For the quarter, revenue came in at $448.4 million, up 25% over the first quarter of last year, and a decrease of about 1% sequentially. The foreign currency effects attracted approximately 1 percentage point on a sequential basis, and added 1.5% year-over-year.

Product revenues of $394.6 million grew 22% over Q1 last year, and declined 1.6% sequentially this quarter. Add-on software and software subscriptions accounted for 35% of total revenue this quarter. This figure is a combination of software subscriptions that were 12% of total revenue, and add-on software products that were just over 23% of revenue.

Revenue from services, which includes hardware support, professional services, and educational services was 12% of revenue, up 6% sequentially, and up 59% over Q1 of last year. Professional services continued its strong performance increasing 72% over last year.

Non-GAAP gross margin finished at 61.2% compared to 61.5% reported last quarter. Non-GAAP product gross margin showed continued strength at 66.4%, reflecting strong software contribution and demonstrating no usual pricing pressure during the quarter.

GAAP services margins improved from 20.9% last quarter to 23.5%. This is a natural result of the improved economies we are experiencing in our service operations, both in support and professional services. We expect non-GAAP service margins to be in the mid-20s for the balance of this year.

Looking at our expenses for the quarter non-GAAP operating expenses totaled $207.6 million, or 46.3% of revenue. This was higher than our target model operating expense structure of approximately 44%, as result of lower revenue.

Expenses increased approximately 2% from the $203.6 million reported in Q4. Our employee headcount at the end of the quarter was 4,001, an increase of 200 employees from the fourth quarter of FY '05. Our plan was to hire approximately 300 people, and we ended the quarter was just over 100 offers outstanding.

Non-GAAP operating profits finished at 14.9% in the first quarter, and non-GAAP other income was $8.8 million compared with $8.1 million reported last quarter. Non-GAAP pretax operating income for the quarter was $75.8 million, or 16.9% of revenue. The effective non-GAAP tax rate decreased to 18% starting this quarter and for the foreseeable future, due to a favorable international tax ruling.

Non-GAAP net income for the quarter was $62.1 million, or 13.9% of revenue. Non-GAAP net earnings were $0.16 per share based on approximately 386.5 million shares outstanding. GAAP net income was $60 million -- $60.1 million -- rounding to $0.16 per share. The reconciliation between GAAP and non-GAAP financial results is provided in our press release and as a separate reconciliation table, both of which are posted on the Investor section of our website at NetApp.com.

Our balance sheet continued to demonstrate the strong financial health of our business, with cash and investments increasing approximately $45 million to $1.2 billion. The deferred revenue balance increased $36.2 million this quarter to $485.4 million, an 8% sequential increase, and now stands 57% higher then the $309.2 million reported a year ago. Recall that deferred revenue consists almost entirely of unrecognized revenue associated with software subscriptions and hardware service contracts.

Increases in deferred revenue indicate continued penetration of enterprise accounts. Cash generated from operations totaled $139 million in the first quarter. Capital purchases totaled 33.5 million, while depreciation and amortization were $17.9 million.

Accounts receivable sales days outstanding were down to 49 days versus 60 days reported last quarter. This was primarily due to more linear -- a more linear revenue pattern in the quarter. Inventory turns decreased slightly to 17.2 times compared to 17.8 times in the fourth quarter. As part of our stock repurchase program we purchased a little more than 3.2 million shares of outstanding common stock this quarter, spending approximately $95 million, or $29.29 per share. We have about $225 million remaining in our current buyback authorization.

In summary, while first quarter expenses were lower than we would have liked, -- excuse me -- while first quarter revenues were lower than we would have liked, our balance sheet and cash flow remains strong. Our expenses are under control. We have confidence we will execute more effectively going forward. But before I talk about our target operating model for Q2 and the remainder of the year, I will turn the call over to Dan for his comments.

Now that we have had an opportunity to take an in-depth look at the final results and run analyses of our first quarter performance, we have a very clear and more detailed picture to share with you today. As we discussed in our call two weeks ago the launch of our new midrange FAS 3000 series impacted our revenues in two primary ways, and further analysis of our data reaffirms our preliminary conclusions.

First, the introduction of the FAS 3000 products in mid-May caused evaluation periods for many of our sales engagements to be extended. We experienced delays in customer purchase decisions, while they evaluated these new products both competitively and compared to our other product lines. This became apparent in the last month of the quarter where it was 90% of the orders for the 3000 series coming in that last month. A significant number of orders were received in the last few days, resulting in a large concentration of FAS 3000 units populating the backlog coming into Q2.

Secondly, the FAS 3000 caused a greater decline in units shipped of both our FAS 960 and NearStore products than we had anticipated, which contributed a significant amount of the shortfall. Our forecast also supports this thesis with units of the FAS 3000 expected to increase, and units of the FAS 960 and NearStore R200 expected to continue to decline in Q2.

With the lower ASPs in the FAS 3000 Series, and taking the same amount of time spent on the sales process, we expect to see lower sales productivity and some continued cannibalization in Q2.

Overall the rest of our business continued to perform well, and measures have been implemented to improve our linearity going forward. Let's walk through some of the business metrics for the quarter, starting with the micro cuts of the data.

From a geographic perspective this quarter's profile was very similar to Q1 of last year. The Americas accounted for 60% of revenues compared to 58% last year. And the Americas' revenue was up approximately 6% sequentially and 29% year-over-year, despite weakness in the federal group. Europe contributed 28% of revenue this quarter, the same as last year's Q1 percentage of contribution. And overall Europe was up 25% year-over-year, although down 10% sequentially.

We generally saw strength in most of the regions of Europe, particularly Germany, but some weakness in the UK. Asia-Pacific was 12% this quarter compared to 14% of revenue last year. And this was only an 8% increase year-over-year largely due to some weakness in Japan.

In terms of channel mix, approximately 50% of revenue came through indirect channels this quarter, down about 6% sequentially, and about 50% came through direct sales. Since most of our Japanese and U.S. federal business goes through the indirect channel, both of those weaknesses contributed to the channel decline. Discovering our forecast we do expect federal to pick up in their seasonally strong Q2, which includes the end of the fiscal year for the federal government. And measures have been implemented to improve forecasting and performance in Japan.

Our two-tier distribution partners, Arrow and Avnet, were up to the combined 10% of revenue this quarter, continuing to gain traction in the United States. Competitively the landscape remains largely the same as last quarter. EMC continues to their most frequent competitor, and we're competing more often with them. There are still some regions where HP is our most frequent competitor. And overall our win rates have stayed consistent with prior quarters.

As the innovation leader, NetApp still offers customers the best value and most flexibility in the industry. And as Steve pointed out, our strong product gross margins demonstrate that we have not had to resort to drastic pricing discounts to win the business.

Let's turn now to some more product specific aspects of the business. Our low end FAS 270 showed the strongest growth in Filer System units this quarter, up over 10% sequentially. Our V-Series heterogeneous virtualization engine continues to gain traction, also posting healthy increases in units sold.

As we discussed earlier, the FAS 3000 midrange got off to a late, but very strong start. We are pleased with the trajectory of growth in FAS 3000 units. Combining this with our forecast and with customer feedback about the product, we believe this will be a healthy contributor to our mix going forward.

On our high end, the FAS 980 was roughly flat this quarter as compared to last quarter. However, the FAS 960 saw a 20% decrease in units quarter to quarter. While the midrange refresh will always challenge the entry point to the high end this was more than we had expected. And now we have modified pricing somewhat to mitigate the impact, we now expect the 960 to continue to decline.

We plan to introduce an even higher end product above the 980 in fiscal Q4 that offers a significant increase in all aspects of performance. So expect a smaller 960 to be gradually subsumed by the FAS 3000 functionality, and it is just happening faster than we had expected.

As Steve mentioned, at 35% of our revenue, software attach rates were right around the level we expect. Data protection solutions continued to be a primary gross driver. SnapVault was our strongest performing add-on software product this quarter, posting a sequential increase in sales of over 10%. Interestingly, almost half of our FAS 3000 business was ordered with SnapVault.

In other words, customers are using the FAS 3000 for secondary data protection. In Q1 we had rolled out a professional services offering related to data protection, and that campaign has certainly demonstrated initial success.

We believe this data protection campaign also contributed to NearStore revenue this quarter, which were 18% of total revenues. We saw a higher mix of software and professional services associated with the system sales. NearStore revenue grew about 4% sequentially, with average capacity per system up almost 6%. However, total system units shipped were down relative to our forecast. And this was an interesting phenomenon. As previously discussed, we expected the lines between NearStore and the FAS 3000 Series to blur, because the FAS 3000 is the first primary storage product to offer ATA disks. However, the impact in this quarter was greater than we expected.

Historically we have been selling a lot of low capacity NearStore systems around the 8 terabyte entry point. And we think some of our customers are using these for primary storage, even though we don't recommend it since it does not have Clustered Failover capabilities. It appears that these customers were the ones most interested in quickly switching to the FAS 3000 for primary storage applications. Looking at our data we believe customers who are purchasing low capacity NearStore systems are now purchasing the FAS 3020 instead.

Well over one-third of the disk drives shipped in the FAS 3020 were ATA drives in Q1. And the average capacity shipped was just under 4 terabytes. In comparison, the average capacity shipped for NearStore was up to over 21 terabytes this quarter. Customers now appear to be buying NearStore for the purpose it is designed for, large pools of inexpensive secondary storage. So we expect the number of NearStore systems shipped with smaller amounts of disk will continue to decline, and we expect the mix of ATA drives and FAS 3020 will continue to be high.

We are expecting the overall ratio of ATA drives to grow in our business mix going forward. This mix shift towards ATA and primary storage serves to actually make us more competitive, because combining this with our RAID DP production and our FlexVault technology customers can decrease the number of units they need to buy. They get the best value and best cost per megabyte from NetApp. But it does also serve to dampen revenue in the near-term because the dollar value of each deal comes down.

When the next generation R210 is launched later this quarter with a lower entry price and upgradability to Clustered Failover capabilities later this year, we expect to see growth in the number of NearStore units shipped.

Total capacity shipped this quarter was over 35 petabytes, a 17% sequential increase. I should point out about 67% year-over-year with total file units shipped down about 5%. Average capacity shipped increased on every single product this quarter. The total capacity increase was driven primarily by a 33% increase in ATA capacity, with Fibre Channel drive capacity also increasing about 6%, reflecting the ATA mix I just described.

Block based storage, which includes both the Fibre Channel SAN and iSCSI protocols, was a factor in 28% of our business this quarter. SAN was in 20% of the business, and iSCSI protocol was included in 11% of our business. The 3% overlap included both SAN and iSCSI, and the majority of this block based business also included NAS and other protocols. This is one of the many reasons customers continue to turn to Network Appliance. We're the only vendor to offer the flexibility to run multiple protocols concurrently out of one storage system, a capability we call unified storage.

And while the inclusion of iSCSI was down relative to its very strong performance last quarter, it remains above our outward and the external expectations, and we believe it will continue to grow significantly over the next several years.

Our NetCache products contributed about 3.5% of revenue this quarter. It is a small but very profitable area of our business, and is an important part of providing complete solutions to enterprise customers, particularly in the telecom vertical. This quarter top NetCache customers included Caterpillar, Deutsche Telecom, the Department of Defense, Qwest Communications, and Telephonic of Sonya (ph).

One of the highlights of the quarter was our announcement of our acquisition of Decru. Decru is the leading supplier of storage security encryption appliances. And we are very excited about this acquisition for several reasons. Decru is a perfect fit with our data management strategy. Their DataFort appliances support SAN, NAS, iSCSI and tape, and works with all the leading storage vendors in the industry. They are also the only vendor that achieved the most stringent government and industry certification.

We plan to operate Decru as an independent business unit. And they're encouraged to partner with companies like EMC, our competitors in our core business. And EMC recently announced their agreement to resell to Cruz Products.

The storage security space is projected to grow quickly over the next several years, and we are pleased to participate in that as the leading supplier. And we expect the acquisition to close this quarter.

Other positive news came from IBM's announcement that they will begin selling their OEM version of the FAS 270 product line this quarter. While IBM had originally planned to begin with our FAS 3000 Series, which is to on track for launch this fall, they decided to begin the integration work sooner with a product that was already shipping, rather than wait for the launch of the 3000.

Now with the business process integration work completed, each subsequent product line introduction should be easier than the last. This OEM agreement is a tremendous endorsement of our innovative capabilities. And we are working hard to insure that this is a successful and lucrative partnership for both parties over the long term.

In summary, reflecting on our performance this quarter, I take responsibility for the product transition impact we experienced with the launch of our new midrange. And we've implemented measures to improve our forecasting. But overall, after carefully scrutinizing our forecast, we still believe there (indiscernible) directory issues affecting short-term performance, not anything fundamental in our long-term business model.

We continue to make tremendous progress across many areas of the organization, including honing our go to market initiatives, developing and supporting our partners, and deepening our professional services coverage. We believe our products continue to offer the best price performance value in the industry. And we further extended our ability to help customers do more with less with the launch of the FAS 3000 midrange series.

Before I talk about the future, I will turn the call back over to Steve to share our financial targets with you.

Our business outlook is based on our current business expectations and reflects our non-GAAP presentation. Again I will remind you that we making forward-looking statements and projections that involve risk and uncertainty. Actual results may differ materially from our statements or projections.

We expect FY '06 second quarter revenue to be in the range of -- revenue growth to be in the range of 25 to 28% year-over-year, which reflects roughly a 5 to 7% sequential increase over Q1. Based upon our expected first-half performance we are modifying our FY '06 expected annual growth target to be in the range of 25 to 28%. This reflects the impact of the product transition issues Dan discussed, the impact of the increasing ratio of ATA drives in our unit mix, as well as the impact of foreign currency in the second half of the year. Our target operating margins during the year are expected to be between 15.8 and 16.4%.

Second quarter non-GAAP earnings are expected to be in the range of $0.18 to $0.19 per share, reflecting a return to our target operating expense levels and an improved tax rate of 18%. GAAP earnings are expected to be $0.17 to $0.18 per share. For the full fiscal year we expect non-GAAP EPS to be in the range of $0.76 to $0.79, with GAAP EPS of $0.74 to $0.77. Total shares outstanding should be approximately flat to to modestly down over the remainder of this fiscal year, depending largely upon the stockprice.

Going forward our focus is on growing revenues and returning to our target level of profitability for our operating model. I'll now turn the call back over to Dan before we open the floor to questions.

Thanks. Although we decided to temper our guidance based upon the impact of our new FAS 3000 Series, we do believe the 3000 is an incredibly strong product. In fact this compelling value proposition is what caused the delay in sales cycles, and also caused a shift in our mix towards lower dollar value ATA drives to happen more quickly than we expected. This phenomena should normalize over the long-term because it is a very competitive product.

We're confident in our ability to capitalize on the opportunities ahead of us, so we have made -- have done much to look forward to. The seeds in our IBM partnership are beginning to germinate. We will have a tremendous addition to our selling opportunity with the Decru encryption appliances. Our product lines will all be refreshed over the course of the coming year. And in the fall we will launch the next generation of our operating system, Data ONTAP NG, the first converged version of our classic Data ONTAP 7G with the scalable operating system. And this is the future of storage, and we will be there first.

We expect a one to two year adoption period initially targeting compute grids with high-performance computing. And we're planning to offer both our current 7G operating system with the new next gen operating system in parallel to allow customers ample time to begin their migration. And we believe it will open up more new doors for us.

To wrap up, let me just say that everyone in our Company has recommitted themselves to producing the highest growth rates in the industry, on achieving the standard of excellence we have come to expect of ourselves. Commensurately we will continue to invest in people and infrastructure to sustain and support our continued growth. We remain steadfast in our belief that our innovative solutions will continue to disrupt the market, and the infrastructure we are developing will support and fuel the strongest corporate growth rates in the sector.

At this point I will ask that you limit yourself to one question and one follow-up, so that we may address everyone in a timely manner.

(OPERATOR INSTRUCTIONS). Andy McCullough with Credit Suisse First Boston.

When you talk about the frequency of EMC engagements increasing, would you say that that is happening more in high end enterprise space where you're moving into, or more in the commercial market where EMC seems to be moving into? And then are there any particular verticals that you're seeing the frequency of engagements increase in particular?

It appears it is actually across the board. I think is more of a case of us having a broader distribution capacity, more channels and more direct sales, etc. And it is both enterprise and the -- I guess what you call commercial sector. We think about it as the named accounts sector. It is also through the channel.

It is just a case -- we're competing -- as you look at it, I think we are the only two vendors that offer the complete array of low end to high end, primary and secondary, SAN, NAS, and so we're competing with each other right across the board. I would say the mix has definitely shifted away from kind of file service NAS to more enterprise style apps, that's for sure. And we're really taking it to them I think. We are challenging them in their installed base.

This is Tom. If I could add to that. Our goal has been for years to have EMC's base look for an alternative, so that they have a two vendor approach. Certainly they are the dominant vendor in almost all IT shops, so for us to accomplish that we have to -- we better be competing with them on a more broad-based basis. And that is what we are seeing. What we're not seeing is the other guys show up and even near as much as they did.

So most companies I think -- what I hear over and over from customers is they believe it is a two horse race. There is only two companies innovating. In fact, the way they are looking at it now is Del, EMC, IBM, NetApp. That is fine by us. So we have always said that a big part of the storage market is outside of that envelope. It is Sun and other guys losing their storage HP (ph). And we're going to keep on taking that, and we hope that our engagements with EMC continue to climb.

Richard Chu with SG Cowen.

A couple of questions. One, given what looks like a relatively modest sequential revenue increase that you're guiding to for Q2, and the actual performance in Q1, it looks like the -- your full year target is going to require an acceleration to more like 10% average gains in the second half. Can you talk about the factors that drive that?

And then could you talk a little bit about Accenture (ph) which transitioned to the NG platform, which is around the corner. (indiscernible) will not represent a challenge in generating closings, especially given your discussion about global mainstays specialization in the EMC acquisition.

This is Dan. I would like you to select which of those two questions -- I hate to be rude, but I would like everybody to restrict themselves to one. And then there will be a chance to come back through the queue later.

Fine. The first question is driving second half acceleration.

I think you have calculated that correctly. Part of the effect here is that we expect to see a waning of the cannibalization that Dan described. You know, we saw -- we're caught off guard here in the first quarter, if you will. We expect a little bit more in the second, not much in the third, and by the time we're in the fourth quarter we should be dealing with normal market business effects, etc.

This is Dan. I also think there's a factor here which is as we have grown up to the kind of almost 2 billion run rate we are seeing significantly more seasonality. I think if you look at it quarter over quarter, we are 25 -- forecasting 25 to 28% on each quarter. So showing the same sequential growth pattern as we did last year with higher percentages in the 10% range in the second half.

Mark Kelleher with Adams Harkness.

Dan, back on the competition, could you talk about the HP surge in their EVA that they put up last night? We saw a 20%, 19% sequential growth there. Do you think -- did that extend the sales cycles? Did that have any effect in the quarter?

I'm going to give you two answers. First one is I don't know. I suspect it did. HP introduced that product line I think in March, April just before our quarter started. And my comment in there about customers looking at our new products as well as the competitors, I think EVA product factor in there more. We did the HP climb in frequency of competition, although it was primarily outside the U.S. It was primarily Europe and Asia.

It seems, however, that HP's storage growth was pretty similar to their server growth. I think probably you saw a more -- or higher attach rates. We did not see a great deal of competition in what I would consider to be storage infrastructure as opposed to server centric storage. If you understand what I mean by that differential. So, yes, I am really not surprised. The EVA is a significant upgrade from their prior generation. And I'm not surprised, especially their installed base found it much more attractive than what they had installed.

Okay, thanks.

Just in kind of up leveling the question a little bit, I think we've now had at least four major vendors announce their results for the quarter, EMC, Hewlett-Packard, Dell and ourselves, each posting growth rates in the high double digits. In our case, 25 and HP said about 20. It could be that the market is getting much stronger than certainly anybody had forecasted at this point.

Ben Reitzes with UBS.

I wanted to clarify in terms of the guidance for the year, for the fiscal year and for the second quarter how much is for Decru and IBM in there, both in the current quarter and for the year? And then I guess I will follow-up on the guidance issue.

This is Steve. As far as Decru is concerned, the guidance was excluding Decru. We have not closed on Decru yet, so they are not included in our guidance. And we will update you on that at our next conference call.

As far as IBM is concerned, we are excited about the product introduction that they just announced. We are still planning virtually no revenues this quarter. a diminimus amount in the third quarter, and an immaterial amount in the forth. This again is the year of product introduction, and we think that next year is the year of revenue growth from the IBM relationship.

I want to remind you all IBM introductions are not only staged in a product sense, they are staged in a geographic sense. I believe their first announcement was only North America. And so they don't really get a full global rollout until really near the end of our fiscal year.

And then just as a follow-up to the guidance, big picture is -- obviously we had a scare when you guys preannounced and it turns out the EPS guidance is not too different from where you started from. But yes the revenues are lower, but if you factor in currency and the near-term transition, this is still over the mid-20s. So I guess what happened? And what did you hear from your sales force when you came back in order to give this kind of guidance, which is still growth (multiple speakers).

Could I ask you to hold that? I think we have already answered your first question. Could I ask you to hold that question for the next round?

Yes.

Paul Mansky with Citigroup.

Just a quick question. Again back to that IBM relationship. Clearly that kicked off with a lower end product than many of us had expected, specifically the 270 versus the 3000. Was there any relationship between that event and your recently expressed concerns over the cannibalization issues related to the R200 and the FAS 960?

This is Dan. No, not all. This is truly opportunism. As IBM looked at their alternatives they concluded that the 270 has the longest life. It is the last one to be refreshed. It was an easy one to get to market. It is the least complex of the family. It is a good way to start. It is a great way to get all the infrastructure processes put together, how they order and how they manufacture, how they support it. And it it was just -- really in retrospect it was opportunism. The initial thought was they would take new products as they came out, and then they realized we've got a great opportunity to kind of grease the skids with this thing with the FAS 270. But it had nothing at all to do with anything about product line management issues at all. It was strictly opportunism. And I'm glad they did it.

Great, thank you.

This is Tom. Let me just make a comment on IBM. I have been doing a lot of global travel, and I meet with IBM executives all over the world. And I've had a lot of meetings in North America. One thing to remember about how IBM announce its product is when -- they do not brief their sales force until it is publicly announced period. So -- we are just starting on how they are going to roll this thing out. But I can't -- the level of enthusiasm at their senior level in their sales levels to have our products in their bag is spectacular. Better than I thought. There has been no -- it is not like I have to go convince them this is an exciting thing. They have had some gaps in their product line. They know it. They have competed with us long enough and lost. And I think they're very happy to have this product. We're just excited. We just want to make sure we do it right.

Keith Bachman with Banc of America Securities.

I just wanted to see if you comment if you can on how you're thinking about your hiring plans and how you're thinking about building that out, not only because of perhaps lower revenue growth rate, but also because of how the relationship with IBM may impact your thinking?

This is Dan. We have not moved off of our plan to try to hire about 1,200 this year, about 300 a quarter. As Steve mentioned, we fell a little bit behind that this quarter at 200. And we had 100 offers outstanding that are yet to be resolved.

But let me also point out to you that the primary metric for us in terms of trying to manage the business, expense to revenue if you will, is the roughly 16% operating. I think Steve gave you a range of 15.8 to 16.4 operating income. And that is really the primary metric, is we're going to try to steer into that. If revenues move up, we will probably continue to invest more. And if revenues move down off our expected levels, we will probably squeeze the expense line. Sixteen is kind of my nominal target.

Rebecca Runkle with Morgan Stanley.

Just hoping you could sync up all of your comments about the business model not changing and the second half growth forecast, etc., with your stretch goal for '07, and what you're currently thinking about the 2.8 to 3 billion.

It certainly moved away from us. You know, it is still a stretch. We would have to see something miraculous happen. That would be very difficult. I think the numbers we gave you should guide you somewhere slightly north of 2 billion this year. And to make 3 next year would have to be really a significant acceleration of the business that obviously we're not forecasting.

But to be fair just in terms of thinking about the business model near-term, if you just looked at the mechanics, it seems as though revenue growth is coming down, yet operating leverage is kicking in. But the longer-term message is that revenue growth is still the primary goal here. Is that a fair way of characterizing this?

I would take it even one level higher. Market share gains, which are reflected under revenue growth are the primary objective.

Joel Wagonfeld with First Albany.

Just a quick clarification. It wanted to make sure I heard you correctly. You said that the majority of last quarter's miss was cannibalization rather than push outs, and that is essentially why the sequential guidance doesn't seem to reflect recoupment of any meaningful level of delayed orders, if you will?

I think there is two factors. One is cannibalization. The second one though is lower dollar deal size. We're selling systems that were an ASP of 120 K, and now they are replaced by systems their ASP is 90 to 100. And it is very difficult to make that up. So essentially we impacted sales productivity by reducing the cost. And the question is how many deals can we be in? How many units can we transact, etc.? The cannibalization is less of a factor going forward than the recovery on productivity.

Okay. I was just referring to -- I came away from the previous call with the impression that there were some orders that got booked kind of at the very end that you would be seeing this quarter. And your guidance seems to suggest that that is not a big number.

It is consistent with the end of first quarter of prior years. So there is no bulge in the backlog.

Harry Blount with Lehman Brothers.

Dan, you had indicated that you did see the evaluation times stretch out, and that the guidance basically assumed -- I think I heard you say that the evaluation cycles would continue to remain stretched out. But have you seen any changes in that sales productivity metric or any other productivity metrics -- an improvement?

No, I think that the stretch out period is over. Customers kind of now understand how our new products stack up against the old ones, and how the new competitive products stack up, etc. So think we're back to normal sales cycle in terms of time. But at the same time, I think those sales transactions are going to yield a lower dollar value. That is the part that continues on.

Okay.

Did I answer your question?

Yes, that's helpful. Then the second question on the follow-up side is also a clarification which is, you indicated that you saw EMC more frequently, and the win rate against HP is about the same. Do I take that to also mean that the win rate against EMC and everybody else is roughly the same as well?

They are pretty consistent. Obviously they bob up and down based on deals and deal sizes and all the rest. But, yes, if you look at it as plus or minus some percentage, yes, we're staying right on the same zone.

I really do want to reemphasize that -- and Tom said it -- this has increasingly become a two horse race. We are becoming the alternative to EMC. And when you look at it across the spectrum, we're the only two that have a strong NAS solution. We're the only two that have a strong secondary storage solution. And so you would expect the volume -- or the frequency of competition to go up as those technologies are more widely adopted. We are really the only two vendors that the customers have to choose from. You add to that the fact that we are really focused on growing our SAN business, as reflected in the fact it is now up to 20%, and in general the SAN incumbent EMC. So the point is we're kind of across the board now squared up against them.

This is Tom. We have had some significant SAP wins. We have had some very significant wins with Oracle. Veritas remains an extremely strong partner. And our Exchange business has grown. So when you get into those type of applications it takes quite a while, and that is how we will get our deal sizes back up. So we have invested -- as you guys know, we have focused on the enterprise very aggressively, on the largest enterprises. We have focused on channels, and I think that is trying to play out.

The average deal size going down is a short-term issue, but the real answer for us, as Dan has brought up, is market share. It is driving these products into more accounts, getting into more competition, and getting people to believe that we are the logical alternative.

We're having some big speaking engagements, Dan and I, around the world. I am keynoting Oracle World this year. There will be somewhere in the area of 10,000 people there. We didn't used to get those kinds of speaking engagements. And our big partners are bringing us in and we're starting to get placed in a different place in people's minds. And I think that is going to, over time, especially when you have a better price performance because of our new products, it is going to give us more opportunity.

Shebly Seyrafi with Merrill Lynch.

According to my estimates and my model, your federal business usually grows double-digit sequentially in the October quarter, and the ex federal maybe at low single digits. You said on the call that you expect the federal to be up this quarter. But Dell made comments that the federal vertical is rather weak for them. I'm wondering if you could say whether your federal business is expected to be up double digits at least sequentially and grow in line with the past?

I'm not sure about sequentially, I haven't done that math, but I expect them to be up significantly year-over-year. I expect them to grow faster than the Company as a whole. The federal business this year looks very, very, very good this quarter. I personally did an in-depth review the other day and there's probably a wider funnel than we have ever seen before. I've got to believe that during the end of the fiscal year -- federal fiscal year that is -- we can close them. Yes, they had a soft quarter, and let me tell you, they're very, very committed to delivering on everything this quarter.

As Dan said, he and I both just went through the federal business, and there are large deal sizes. We're now getting into programs. In the past we have grown our business primarily in the intelligence community. We have done extraordinarily well. But we have invested hard in the last 15 months to get into programs. We're won one or two already, but we are positioned now in many, many bids by major integrators, and that is what we told our team to do. And I think you're going to start seeing some of these come to fruition over time. But for this particular quarter we're confident they're going to come through in a big way.

Steve just answered the question sequentially, and the answer is yes, sequential growth is high double digits.

High double -- you mean double digits, right?

Yes, double digits -- excuse me, yes.

Dan Renouard with Robert Baird.

This one may be for you Tom. You had mentioned linearity measures, or things you were going to do to try to improve linearity. Always a challenge for anybody in IT. Maybe you could just give us a little more details on how exactly or just directionally how you think you might be able to accomplish that?

From a sales perspective I think that the Company -- the customers don't know when the quarter ends, especially ours when it is July and things like that. In some cases I think that we hurt ourselves by where we put our sales kickoff this year. And we have talked about that internally. We have had some things that we put in front of ourselves early in the quarters, which I don't think were smart because it took people out of the field for a little more time that we expected. We have done a whole scrub on that and reworked our schedules to make sure we don't have a lot of our field leaving at the same time.

That is why -- if we just had one week more of productivity -- actually days in some cases -- we wouldn't be -- we would be having a different call. Every single sales manager in the world is focused on making sure that we have as much productive selling days in the early part of every quarter as possible.

Secondarily, we have really through and we have done this successfully in the past, we thought of how you can put different types of incentives or contests -- it doesn't have to be a lot of money -- just different things to make sure people focus on months rather than quarters. We have done that very, very well over the years. And I think this particular quarter -- it wasn't really bad or anything, but internally we don't like this kind of stuff. So everybody is very focused on getting back to focusing on months and weeks, not quarters. That is from a motivational and management leadership point of view. I think we do a good job of that, and I will be zeroed in on it.

Tom Curlin with RBC Capital Markets.

With respect to the full year guidance, previously it seemed that the high end of the range of guidance was directly aligned with the internal targets. Have you taken a more conservative approach this time around or are we still aligned at 28% with the internal sales plan?

I don't know how you can reach the conclusion you just did that they were aligned with -- the high end was aligned with our our internal targets. All I will tell you is that the guidance we gave you, we anticipate that we will be right smack dab in the middle. That is our best shot. Take the guidance, go to the middle of the range, that is the best shot. And we put a little buffer around it, because of all the ins and outs on the last day of the quarter that, by the way, could be even bigger than the guidance range we gave you.

Yes, our whole philosophy was to try to guide to what we expect, and then push for more. And we're always looking for ways to accelerate our growth rate, to gain share faster, etc. If you ask the people in this Company are they satisfied with 25, 28% growth rate, you're going to get the answer no.

Aaron Rakers with A.G. Edwards.

A real quick question on your ATA mix in the quarter. You guys kind of mentioned or alluded to the fact that roughly one-third of your 3020 Series solutions carried ATA drives. You also pointed to the fact that ATA was up about 30% during the quarter. Can you help me understand of those 35 petabytes shipped what percentage of that, or any metrics you can, what that represent in terms of ATA and where you expect that to go let's say over the next several quarters to a year?

Roughly about 47% of all (indiscernible) that we ship is now ATA. Significantly up from where it was over capacity quarter. So that is roughly what the ATA mix looks like of the total petabytes shipped.

Where do you expect that -- let's say -- looking out a year from now?

It is hard to put a number on where we will end up a year from now. The one thing that we have seen is a steady progress towards more ATA deployments, not just for secondary storage, but also for primary storage, particularly with us because of some of our technologies like RAID DP, which is harder for others to do. I'm not sure I can give you a number on where we will end up a year from now.

There is a significant segment of the market, the midrange in particular, and maybe we should define semantics. I am defining the 960, 980 out of the midrange. Those are very high end. But the midrange of the market is very price performance sensitive, or alternatively, priced for capacity. It is a very price focused market. And as customers gain more confidence that ATA can meet both the performance and the reliability requirements of their applications I expect the adoption rates to go up. As Suresh just said, given RAID DP, is a pretty -- highly available solution. We have now got ATA in systems that have redundancy with the Clustered Failover. So you add all that together, I would say ATA has got to up in the mix.

The pricing impact, ATA versus Fibre Channel, if you can real quick?

ATA systems offer a much better dollar per gigabyte then Fibre Channel based systems, and that is partially why we're so emphatic in emphasizing ATA. Longer-term, if you think about what the implications are for us, it translates to a much higher pedabyte share. And that is what we're really gunning for with better value on a dollar per gigabyte basis. That is what is reflected in many of our models as well.

The interesting thing is, I haven't verified in this in excruciating detail, but ATA systems are generally shipped with higher capacity at the same dollar value. And the reason for that is customers buy it in increments of shelves, not disks. And a shelf contains either -- what it is 16? -- 16 Fibre Channel drives or 16 ATA drives. So they buy a full shelf. So they're basically getting more capacity for the same dollar.

Brent Bracelin with Pacific Crest Securities.

Actually I had a follow-up on ATA as well. Clearly you cited this mix shift to ATA as one of the factors kind of impacting growth. How does that mix shift impact margins? I would assume that there is the dollar value of software attached to a system with a lower hardware kind of disk drive, a lower-priced disk drive would actually have a favorable impact on gross margins, or perhaps competitively maybe you're being more aggressive there.

And then on the competitive front with ATA, or do you plan to get more aggressive by bidding ATA systems, ATA configured systems, and view that as a kind of competitive tool to win against the competition in that space?

Steve Gomo here on the first part of the question. We believe that -- and you have seen it a little bit in our results this past quarter -- there's not a significant impact as we move to ATA drive in terms of gross margin. Depending on the -- because the application set could change to more of a secondary type of application. It is hard to say. Let's just say for now that I think it is safe to stay within the range that we have given you, and assume that the gross margin is going to be roughly along the lines of our guidance.

This is Dan on the competitive issue. We launched this product line in May. The headline was price, performance, leadership. And price capacity goes the same way. I'm less focused on trying to squeeze an extra dollar of margin out than I am of figuring out how to provide a lower cost solution to the customers and gain more share.

We have always believed -- this is Tom -- that ATA drives are going to take a bigger and bigger share of the market. When we started saying that two years ago, people -- legitimate CIOs people like that would look at us and go there is no way. In the early '90s I had told you SCSI was going to be in all the data centers, you would have said no until EMC built out redundancy, redundancy, redundancy and proved it could.

When Turek (ph) bought up Raid DP, that allows you to take two disks -- say you are the same array -- and not go down. And that makes people -- now it is good enough for many apps. And the proof point for us is our largest customers have moved significant parts of their infrastructure to ATA along with our other offerings. So now all of a sudden we're getting way, way more disk in there. A lot of the locally attached disk has moved to us. And we see this trend happening in a big way. We have always believed we were going to help drive this trend. And the key is to protect -- you can't make disk drives more reliable, but you can protect the end-user from anything that happens. And if you can do that at the price points we are talking about, you're going to get a lot more storage.

It is early, but have you seen a change in the win rate with the ATA RAID DP configured systems, or is it just too early?

It is too early. We didn't see any significant change in competitive engagements or outcomes either way.

Kaushik Roy with Susquehanna.

On margin what are your margin expectation for the whole fiscal year? As IBM ramps up in Q4, what are your margin expectations exiting this year?

That margin I would ask you to focus on is the operating income. It is 16%. The range is 15.8 to 16.4. We've got a lot of dynamic variables flowing through this year. Like you said, the IBM relationship, a bunch of other things. Overall I expect we're going to keep focused on the 16%.

Yet, I would only modify that by saying that we're going to grow as fast as we can and still achieve that margin range.

So for modeling purposes should we use somewhere between 65 to 66, or somewhat lower exiting this year?

You should use 15.8 to 16.4% operating margin.

Just to be consistent with the past. I still think that gross margins tend to decline over time. And I would encourage you to model the gross margin having a very modest rate of decline sequentially.

Brian Freed with Morgan Keegan.

Net cash looked like it was down about 3 million sequentially. And I know you guys just announced some new products in that segment. Did you see any product transition issues in this segment as well?

And secondly, looking at Blue Coat whose industry analysts put as your primary competitor there, one, do you think that is fair? And two, are you seeing any share loss from that?

This is Dan. yes, that product line did get somewhat of a refresh this quarter. And, no, we did not see any product transition issues. Blue Coat is by far our most significant competitor. In fact, I'm not sure who the other one would be. Cisco has basically exited this space. We are seeing more engagements against Blue Coat, only because I think they are the only one there.

They were up about 18% quarter on quarter. Do you see that as an area where you have lost some focus, and perhaps a little share and maybe could --?

I would save actually we have increased our focus to take it to really large multinational companies, to primarily to direct organization and system integrators, as well as telcos. We're not trying to supply these solutions to mom-and-pop through every channel in the world.

Clay Sumner with FBR.

Dan, you talked last quarter a little bit about next gen NearStore product and clustering. I'm just wondering how much pent-up demand for clustering do you think there is in your NearStore customer base? Such that if they could get NearStore clustering what percent of them do you think would use it?

I can't say you exactly what percentage of NearStore systems will ship with clustering, when clustering is available. Let me give you a sense for what happened with the 3000 Series -- the portion that Dan talked about as having replaced the demand for lower end NearStore systems. Many of them went clustered. A large percentage of them went clustered, and that reflects both anecdotally what we have heard that customers even for secondary storage systems are looking at clustered systems as the way to go. And that also is a primary driver for why we think we will have clustering in our NearStore systems going forward.

Was it one-third or more?

Unfortunately I don't have the specific numbers with me.

Glenn Hanus with Needham & Company.

This is really the first time in many years I can remember that you had sort of a glitch from the product transition standpoint. Are there some -- I guess there are takeaways out of this process that you are kind of reflecting on that you're willing to share with us about -- in the past I guess you always did high end first, I think you mentioned in the last quarter. Are there any takeaways here that you're willing to share?

Several actually. And you're right, I have been here now eleven years. I think we have done seven or eight product transitions for the 1400 or 330 to the 540 to the 630 to the 760 to the 840 to the 880 to the 960 and we didn't miss a one. And you had the pattern right, we always count at a high end, sometimes concurrently a new midrange, but at least the high end came out.

This is the first time we have just done a midrange and this system is architected only for the midrange. In general we have had a shared architecture between high end and midrange. Midrange is kind of a cost reduced version. This one is specifically aimed at midrange. I certainly underestimated the extent of the collateral damage we caused with the other product lines. I think we are a lot more sensitized to that.

I will be very honest with you, I kind of screwed up. We got very focused on becoming more competitive in the midrange against EMC Clarion. And the seeds of this problem were sown a year ago when we decided we were going to just regain price performance leadership in that sector. And our focus, rather than thinking about the spillover effect of our own product line, was to go become more competitive against EMC's midrange, and we did.

Now that said, what would I do differently having that product come to market. I think a lot of this could have been mitigated if in fact we had changed our volume ramp. We did not have enough demo eval systems out in the field early enough. We introduced it to our sales team in the 1st of May. We introduced it publicly mid-May. At that point we should have had -- essentially been ready to spray the field, if you will, with lots of demo eval units. And that didn't really effectively happen for another month. By the time everybody got one that wanted one. That is probably what slowed it down.

Actually I heard something like that from one of your channel partners.

Yes, we normally -- demo and eval equipment are still the best sales vehicle we have. And if customers can't evaluate themselves, they're not ready to place a purchase order. We populate the field pretty broadly with those things, and we just weren't ready for that kind of ramp. So by the time the demo eval units got fully propagated it was mid June, iWhich is why the orders really didn't really start to flow until early July. So yes, I would do that definitely differently.

Les Santiago with Piper Jaffray.

Most of my questions have been answered. If I could throw a couple in. Firstly, could you just give us your opinion of the EMC Cisco partnership? Is that gaining any traction at all?

And secondly, this is a question regarding net cash. With this improved focus -- increased focus on security can we expect net cash to have any kind of a resurgence? Would you think of incorporating maybe Decru technology into your NetCache product?

Those are two very different topics. Which one would you like us to address?

Let's start with -- let's start with the second one, since the first one maybe someone else can ask that question.

Yes, I'm very pleased with the NetCache business. This is a nice business. It is in many ways it is really leveraged business off our core product line. It shares a lot of the same system platforms, and certainly all the operating system is basically the same.

It is not what I am focused necessarily on revenue growth, but it is a great profit producer. It runs on the same profit model as the rest of the Company, and that is really kind of the way we're managing it. It is doing fine from my vantage point. And I got to tell you it is a great entry point to a lot of large accounts. A lot of the telcos that we have managed to penetrate in the rest of the world started off as NetCache. We have talked a lot about Australia Telecom or Telstra. That was one of them. Telstra had our NetCache solutions for several years before they tried the storage. We're not backing off of that at all. But again it is not getting the bulk of the investment either. It doesn't look like a growth market going forward.

Bill Fearnley with FTN Midwest Securities.

I was wondering if you can give a little more color here on the channel traction that you had during the quarter? Could you compare and contrast the VAR momentum and the system integrator momentum here for the quarter and what you expect here near-term as well?

The channel mix was roughly the same, except the indirect side came down, which I think we mentioned was largely related to Japan, which is all indirect basically, and federal, which is 80% through systems integrators. Is there something more behind that you're looking for? (multiple speakers) that was up.

But outside of the federal space, for instance, the traditional VAR channels, are you satisfied with your momentum there for the quarter?

I'm never satisfied. There's always more to be had, right? The fact that Arrow and Avnet were up 10% of the total mix I think says they really scaling very nicely.

I had the opportunity to speak at their sales kick off, both of them, and the feedback from them is they are extremely excited about what we have accomplished so far, and they see a lot of upside going forward in the relation. They are investing a lot more. I think that took a lot of smaller resellers off of our plate. It allowed us to focus on the biggest ones. And our biggest resellers I think are very strong at at this point. It is not like we're out looking for a lot more. We're trying to just make sure that we get more and more out of the same ones because we have a lot of headroom I think in the ones we have.

Paul Mansky.

Actually my question has been asked and answered.

Harry Blount.

One follow up I might on the Japan business. Dan, you have talking about different efforts on your way in Japan for several quarters to get that business going. It is a tremendous opportunity. Tom, you had mentioned that in the past. What is the latest on that? You hit on that lightly, but I would love to get a little bit more details of what it is going to take to really get Japan going.

This is Tom. Last year we had a great year in Japan. It is one of the best geos in the world for us. And in fact we had a monster April, which was the end of our fiscal year. It is really, really a big month. So just chatting with some of the CEOs of resellers, they feel like they had a great quarter because if you keep April in there it was a monstrous one. But after that I think they lost a little focus and we didn't really execute as well as we should. So I don't think it is a market dynamics. I don't think it is something we have to go change. I'm going to be in Japan next couple of weeks to talk to them. I think it is a matter of focus. Because all of our channel partners are very big companies, right? And they have been with us a long time. And they saw -- they're making more money on our profits than any other ones they sell. We were the highest growth engine for every single one of them last year. So I was just there two months ago and went through all this. But I really think that we have to make sure that we have specific plans on how we're going to accelerate into what markets. And I think there was a bit of an execution glitch as opposed to anything else. We have made sure that everybody understands how we're going to correct that and get back on the path we were on.

This is Dan. We hired a number of new people in Japan, in Tokyo in particular. And we started to move to a high direct touch model, even though it is indirect fulfillment. And I think the absorption rates of all the new people and things like that, it has been a real challenge. Like I say, that team is extraordinarily committed. I'm sure they will be back on track this quarter.

Harry Blount Then the other question on the follow-up is on iSCSI. I am very surprised to hear that was down sequentially. Is there any product transition issues that impacted that?

I don't think so. In fact, I have gone through that with the business unit head for the SAN and iSCSI business, and it just seems like the SAN business for some reason just really shot up. The 3000 was aimed right at kind of the sweet spot of the SAN market. I think it may have been just an easier opportunity for the sales guys. I'm not sure exactly how to explain it. It is a little bit of a discontinuity though and I expect it bounce back pretty quick.

Our last question is from the line of Clay Sumner.

Just to hit ATA issue one more time. And maybe this is for you, Suresh. Could you tell us what the average ratio of fiber to ATA drives shipped in the 3000 Series that could do intermix?

No, I don't have that data with me. We could give you the overall ATA to fiber mix, but not within the 3000 Series.

I thought I would try. One other way maybe. Do you plan to have ATA intermix options on any other fiber products coming in the near-term?

In general our technology base with the 3000 Series allows us to have ATA and Fibre Channel mix going forward for a platform. You'll see a different uptake in high end versus low end products and midrange products and so on, but, yes.

High end is always more performance oriented, so they don't want to take the performance hit that ATA offers. One comment I want to make on the mix issue, the mix shelves or whatever -- that is actually less meaningful in the marketplace. It has got more marketing hype to it than it has substance. And the reason is because if I have an array of Fibre Channel drives and I slip in one ATA drive the entire RAID goes down to the lowest performance by the ATA.

So in general customers don't mix shelves. And in fact in most cases they don't mix drive types on the system. It is an interesting flexible offering, and a lot of vendors made a lot of noise about it. But the reality is you use ATA when you don't need the performance, you use Fibre Channel when you do. And that has a tendency to bifurcate the way the systems are configured.

Dan, I'm sorry, just to clarify on that. Are you saying you don't mix drives within the shelf or you don't mix -- you would have a fiber shelf and an ATA shelf?

You don't mix drives in either a volume or what we call an aggregate, because the aggregate typically in a small system is all the drives in the system. So in the flex model since they are striped across all drives, in general you wouldn't want to have an ATA drive in a Fibre Channel mix because it would slow it all down.

That's helpful. Thank you very much.

We have no further questions at this time.

Ladies and gentlemen, I want to thank you all again for joining us this afternoon. And we will look forward to seeing you about this time next quarter. I want to remind you all also of the Analyst Day which is on December 6 in San Francisco. Thank you all very much for joining us. Have a great day.

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