NetApp Inc (NTAP) 2006 Q4 法說會逐字稿

Good day, ladies and gentlemen.

Thank you for standing by, and welcome to the Network Appliance fourth quarter and fiscal year 2006 earnings conference call.

My name is Carlo, and I'll be your coordinator for today's presentation.

At this time all of our participants are in listen-only mode, and we will be facilitating a question-and-answer session toward the end of today's prepared remarks. [OPERATOR INSTRUCTIONS] I would now like to turn the presentation over to your host for today's conference, Ms. Tara Calhoun, Director of Investor Relations, Network Appliance.

Please proceed, ma'am.

Good afternoon, everyone.

Thank you for joining us today.

Our conference call is being webcast live and will be available for replay on our website at www.netapp.com, along with the earnings release, the financial tables, and the reconciliation between GAAP and non-GAAP numbers.

In the course of today's call, we will make forward-looking statements and projections that involve risk and uncertainty, including statements regarding our expectations for operating results for fiscal Q1 and FY '07, stock repurchases, hiring goals, pay down of debt, timing of and benefits to be derived from product introductions and technology advancements, including our VTL, Decru, and FAS 6000, and NearStore products, FlexVol and ONTAP GX technologies, and benefits from our relationships with channel and technology partners.

Actual results may differ materially from our statements or projections.

Important factors that could cause actual results to differ include, but are not limited to, customer demand for products and services, increased competition, a decline in general economic conditions, and foreign currency exchange rate fluctuations.

Other equally important factors that could cause actual results to differ from those in the forward-looking statements are detailed in the risk factor section of our 10-K and 10-Q reports on file with the SEC, and accessible through our website, all of which are incorporated by reference into today's discussion.

We disclaim any obligation to update information contained in these forward-looking statements, whether as a result of new information, future events or otherwise.

With me on today's call are Dan Warmenhoven, CEO; our President, Tom Mendoza;

Steve Gomo, CFO; and Tom Georgens, EVP of our Enterprise Storage Systems group.

Steve will review this quarter's financials and discuss our financial outlook for the first quarter.

And then Dan will share his thoughts before we wind up with everyone here for Q&A.

Steve?

Thanks, Tara.

Good afternoon, everyone.

NetApp posted very strong results this quarter, executing well in all major areas.

We're very pleased with these results.

Now let's walk through some of the details.

Please note that all numbers comply with GAAP, unless stated otherwise.

For the fourth quarter, total revenue came in at $598 million, up over 32% compared to Q4 last year, and an increase of over 11% sequentially.

This was the third consecutive quarter of accelerating growth for both sequential and year-over-year comparisons.

The foreign currency effect added about 0.5 percentage point to this quarter's results on a sequential basis, and subtracted over 2 percentage points year-over-year.

For full year FY '06, revenue totaled $2.07 billion, up 29% over FY '05.

The FX impact for the full fiscal year reduced the FY '06 growth rate by 1%.

Product revenues of $522.9 million grew over 30% year-over-year, and over 10% sequentially.

Add-on software and software subscriptions accounted for about 35% of total revenue this quarter.

This figure is a combination of software subscriptions, which were 11% of total revenue, and add-on software products, that were approximately 24% of total revenue.

Product revenue for the full year was over $1.8 billion, up 27% from 2005.

Revenue from IBM and Decru both increased, with IBM just over 2% of total revenue this quarter, and Decru, about 1.5% of total revenue.

For the full year, IBM contributed slightly more than 1% of revenue, and Decru, just over 0.5 percentage point.

Revenue from services, which includes hardware support, professional services, and educational services, was 12.5% of revenue, up 19% sequentially, and up 48% over Q4 of last year.

Service maintenance contracts increased 17% sequentially, and total professional services grew 25% sequentially.

We continue to see increasing traction from the investments we're making in global services, as well as increases in the utilization rates.

Service revenue for the full year was $249.9 million, up 49% from 2005.

Non-GAAP gross margins were 60.3% this quarter.

In line with our expectations, non-GAAP product gross margins finished Q4 at 65.1%.

This decline in product margin was almost exclusively due to shifts in revenue mix.

High margin add-on software showed a modest decline from last quarter, while disks and enclosures, as well as the IBM OEM business, increased in mix.

Service margins of 27.3% increased by over a percentage point from last quarter.

Underlying professional services utilization rates showed continued improvement and contributed to the increase in the service gross margin.

Turning to expenses, our non-GAAP operating expenses totaled $264.7 million, or 44% of revenue.

Expenses increased 11% from Q3.

Sales and marketing expenses included higher than expected sales and commission expenses.

R&D expenses increased 17% sequentially, as about 100 employees were added during the quarter, and new product project material costs increased by about $2 million.

Total employee headcount increased by 345 people this quarter, ending the year with 4,976 people, a net increase of 1,175 employees during FY '06.

GAAP operating expenses include the effect of intangible amortization, previous merger-related stock compensation charges, and some minor adjustments of restructuring charges this quarter.

At $96 million, non-GAAP operating profit finished at 16.1% of revenue.

Other income, which consists primarily of interest income, finished at $12.8 million, an increase of 18% over last quarter.

This was largely the result of higher average cash balances and higher interest rates.

Non-GAAP pre-tax operating income for the quarter was $108.8 million, or 18.2% of revenue.

Our effective non-GAAP tax rate remains at 18%.

Moving on to the balance sheet, cash and investments totaled $1.32 billion, up approximately $182 million from Q3.

This cash and investments total excludes $247 million of restricted cash associated with our foreign cash repatriation.

In the fourth quarter, we added $300 million of debt to our balance sheet as a result of our foreign cash repatriation activities.

We expect to pay this debt off within 2 or 3 years.

During the quarter, we repurchased approximately 2.8 million shares of outstanding common stock at an average price of $35.04 per share, for a total cash outlay of roughly $99 million.

Our buyback was lower than planned this quarter.

We plan to continue to buy back stock at a rate of roughly $150 million to $175 million per quarter.

Cash generated from operations totaled $171.9 million.

Capital purchases were $36.4 million, and depreciation and amortization totaled $22.8 million.

A deferred revenue balance increased $88 million this quarter, to $681.5 million, a 15% sequential increase, and up 52% year-over-year.

Accounts receivable day sales outstanding were 63 days compared to 62 days reported last quarter.

DSO's remained in the 60s, primarily due to a shipment linearity profile weighted toward the second half of the quarter.

We expect to see improvement in DSO levels next quarter.

It's also important to note that over 85% of accounts receivable are current.

Moving on to inventories, inventory turns improved to 14.7 times, compared to 12.9 times in Q3.

Now, before I turn the call over to Dan for his comments, I'll share our target operating model for the first quarter.

Our outlook is based on current business expectations and current market conditions, and reflects our non-GAAP presentation.

As a reminder, we're making forward-looking statements and projections that involve risk and uncertainty.

Actual results may differ materially from our statements or our projections.

We expect FY '07 first quarter revenue growth to be in the range of a 2% to 4% sequential increase over Q4, which translates to a 36% to 39% growth rate year-over-year.

We expect total gross margins to remain about the same for the first quarter.

Our target operating margin for the first quarter is expected to remain approximately 16%.

First quarter non-GAAP earnings are expected to be $0.23 to $0.24 per share.

GAAP earnings are expected to be $0.13 to $0.16 per share, taking FAS 123 into account for the first time.

Our targets for FY '07 remain in the range of 28% to 30% growth over FY '06 revenue.

Non-GAAP earnings per share are expected to be in the range of $0.99 to $1.04 per share.

With the implementation of FAS 123, GAAP earnings become increasingly difficult to estimate, given the volatility of some of the variables, including our own stock price.

Therefore, our target range is estimated to be $0.62 to $0.72 per share, based upon the information we have and the assumptions we make today.

At this point I'll turn the call over to Dan for his update.

Dan?

Thank you, Steve.

The fourth quarter wraps up another terrific year of growth for Network Appliance.

Despite a rocky start in Q1, our growth rates accelerated every quarter.

And we ended the year with a 29% increase in annual revenues, and a 33% increase in non-GAAP net income.

Over the course of this year, we've built additional infrastructure to manage our growth and broadened our total addressable market.

We're moving upward, outward and downward to bring a more comprehensive set of products the to the marketplace.

With the new ultra high end offering, the recently launched disk-to-disk back up solution in the VTL space, the Decru storage security and encryption solutions, and soon at the very low end, our entry to small to medium business space.

All of these expansion areas embody the fundamental differentiating principals at NetApp, reduce complexity, minimize management overhead, improve utilization, reduce costs, and preserve flexibility for our customers.

These benefits clearly resonate with corporations around the world, driving our continued growth.

In our core Enterprise Storage business this quarter, which excludes the products in Jay Kidd's emerging products group, namely Decru, VTL, V-Series and NetCache, total units shipped increased 6% sequentially.

Average capacity in each system increased almost across-the-board, in some cases dramatically.

Our low end FAS250 and FAS270 products were both up modestly.

The 3000 Series had an 11% sequential increase in total units shipped, and accounted for over 40% of all systems sold again this quarter.

The average capacity in the FAS3000s increased 16% sequentially.

The FAS960 continued to decline, as it is subsumed by the 3000s.

But the FAS980 had another strong quarter, with a very strong 19% sequential increase in units, and a whopping 50% increase in average capacity.

Our ultra new high end FAS6000 Series accounted for about 1% of units sold as part of its early adopter program in Q4.

While not officially launched until a few days ago in Q1, the inventory build up and the product rollout of FAS6000 Series were ramped up during Q4, and is off to a healthy start.

These new high end systems are positioned well above the FAS980, scaling to over 1,000 disks, with performance and reliability characteristics that provide the high availability, ease of management, flexibility and scale-out capability that challenge even the very high end frame arrays.

NetApp is [inaudible] our ability to penetrate large scale data center environments.

Just recently, NetApp launched a well executed data center proven marketing campaign, along with new product offerings beyond the FAS6000.

By expanding awareness of our success in over 5,000 data centers worldwide, conveying the message that NetApp is best at reducing TCO and improving application service levels, and offering data management capabilities, like our new FlexShare software, we will continue to capture market share and grow our penetration in existing accounts.

With the strides we've made in data center environments, it's not surprising to see a commensurate increase in demand for SAN configurations.

In the fourth quarter, a record 34% of storage systems ordered, included block base connectivity.

Of this, 24% of orders included Fibre Channel SAN, 14% included iSCSI, and 4% of the orders had both.

For the full year, business that includes block connectivity is up 74% over fiscal 2005.

And while Fibre Channel SAN and iSCSI are likely to fluctuate quarter to quarter, we've clearly established ourselves as a serious contender in the SAN segment.

Our goal is to increase share in SAN, while maintaining our leadership in both NAS and iSCSI.

In Q4 we shipped over 60 petabytes of storage, up 26% sequentially from the 48 petabytes shipped last quarter.

There were several drivers contributing to this increase.

Units of 320 gigabyte drives were up 66%. 500 gigabyte drives were introduced this quarter, and accounted for a full 6 percentage points of all capacity sold.

Purchases of add-on disks and associated shelves increased again this quarter, and average capacity per system shift was up in each of the FAS3000, FAS6000, the R200 and the FAS980 product categories.

Fibre Channel drives accounted for 52% of the total capacity, and ATA was 48%.

This ratio is very similar to last quarter, where 53% were Fibre Channel and 47% were ATA.

As an aside for those of you tracking these numbers, last quarter we had a misclassification of 1 of the new drive types in our data warehouse, causing Fibre Channel capacity to be overstated by about 6 percentage points, and ATA to be understated by the same amount.

This has been corrected in the 53% to 47% ratio for last quarter that I just gave you.

ATA petabytes shipped increased 27% sequentially.

We expect this number to grow in the mix as our NearStore Virtual Tape Library solution gains traction.

Launched on February 7th, this VTL solution allows us to provide heterogeneous backup for any storage environment, using a customer's existing backup software solutions from any vendor, including Symantec, Tivoli, and Legato.

VTL is sold into a different constituent in the IT organization that our sales force usually interacts with, and so the sales cycles tend to be a little longer than they are for our core systems.

We should begin to see more contributions in this solution over the next few quarters.

As I discussed last quarter, the NearStore concept has evolved into a brand, encompassing a category of platforms optimized for data protection and retention applications.

Data protection includes disk-to-disk backup and business continuity solutions.

Data retention includes compliant retention, archival, and digital content storage.

As we win more data center deployments, we expect our NearStore family of solutions to be pulled along with these sales.

Customers choose NetApp data protection solutions to backup their mission critical systems because we offer the most reliable and easy to manage solution, which integrate easily into customer's existing data center infrastructures.

By combining our patented RAID-DP software technology, or RAID 6 as it is known in the industry, along with high capacity, inexpensive serial ATA drives, customers are protected from double-disk failures, with no performance overhead and fast recovery, at a much lower cost than competitive solutions.

RAID-DP is a standard feature in all current versions of our Data ONTAP operating system.

Innovative features in Data ONTAP 7G, the latest version of our operating system, continue to drive the fast uptake -- the fastest uptake of a new operating system in our history.

Over 52% of our installed base is now running ONTAP 7G.

We believe that another important feature, FlexVol, which is also standard in 7G, is also driving increased purchases of NetApp equipment.

FlexVol is an innovation that allows customers to dynamically allocate storage and dramatically increase their utilization rates.

Customers do not have to buy as much storage up front, and can more closely match their storage purchases with their actual needs.

No other vendor has the capability to offer this flexibility across all their products.

We believe this type of innovation is an important driver of our current success.

Our next generation operating system, ONTAP GX, has successfully completed beta, and will begin revenue shipments in Q1.

It will be formally launched in the very near future as an option on our FAS3000, and soon after that on the FAS6000.

ONTAP GX brings to the industry a massive, horizontally scalable architecture, allowing customers to cluster many systems and have them appear as one.

Initially, it will be targeted at high performance computing environments running NFS, where it's being demanded today.

Eventually we will bring this true storage grid architecture to the mainstream, as we bring forward additional functionality from ONTAP 7G over the next few years.

Decru continues to gain traction, growing to about 1.5% of revenue in the fourth quarter.

Financial institutions were the largest market segment for Decru again this quarter, followed by governments and Global 2000 companies.

NetCache contributed just under 3% of revenues this quarter.

Looking at the business on a geographic basis, the Americas are up 15% sequentially, contributing a little over 50% -- 56% of revenue.

EMEA contributed 31% of revenue this quarter, almost exactly the same percentage as their contribution in Q4 of last year.

And the best news is the 22% sequential increase generated by our Asia Pacific region, accounting for almost 13% of Q4 revenues.

The leadership changes made there during the first half of fiscal year '06 have begun to have a very positive impact.

Our indirect channel business accounted for 56% of revenue in Q4.

Arrow and Avnet finished the year well, contributing about 10% of revenues in Q4, and almost 11% for the full fiscal year.

The leverage gained by helping our channel to be successful is an integral part of our success, and one of the reasons we continue to invest deepening business relationships with VIP channel partners, and technology partners like Microsoft, Oracle, SAP and said Symantec.

There are now approximately 5.5 million seats of Microsoft Exchange running on NetApp around the world.

Both Oracle and SAP run their businesses on NetApp storage, while we have co-developed and co-branded products with Symantec.

The partner discussion would not be complete without IBM, which contributed about 2% of revenue in Q4.

Momentum at IBM continues to build.

Awareness within their sales force is increasing, and our storage group partners are anxious to bring our new FAS6000 Series to market, which should occur some time before the end of summer.

In terms of verticals, our largest vertical continues to be high-tech in computer, at about 18% of our business.

Followed by financial services at 11%, government around 9%, and telecom at 8%.

Looking forward, many important drivers are in place to make fiscal year 2007 another successful one.

Our product innovations lead the industry, and are increasing our total available market.

Our sales force is effectively competing around the globe, and our services and support consistently generate high marks in the industry for customer satisfaction, most recently garnering a 9.3 out of 10.

We are perceived as the more nimble alternative to EMC in the marketplace, and we look forward to capitalizing on our achievements.

As Steve mentioned we expect to grow revenues between 28% and 30% next year, on top of our outperformance in Q4.

We believe we are gated primarily by our coverage in the field, and we plan to continue to invest to drive continued top line expansion.

With that I'll open the floor to questions.

I would again ask that you limit yourself to 1 question.

If you have a follow-up question, please return to the queue, so that we may address everyone in a timely manner.

Thank you.

Operator?

Thank you, sir. [OPERATOR INSTRUCTIONS] Keith Bachman, Banc of America.

I had a couple, if I could.

I'll just try 1, Steve, with you to start out with.

You indicated that the revenues, you kept your percentage change in terms of the guidance.

Yet the EPS was consistent, which suggests that the back half of the year -- in fact if we kept the same numbers on the EPS side, that numbers would be coming down a little bit.

Are you guys just being conservative there on the EPS side, or is there something on the margins that we should think about?

Keith, I presume you're talking about the guidance for the full year -- ?

Correct, Steve.

Correct, Steve.

So we are keeping our percentage growth rates consistent with what we told you at analyst day, as Dan just mentioned.

Yes.

And then the range we gave you before was the same, $0.99 to $1.04.

And if you do the math, we're still inside the range there, given our operating margin targets of 15.8% to 16.4%.

Right.

I would have thought Steve, those might come up a little bit.

Should I just think about being conservative, or just some movement within the range?

You should think of it as movement within the range.

I guess, one could make an argument that we're going to be a little higher in the range than we would have otherwise thought we were.

Okay.

Could I sneak 1 more in, Steve?

Go ahead. [inaudible]

In terms of the IBM numbers, terrific, I think, results out of the gate there.

IBM was reselling products before.

So in terms of the 2%, how do you think about that?

Because they were actually reselling NetApp products.

Is that continuing to selling the NetApp [re-products] and these are rebranded products?

But how do you account for kind of the ins and outs, so to speak, there on IBM?

Yes, this is Dan.

This was the first quarter that IBM had most of our software suite.

And I think that helped accelerate a number of their transactions.

This was, I think, also the first quarter we had the FAS3000 in the product line for the full quarter.

So the combination of the 2, the FAS3000 and the evaluated software, I think are allowing them to be much more effective.

Okay.

The other business with IBM would be out on top of that and blurred in the rest of our business.

Andrew Neff, Bear, Stearns.

I'm asking this because we ask every company, so don't take it personally.

But just have you had a chance to look through your policies and procedures on options, and is there any concern about the post-dating of options, or anything like that?

Andy, this is Dan.

I guess I'm not surprised at the question, given all of the press activity in the Wall Street Journal, and so on.

First, I'd like to make it very clear that we have not received any inquiry from any regulatory body.

But more importantly, as part of our Sarbanes Oxley certification process last year, an independent review of our option grant process was conducted in a period from fiscal year 1994 through fiscal year 2005.

That review was initiated by our audit committee, and conducted by our internal audit team with assistance from an outside audit firm.

As part of the review, all options issued to Senior Vice Presidents and above were specifically reviewed.

And the review confirmed that we have been 100% compliant with GAAP and SEC requirements concerning the granting of options.

Rebecca Runkle, Morgan Stanley.

Good afternoon, you can hear me?

Go ahead.

Hello?

Rebecca, please proceed.

Can you hear me?

Yes, we can.

Okay, great.

Thanks.

Just, I'll keep it to 1 question.

But within the context of the quarter that you just reported and then the guidance, if we think about EMC really being on its back with the Clarion franchise last quarter, and then having new product in the market this quarter, how are you incorporating that into your thought process?

And what are you seeing on the margin within the competitive environment, both pre and post the product launch, vis-a-vis Clarion t specifically?

This is Tom.

As far as the Clarion launch goes, we view the Clarion launch as primarily a hardware refresh.

So in terms of the impact of the business, there really isn't anything new there from the point of view of software and reducing complexity, and dramatically entering new markets.

So I think the Clarion refresh was very much expected from a hardware perspective, and clearly had been in our plans all year.

So I would say that there's nothing new in that release that would change our plans from our previous guidance.

I think your second half of that that was around margins.

And we think our win rates against the new Clarion series are going to stay very strong, and we don't expect to see any change in discounting on margin results.

Ben Reitzes, UBS.

Could you just talk a little bit more about Excelsior?

How you think that product will do and impact your margins?

And then as well, the other product I think you're excited about that's incremental is your new low end product.

When should we see that?

And what does that add?

And maybe if you could talk about what both mean to margins and top line?

Let me talk about -- this is Tom Mendoza.

Let me talk about it from a sales perspective.

I'll let the other guys chat about margins.

But we put over 80 customers in with our high end systems this quarter, about 50 for revenue I guess, and about 80 total out there.

I've been amazed at the consistency of feedback.

Most of them are in the high performance computing, as Dan indicated they would be.

We had tremendous results in that environment, across a wide range of applications.

But we've also seen like, AmeriGroup and us are putting out an announcement this week in their SAN installation.

They found that it's a combination by the way, between that and the other tools.

They found Flexclones and FlexVols have done an amazing job for them.

They said they are getting 10X reduction in the time required to perform simple SAN provisioning tasks, their Exchange recovery times are dramatic over their previous vendor.

So we're seeing approximately 2X the performance.

So when you first put a product out, more importantly than the revenues initially, is what's the customer experience?

What are they saying back to us?

And what do they think their expansion plans are?

And across the board, they are very, very positive recommendations.

So I would expect this product line to be extraordinarily successful.

I'll turn it over to Dan.

Yes, on the SMB product, you may have seen the cover of CRN, Computer Reseller News, I'm holding a prototype of our new product aimed at small and medium business.

We do not expect that to contribute significantly to revenues in the next couple quarters, and I'll give you some kind of forecast around mid year.

The product introduction -- this was a channel announcement, is really what it was.

The product introduction will occur, I think really near the end of Q1, and begin shipment in Q2.

We're now in the process of recruiting VARs to help sell that product later on.

Just as an aside, I through out the name AmeriGroup.

For those of you who aren't familiar, they are number 732 in the Fortune 1,000 list.

They are a very large healthcare insurer, and it's your basic, big time, mission critical data center application, and it's all [SAN].

Dan Renouard, Robert Baird.

Just curious on the -- at the end of your release here, you talk about opening a facility in Bangalore.

Wondering if you could give us a little more detail there, in terms of how many people do you have currently, exactly what will they be doing, what are your intentions in terms of headcount?

And is this partly aimed at alleviating some of the hiring headaches, given the current market?

It seems like every quarter you have high intentions of hiring X number of people, and it seems like it's just a challenging hiring environment.

This is Dan.

I wouldn't say it's all that challenging, actually.

We've been pretty successful, even though we've always trailed our objectives.

The Bangalore facility is actually not a new location for us.

It's really just a new building.

We've now moved into a much bigger building than what we were in.

We had people really kind of doubled up to excess.

I believe right now we have in the order of about 260 employees in Bangalore, and we would expect that number to double during this next year.

And the facility we moved into can handle about triple that capacity.

So we've got plenty of expansion space.

But no, that was just part of the plan all along.

We finally got the facility online and now that we've got the space, we expect to grow that site quite aggressively.

They have a number of projects over there. 1 that I reviewed yesterday was VTL, which is -- and I what I was captured by, is they said it is one of the highest quality releases that we've done, the team is extraordinarily motivated in doing a good job.

So we're very proud of it.

When you first start up a facility like we did there about a year and a half ago, the key is to get the right leadership in, and then bring the right people.

We've been very fortunate that we brought a good number of strong leaders in there.

We're getting a very good reputation in the area, which is key over there.

And we're finding that we can give them complex problems, and they come back with extraordinary solutions.

So it's not just some kind of like little pieces of a puzzle.

We've give them specific programs that mean something to us, and they are delivering a high quality product.

Laura Conigliaro, Goldman Sachs.

Yes, if you look at the guidance that you gave for the July quarter, and then also combine it with the fiscal year guidance, it looks like you're actually only looking for top line growth of 25 to 28% over the last 3 quarters.

One would presume, given the kind of numbers you're seeing in deferred rev and your new products, and presumably backlog, that those are extremely conservative numbers.

But can you sort of juxtapose that against what it is that you're seeing in the market at this point, that would cause you to have that kind of, I guess, conservative growth ?

Well, Laura, as you recall on our analyst day, we talked a little bit about the seasonality of our revenues and the seasonality of our operating profit.

You recall the seasonality of our revenue slide that I showed, the first quarter is typically -- shows the lowest sequential growth rate of the fiscal year.

And indeed, we're modeling this coming first quarter, based on that past experience.

Now, having said that, despite the fact that it's a relatively low sequential growth rate, which would be compared to the fourth quarter obviously, the guidance we gave was for growth 38, 39% type of thing.

So I think the year-over-year growth rate is more important here.

If you go forward into the fiscal year, again, I think you can pick your number between 28 and 30%.

I don't think there's many companies, our size, growing at those kind of rates, and certainly not in our industry.

Chris Whitmore, Deutsche Bank.

Sir, if your line is muted?

I was hoping you could talk briefly about software attach rates going forward, particularly as the new high end product ramps?

I'm sorry, I didn't catch it all.

The tax rates going forward?

Software attach rates?

Oh, attach rate.

Excuse me.

I personally see very little change in the software attach rates.

The -- as I have forecasted for some time, I think the software attach rates are hitting really kind of a threshold around 35%, and you may see minor oscillation,.

But I don't think the high end products will necessarily drive that up or down.

As a percent of revenue, I expect it to be pretty consistent with the current business mix.

Harry Blount, Lehman Brothers.

Quick question, really on the marketplace right now.

Dan or Tom, was wondering what you guys are seeing in terms of any changes in the principle application drivers, partner drivers, and win rates on competitive engagements.

If you're seeing any fluctuations there?

This is Tom.

One of the key drivers, I think, is SAP is picking up with us in a fairly dramatic fashion.

We've had very good success with them in Europe, but we're starting to get infrastructure built around teaming arrangements here in North America.

Bill McDermott and I are both working closely together, as are the organizations for North America.

And I think that that is going to be a big play for us in the future.

We've done a lot application optimization actually, with a number of our key partners that is starting to pay off.

But Dan put in his comments, he said just those 4 partnerships.

Microsoft, we've had the best relationship and the best meetings and best strategy we've had with them ever, over the last 2 quarters.

Oracle remains very, very strong with NetApp.

Has been very strong with NetApp, both for their internal uses and I think now I've done 7 Oracle World keynotes with them over the last 18 months.

And now I believe also IBM is looking at different public sectors, a [big key].

It's not just applications.

It's which sectors they want to take us into, where retail, public sector - places we haven't been in a big way - healthcare.

There was a big win with IBM this quarter into a big hospital with McKesson, which happens to be a big IBM application, that we never were in.

Didn't know about it until we got the purchase order.

So I think we're going to start going into new markets with different partners, but all around those same set, and we're just going to -- we don't need to find new partners.

We need to make sure we go deeper with the ones we have.

Hi, this is Dan.

I want to amplify on Tom's comments.

For those of you that have followed us awhile, you'll recall that several years ago, probably around 2001 or 2002, Microsoft labelled us a competitor, as they brought out what is now called Windows Storage Server.

In recent meetings with some of the senior executives there, they were actually sending out communications to their field, that they should view us as a partner.

And we've really come full circle based on the value add we can offer, and the way we've integrate the our technology under the Volume Channel services and Exchange and so on, and Snap Manager for Sequel, and a bunch of other examples.

So as Tom said, the Microsoft relationship is very, very positive at this point, and the issues that we faced several years ago are now well, well behind us.

Let me bring up 1 other comment if I might, and it has to do with Decru.

We're not talking about that as a big volume revenue thing right now.

But I can tell you the presence in the market -- you read the paper today is about 26 million soldiers got their identities stolen, basically the information is on the Web.

These things are so active every where, I'll give you a couple thoughts. 1 is, Dan mentioned we had a very good financial services quarter, with 5 major firms, major firms, committed to them from an architect point of view long term in last quarter.

So the traction is faster than we ever expected.

I've commented before on these things, I go to Japan a lot. 1 of the things that you normally see in Japan is they follow 2 years behind in technology.

Not true with Decru.

This is a topic that's hot internationally.

So the reason I point that out, not only are we selling -- do I think that Decru is going to have a very strong roll over a period time, I believe that we're having conversations with CEO and CIOs of this institution because of the type of thing we are having.

It has given us much greater exposure in branding in these accounts than we've ever had before in just the storage play.

If I could add 1 other point on that, is that I think 1 of the other things that is driving our business, is as our software portfolio grows with things like FlexVol and SnapMirror, I think we're opening up new markets for our products in the areas of business continuance, disk-to-disk backup, archive and compliance, and digital imaging.

And I think that's driving part of our growth in serial ATA drives, and also driving a part of the explanation of why our average capacity is going up.

So I think in addition to our traditional primary storage markets, I think our strength of our software is opening up a lot of secondary markets.

And I think that's a big part of our growth, as well.

Operator, we would like to back up and address -- add some more color to a question that I think we may have misinterpreted a minute ago from Laura.

Yes, Laura, this is Steve here.

Evidently, I was the only one sitting at the table that misinterpreted your question.

I was handed about 6 different notes by everyone else who completely understood the question.

So I apologize.

So your question was, why -- given our guidance for the full fiscal year, why does the growth rate that we're projecting in revenue appear to be declining, or slowing in the second half of the year?

Let me describe.

So in the first quarter, as you know, we were having easy compare to the first quarter of last year, where we had the very difficult product transition with the FAS3000.

So that's why we're off to a very, very quick start in terms of the growth rate in the first quarter that we just gave you.

In the second half, or in the next 3 quarters-type of thing, while we're still in the 25 to 28.5%-types of growth ranges, we think that's appropriate at this point in time, until we see how things unfold.

We have a lot of new products coming out.

We have some new technologies in VTL and the SMB product that Dan was just talking about.

We need to see how those products gain traction, et cetera.

So until we do that, we're kind of keeping up the pulse on our core business, making sure it's growing at these kind of rates.

And then we'll keep you updated as we go.

Clay Sumner, FBR.

With the demonstrable value, or TCO value in your operating system, with FlexVol and some of the other products you've outlined, I assume since TCO is kind of hard to measure up front in a sales process, that you tend to under price it up front.

But are you able -- have you been able to come back and recoup some of that later, possibly with higher software maintenance or some other way?

This is Tom.

I don't think that's the way we look at it as much.

I remember when we first had the first conversation with the execs at Oracle, who were the guys who really, really helped us drive even the thought process on this.

And they said, if you're successful at this, we'll buy less disk.

And I said, yes, but everybody else will buy more, meaning new customers.

So I think as we demonstrate the value of -- data grows at 60% a year.

Which means every 5 years you grow at 10X.

So that means -- and as I say to people, let me guess at how much your administrative growth will be.

And they always launch it to either 0 or down.

So there's only 2 axes.

You either can manage the data simpler, which NetApp has always been known for.

Or you can store less information.

We're getting that message out effectively now.

And so our goal is to get people using it, driving their utilization rates up, and telling other people.

As opposed to thinking how we would make more money out of them, it's how do we focus this and get into new organization, new parts of an organization. 1 thing NetApp is getting better at is wallet share.

When we say we win in Citigroup, as an example, that's great.

But what percentage of the wallet share?

Our wallet share is growing in these big accounts as they -- and this capability is driving more wallet share than any single thing, because if you can prove higher utilization rates to somebody, now other apps within those same companies move your way.

That's what we're focused on, more than the monetizing that savings.

This is Dan.

The other thing you should look at, I think your premise is largely justifiable based on the IDC data.

If you look at cost per gig, and IDC ships or produces market share data for both revenue dollars and the storage shipped, the cost per gigabyte from NetApp is significantly lower than any of the other competitors in the industry.

And that is on net purchases, right?

I mean so that's after you take into account FlexVols and all the rest, which bring our utilization numbers up.

So they buy less for the same amount of data, and they pay less for it.

Shebly Seyrafi, Kaufman Brothers.

So maybe you can elaborate on why the product gross margin -- well, you said because of mix, it declined to 35.1% because of more disk.

But maybe you can talk about why you're guiding for gross margin to be flat in the July quarter, in light of the fact that the Excelsior, the 6000 series, is going to start ramping.

And you normally ship more NAS heads, i.e. higher gross margin product, at the beginning.

I would think you'd have a rebound in the product gross margin, and therefore your total gross margin.

Shebly, there's a big difference here between the FAS6000 and the prior high ends.

The 6000 is well above the 980.

In fact, after we announce the the 6000 -- or released it to our sales and installed base, you'll notice the 980 continued to be extremely strong.

The 6000 is well beyond that.

So it's not an upgrade like you'd think of -- the 960 was an upgrade to the 880 or something of that order in our historical past.

The 6000 is really positioned up against the big frames, and it's a substantial cost to upgrade.

It's a much bigger system.

So we're not trying to drive upgrade business in this particular one.

We're really trying to drive into new applications and very large data center deployments.

And so I don't expect to see a lot of upgrades in the mix.

Right, which means the disk mix -- the total amount of disks we sell with these systems will also be very high next quarter.

So between the add-on software being roughly flat from this quarter, roughly the same type of mix of disks and enclosures, there could be some minor shifts there.

And then the IBM business which should -- if things go as normal, hopefully that will improve next quarter, or increase in the mix a little bit.

All those things being equal, the gross margin should stay roughly where it is.

Bill Shope, JPMorgan.

Just an elaboration on that last question.

So I guess you're implying that the 6000 series, at least initially, is going to be one of the lower margin products.

And then potentially, I guess hopefully you can expand the overall margin profile with that on software and what not after that?

No, I don't think that's the case.

Okay.

It's going to be consistent with the 3000, in terms of gross margins.

I mean, the wild card in all of this is how much disk customers put on there, but I don't expect to see any significant differences between the gross margins in the 3000s and the gross margins in the 6000s.

Yes, I'd also add that the software pricing is also module-based, so that will also scale with the size of the system to keep the overall gross margin relatively constant.

If you look at ASPs, right?

If the -- let's take some round numbers.

If the ASP in a 6000 is 3 times that of a 3000, you'll still see the same kind of mix of one-third of the revenue being software-related, one-third being basically the core system, and one-third being storage.

And so they just kind of scale up together in that regard.

1 of the appeals of the 6000 also with the increased compute power, is the ability to run more of the software products simultaneously, and derive more services out of a single box.

So the ability to attach more software to a 6000 is actually higher than some of our other products.

So I wouldn't anticipate much movement on the gross margin of that product class.

Aaron Rakers, A.G. Edwards.

In your discussion in regards to the quarter, you had mentioned sales coverages continuing to be 1 of the challenges.

However it looks like 1 area that you continue to invest very aggressively in, is the R&D front.

And I believe at your analyst day, you talked about adding still as many as 300 people per quarter going forward.

Are we starting to see that shift a little bit more focus towards the sales coverage arena?

And if you could give any color there?

And then follow-on to that, how long it typically would take until you see the full productivity of those additions going forward?

This is Dan.

I'd say we were consistent with our historical practice of trying to a lot of sales people, especially in Q4, getting into the training cycles and the sales kick-off and get them productive for the start of the fiscal year.

So you see some mixed shifts, if you will, in terms of hiring quarter by quarter.

Sales dominates Q4, Q1.

Engineering dominates the rest of the quarters.

But if you look across the Company for the year, we expect to hire roughly 1,200 people.

And there will be roughly 300 in sales, 300 in service and support, 300 in engineering, and 300 across the other functions of the Company.

And I think that's about the same model we had for last year.

So I think -- this is Tom. 1 of the things that we have invested aggressively over the last 2 years, and is definitely paying off, but this is where the big play will be on us, is with the channel.

I think that we are becoming much more savvy about how to leverage a channel and becoming where we have them on top [inaudible] as opposed to as a back end function.

You see in some of the biggest, most successful countries in Europe now be dominated by channel sales, even in the enterprise with us, some big partners have come over, and we're able to -- excuse me, I lost my train of thought.

We're able to leverage some of these big, big plays that we've invested in over time, and that's where the focus of our sales leadership is now.

We've invested in channel marketing, channel people, channel programs.

And I think that will provide the leverage, much more than thinking about how many just sales feet can we put out.

Paul Mansky, Citigroup.

Going back to the margin discussion as it relates to that 6000.

Talking with your customers and others, we've been told fairly often that one of the big benefits of the 6000 is that it's essentially a head swap upgrade to the 900s.

And yet, you're indicating that you don't really see that being more of an upgrade play, it's more of an incremental opportunity for you.

You don't have any specific programs in place to encourage the kind of the head swap upgrade to your installed base right now?

I think the difference is allow versus encourage.

I mean, maybe it's subtle.

We've always had a practice that customers can upgrade any system they buy throughout our product lines.

So I mean we have customers that start off with us with the 700 series, and move to the 800s, and move to the 900s.

And now if they want, they can go to the 6000s.

But I think that the question is one of price performance capacity , et cetera.

The 980 is still a very strong contender in the product line.

You saw it go up in units and capacity this quarter.

We're not trying to take out the 980 with the 6000.

We're trying to put the 6000 way above it.

If a customer wants to upgrade, he is certainly welcome to do it.

But we're not going to give a lot incentives and so on, for them to do it.

And I think that's what the difference is.

We used to move customers from the 880 to the 960 very aggressively.

We're not trying to do that with this product program.

It's on the price list.

They can buy it.

We're happy to have them do it, if that's what they choose.

But it is not a focus program.

Glenn Hanus, Needham & Co.

Could you guys give us any update on, at a high level kind of by region, what you're seeing in sort of the spending environment, the selling environment, and I guess Europe has been slow for some companies, maybe comment on that?

Europe was very, very strong for us, especially in Germany.

UK.

And UK.

UK had a bad Q1, and had a spectacular, 2, 3, and 4, enough where they made up their year.

Germany has been the engine all year long.

And this -- we had a big contest of which was the best region in Q3, which is always a tricky one for us, and the other parts of Europe won.

So all 3, we felt that was very strong.

North America continues to excel in all 3 -- all 4 areas, federal and the other 3.

And this quarter, we saw strength come back in Asia.

So we feel like we've had very little turnover at executive levels and executive sales management throughout the world over the last couple years.

And when it did happen, it was because we were growing out in maturity different areas.

So I think that paid off tremendously well.

We don't have any areas of the world that I'm spending time on thinking we have to fix right now.

We think that we can accelerate, but we have strategies in place that are working.

That's a very odd circumstance.

I mean typically, when you look at this kind of situation, you've got to go fix something.

So from a spending point of view, I don't see -- I think Japan is definitely coming back as a country.

We hope to take advantage of that.

The rest of Asia was still emerging, but we're not seeing any dramatic spending issues in any of the other markets.

I'd like to echo that.

I, like Tom, travel all around the field.

And I would say the business climate in general right now is as strong as I've seen it in a long time.

And if you even look back to the bubble period, you'll find that there were certain regions, like Asia, with the currency crisis during that time, that they were soft.

Or Japan, that was actually seeing deflation.

You go around the globe right now, there is not 1 major economy anywhere that is struggling.

And the business environment is very healthy around the globe.

I think Germany has been tough for a lot of countries, because their organizations have been screwed up.

I mean many of our competitors have sent people to us by their actions in their own companies, but our German operations had no turnover.

We've had a terrific team running it for a long, long period of time.

The execs have been in place 8, 9 years, and we've taken advantage of it.

We have long existing relationships, and we've conquered some new, big accounts in the last year.

And that's what it's all about over in Germany.

So that was the one I see other people struggling.

That has been a strength for us for a long time.

Andy McCullough, Credit Suisse.

Steve, you mentioned IBM as a negative mix shift on gross margin.

How are you thinking about the operating model impact as this business ramps in '07.

And then, within that, IBM was 2% of your business this quarter.

Why should we think that that 2 to 3% target you guys talked about at analyst day for fiscal '07 is still appropriate?

You think it ought to be higher?

I would hope so.

Okay, let me answer the first part of that.

So as we've talked about before, the gross margin on the IBM business is less than the average of the rest of our business, because the OEM relationship we have with them.

They buy at a steeper discount from us.

However, the expense stack that's associated with that business is also much thinner than the rest of our regular business.

We don't have obviously, nearly the selling cost infrastructure, the marketing infrastructure, and to some extent, the admin infrastructure, that we have with the rest of our business.

If you looked at the operating profit, it turns out that the IBM business is absolutely neutral to the Company, from an operating profit standpoint.

It has roughly the same operating profit as the rest of the Company, and that's the way it was intended.

With respect to how big this business could get, I think certainly everyone in this room hopes it can get a lot better.

We're encouraged by the strength of the business today and the way things are proceeding.

But we also recognize that it's going to be another year before IBM has our entire suite of products and all the software that they are going to require to compete in all the various markets around the world type of thing.

And it's going to happen at different rates, and different regions of the world, et cetera.

So, I think that for now, I think the range of business we gave you during analyst day is still appropriate.

I'll disagree.

This is Dan.

You know, IBM is currently outperforming both their expectations and ours.

And they are building momentum.

And most of it's come out of North America.

That's actually been the area where it's been the strongest, and that's not surprising.

So, they may be a faster growth ramp than we had forecast back on analyst day, but but I think it's too early to actually change the number.

I mean, we're tracking ahead of plan, and that's what shows in this quarters results.

And the question is, can we keep that momentum up and keep it growing?

And I'm not in a position yet to change that 3% forecast.

Yes, we're very fortunate to have Tom Georgens join us, of course, who built the business for LSI Logic.

And Tom said to me recently, it's going better than he expected, given that kind of time frame.

He's been through this before, typically, so I travel around the world, and many times I will meet with the IBM sales execs who are extraordinarily excited to hear from me, primarily because it's the first time they're hearing about it.

It's that their communications inside goes slow.

And so, we're finding in pockets they are embracing us in a big way.

And guess what?

Pockets of IBM turns into bigger numbers than you expect in a hurry.

So what we said to you before is our belief is when you do something like an IBM relationship, the key is in the first 6 months to a year are people positive?

Because if they are not, it turns a whole different way.

They are definitely positive.

We are definitely positive.

Now it is, if we did what we maximize the efficiency of this.

And we are doing a lot of thinking about it, and they are doing a lot of thinking about it.

And some of the things we've landed on together are, let's go after some certain markets in a deep, aggressive way, because get the references accounts and take them up, with software vendors should we bring over that kind of thing -- I think we're approaching it very intelligently.

But the message I'd leave you with, I think these relationships work if both sides feel positive and continue to invest.

And as Dan said, both sides agree it's going better than they thought, and they will increase investments to make it go faster.

That's usually good news.

Tom Curlin, RBC Capital Markets.

With the VTL technology, are you already offering, or are you contemplating offering some kind of data [de-dupe] support or content factoring support with that?

That seems to be an emerging trend in that space.

I think the answer to that question is yes.

Clearly, I don't want to get too specific about forward-looking things.

But I think that you'll see De-duplication not only in the VTL space, but also some of our mainline ONTAP stuff as well.

Do you think that has some significant implications for the tape market?

We hope so.

I do.

I personally believe that what's going on, is that customers are trying to reduce their utilization of tape, specifically for nightly incrementals and so on.

And are trying to stretch out the intervals between which they do the, what's called level 0, it's a full write of the tape.

And it's not trying to eliminate tape, but they're trying to reduce the utilization.

And that means they are going to buy less new tape drives going forward.

They're not going to take them out.

But I think you will see a reduction in revenues in that market segment going forward.

Jim Porner.

Yes, gentlemen, with regards to operating expenses, historically when you've had the wind to your back on the top line, you've tended to invest the upside on your revenue.

We've seen less operating leverage, incremental earnings on the bottom line as a result of that.

And it looks like with you sticking with your current range for the year, that that continues to be the case.

But how much wiggle room do you have on your expense outlook at this point?

And with regard to the first quarter, could you talk a little bit about how those operating expense categories might look relative to the fourth?

Thanks.

Sure, this is Steve here.

I think the key point is that what we're really, really focused on is delivering an operating profit margin that's in the range of 15.8 to 16.4%.

We keep saying that over and over again.

We view the gross margin and the operating expense structure as elements that allow us to achieve that operating margin.

So the first and foremost thing we're trying to achieve is the operating margin, and then grow as fast as we can.

Depending on what happens with gross margin, will dictate how much is left over for us to invest in the expense structure.

And right now, given the projections we have, our emphasis is on first, sales, services, and R&D, in terms of where we're going to be hitting the investments, probably in that order.

So, going forward, in terms of the expense structures versus the fourth quarter, I don't expect to see a whole lot of change.

And if you'll give me half a percentage point, you won't see a whole lot of change.

And with that, ladies and gentlemen, concludes the question-and-answer portion of today's presentation.

I'd like to turn it back over to the group for any closing remarks.

Yes, this is Dan.

First of all, I'd like to recognize the contributions of really, the team of Network Appliances.

This has been a terrific year of performance for both the sales team and the field, our service and support organization.

The engineering organization has just produced an enormous amount of really innovative distinctive product into the marketplace this year.

And our marketing program has been outstanding.

I mean you just go right across the Company.

I have nothing but thanks and praise for all the people of Network Appliance that has made this such a successful year.

Thank you all for joining us today, and we'll be back in touch with you at the end of Q1.

Have a wonderful day.

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

This concludes your presentation, and you may now disconnect.

Good day.