NetApp Inc (NTAP) 2007 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 '07 earnings conference call.

My name is Carlo and I'll be your coordinator for today's presentation. [OPERATOR INSTRUCTIONS]

I would now like to turn the presentation over to your host for today's conference, Ms. Tara Calhoun, Senior Director of Investor Relations.

Please proceed.

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 risks and uncertainty, including statements regarding our expectations for operating results for fiscal Q2 and FY '07, our stock repurchases and hiring goals, our intention to pay down our debt, the timing of and benefits to be derived from product introductions and technology advancements, including our VTL, Decru® and FAS6000 products, FlexVol and ONTAP® GX technology, our expectations regarding our market share, the importance of our indirect channels 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 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 achieved another terrific quarter, demonstrating strength across every geography, with particularly strong showings from Germany, the UK and Ireland and the U.S. federal team.

Every major geo was above plan.

Please note that I will walk through the following highlights and details with you.

All numbers come comply with GAAP unless otherwise stated.

You will notice that we are providing a GAAP presentation of our financial statements, and have eliminated the separate full non-GAAP income statement.

We and other companies are moving towards this format in order to more easily comply with SEC Regulation G. We will continue to provide key non-GAAP items in our press release, as well as all the necessary supplemental items in our press release and our website, for investors to continue calculating our non-GAAP performance.

Total revenue for the first quarter was $621.3 million, up over 39% compared to the first quarter of last year and up 4% sequentially, demonstrating our continued strong market success.

Foreign currency effect added about one percentage point to this quarter's on a sequential basis and were neutral on a year-over-year basis.

The combination of product revenues and software subscriptions were $540.4 million and grew 37% year-over-year and over 3% sequentially.

Add-on software and software subscriptions accounted for about 36% of total revenue this quarter.

This figure is a combination of add-on software products that were approximately 24% of total revenue and software subscriptions, which were 12% of total revenue.

As you can see in our press release, we are now breaking out software subscription revenues as a separate line item, which we will continue to do going forward.

Revenue from IBM and Decru® both increased nicely again this quarter, with IBM almost 3% of total revenue and Decru® about 2.5% of total revenue.

Given the strong performance from both these segments, we're revising our estimates for their contributions to our total revenues.

For the full year, we now expect IBM to generate between 3% and 4% of total revenue and Decru® to contribute between 2% and 3% of revenue.

Revenue from services, which includes hardware support, professional services, and educational services, was 13% of total revenue, up 8% sequentially and up 50% over Q1 of last year.

Our investments in services organization have continued to drive faster than corporate average growth rates in services revenues.

Service maintenance contracts increased 9% sequentially and total professional services grew 4% sequentially, both of which were up over 50% year-over-year.

NetApp gross margins were 61.2% this quarter and non-GAAP gross margins for the combination of products and software subscriptions finished Q1 at 65.6%, up half a percentage point from last quarter.

This increase was driven primarily by favorable production costs and a slightly higher than average software mix.

Non-GAAP service margins of 31.6% increased significantly over last quarter, as a result of both increased service contract revenue and improvements in productivity.

With aggressive hiring in our services organization, we expect these service margins to pull back and remain around the 30% level for the rest of this fiscal year.

Turning to non-GAAP expenses, our operating expenses totaled $276 million, just over 44% of revenue.

Expenses increased 4% from Q4.

Sales and marketing expenses including sales kick -- included sales kickoff expenses and some favor -- unfavorable foreign exchange impact.

R&D expenses increased only 2% sequentially, as new hires from Q4 were observed -- absorbed and Q1 new hires were somewhat less than expected.

Total employee head count increased by 239 people this quarter, ending the quarter with 5,215 employees.

GAAP operating expense include the effective intangible amortization, previous merger related stock-compensation charges, the effect of FAS 123(R), and some minor adjustments of restructuring charges this quarter.

At $104.2 million, non-GAAP income from operations finished at 16.8% of revenue, above our target range, due to higher than expected gross margins and a slightly lower than planned hiring.

Other income, which consists of primarily of interest income, was $13.6 million.

Non-GAAP income before taxes for the quarter was $117.8 million or 19% of revenue.

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

Non-GAAP net income totaled $96.6 million or $0.25 per share.

GAAP net income totaled $54.7 million or $0.14 per share.

Please refer to the table provided in our press release and on our website to see the reconciling items from non-GAAP to GAAP.

While moving on to the balance sheet, cash and investments totalled $1 billion -- $1.27 billion, down approximately $50 million from Q4.

We repurchased approximately 6.56 million shares of outstanding common stock at an average price of $33.53 per share for a total cash outlay of roughly $220 million.

Next quarter we expect to repurchase roughly $185 million worth of stock.

Our cash generated from operations was $164.6 million this quarter and included two large non-routine items.

The first was a $19 million tax payment related to our foreign cash repatriation, which was recognized in Q4 on the P&L, but actually paid in Q1.

The second was the annual employee incentive compensation payout of approximately $40 million.

Capital purchases were $23.1 million this quarter and depreciation and amortization totalled $23.9.

Cash and investments exclude $232 million of restricted cash associated with our foreign cash repatriation.

In Q4 we added $300 million of debt to our balance sheet to facilitate our foreign cash repatriation.

We paid down approximately $28 million of this debt during the first quarter and we plan to pay off the remaining balance within the next two to three years.

Deferred revenue increased $61.7 million this quarter to $743.2 million.

That's a 9% sequential increase and up 53% year-over-year.

This continued strong increase in deferred revenue is driven primarily by increases in software subscription purchases and hardware maintenance contracts.

The average duration of these contracts remains steady at approximately 31 months.

Accounts receivable day sales outstanding came down to 55 days compared to 63 days reported last quarter.

DSO decreased this quarter primarily due to a very linear shipment pattern during the quarter, and we expect to see similar DSO levels next quarter.

Inventory turns improved again to 17.3 times compared to 14.7 times in Q4.

As we discussed in Q4, we had built inventory in anticipation of the launch of our new FAS6000 product line.

Our finished goods inventory dropped by over $6 million this quarter, partially as a result of the FAS6000 ramp.

Now before I turn the call over to Dan for his comments, I'd like to discuss our operating model for the second quarter and revised expectations for the full year.

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

We are making forward-looking statements and projections that involve risks and uncertainty.

Actual results may differ materially from our statements or projections.

We expect FY '07 second quarter sequential revenue growth to be in the range of 2.5% to 4% over the first quarter, which translates to a 32% to 34% year-over-year growth rate.

We expect total non-GAAP gross margins to moderate slightly, as software returns to more normal levels and we catch up on hiring.

As a result, our non-GAAP operating margin for the second quarter is expected to be back in our targeted range of 15.8% to 16.4%.

Second quarter non-GAAP earnings are expected to be $0.25 to $0.26 per share.

GAAP earnings are expected to be $0.13 to $0.16 per share.

We expect our diluted share count to decrease by about 1% over the remainder of FY '07.

Given the strains we see in our business, we are revising our targets for FY '07 revenue upwards to a range of 32% to 33% growth over FY '06.

Non-GAAP earnings per share are expected to be in the range of $1.04 to $1.06.

With the implementation of FAS 123(R), GAAP earnings are very difficult to estimate, given the volatility of some variables, especially the impact of our stock price.

Therefore, our target GAAP range is estimated to be $0.61 to $0.69 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.

When we looked at all of the quarter end statistics we use to track our business performance, spanning products, new initiatives, operations, investments, and goals, there are many, many noteworthy gains that provided both reenforcement to the effectiveness of our strategies to penetrate the enterprise, and demonstration of our increasing competitive success around the world.

I'm very pleased to have a Company that's executing and excited about our momentum in the market.

This quarter we had the highest percentage in our business ever from enterprise accounts.

Almost 70% of our bookings were from enterprise customers, well ahead of our goal to accomplish this by the end of FY '07.

And according to IDC in their Q1 2006 Storage Tracker, Network Appliance is virtually tied for the number two position in terms of total petabytes shipped.

On the current trajectory, we would expect to move into the number one position of petabytes shipped within a year.

How are we accomplishing this at such a fast rate?

It's a combination of innovations and systems software, a compelling value proposition, effective marketing and the right field operation strategy to accomplish our goals.

No competitor comes close to our rate of new product introductions.

Our rate of innovation is extremely high because we're investing more in a single architecture than anyone else in the industry.

Our Data ONTAP 7G operating system breaks the historical rules about price per megabyte storage, FlexVol's thin provisioning capability that allows customers to buy as little as one-half the amount of storage relative to the competition to satisfy a specific project need and then dynamically add additional storage later as the application grows.

FlexVol is available standard with our 7G operating system.

Our RAID-DP technology is the only RAID 6 for protection against double disk failure in the industry that doesn't have a significant performance penalty.

This allows customers to competently and reliably deploy inexpensive ATA drives in primary storage environments.

And with unified storage, SAN, NAS and iSCSI are all available concurrently on every one of our storage products, and running one operating system across all of our storage product lines requires far less customer management overhead.

Customers get better value, redeployment flexibility throughout the product life, the highest utilization rates in the industry, and greater reliability from NetApp storage solutions.

Through innovation, effective education and successful enterprise deployments, we are also now considered a serious SAN vendor, so they are increasingly turning to us to solve their enterprise storage and data management challenges.

In our first fiscal quarter, our total shipped increased to almost 73 petabytes, a 20% sequential increase from the record 60 petabytes shipped in Q4, and ATA drives accounted for over 85% of this increase, jumping to 54% of total petabytes shipped from 47% last quarter.

The new 500 gigabyte ATA drives, just introduced in Q4, contributed about 30% of the total capacity shipped this quarter.

We believe that close to one-third of all ATA shipped in our FAS storage systems are now used in primary storage environments.

We're also seeing larger and larger average capacities ordered and our transaction sizes continue to increase.

We hit our single largest deal ever in the first quarter this year, rather unusual first quarter dynamics.

Interesting enough, the actual unit number of enterprise storage systems shipped during the quarter only increased 3% sequentially.

But the situation there was the continued decline in the older 900 series systems, which were more than offset by the new product lines.

Units shipped for the FAS3000 increased 6% sequentially and the average volume on the FAS3000 series increased almost 60% sequentially.

We shipped over 100 units of the new FAS6000, double the numbers shipped in Q4, and the average capacity shipped in the FAS6000 increased 27% sequentially.

These larger transaction sizes are a strong indicator of increasing customer confidence and our ability to support even the largest enterprise environments.

This is also evidenced by further expansion of our SAN presence.

This quarter 35% of total bookings had a SAN component included, with 25% fiber channel SAN, 14% iSCSI, and a 4% overlap that included both.

Remember that many of these orders also had a NAS component, indicating that more customers are understanding the value proposition of unified storage from Network Appliance.

They don't have to buy three separate systems, increasing the value and redeployment flexibility derived from our Network Appliance technology.

Historically, we've calculated th SAN component as a percentage of our total business, but as we expand into emerging areas of adjacent storage, like encryption and virtue tape libraries, this number becomes diluted by products that do not have a protocol component.

Therefore, starting this quarter and going forward, we will be calculating and measuring our SAN performance as a percentage of just our total storage business.

Using this new more representative formula, a SAN protocol was included in 36% of total storage bookings, with 26% including fiber channel SAN, 14% iSCSI and still 4% overlap, so a very modest change, but we expect to see that to move going forward.

Another area of significant enterprise traction is the secondary storage.

Data protection, disaster recovery, archival and compliance requirements all contribute to the dramatic increase in our petabyte shipped, particularly in ATA drives.

Both Gartner and IDC currently rank NetApp the number two software vendor for array-based data replication..

The value proposition of our secondary storage gives us a tremendous advantage, especially where primary storage deals are extremely competitive.

The significant cost savings and flexibility of our data replication software make the primarily and secondary package as a whole the most compelling solution.

Our emerging products are also providing -- proving to be very effective ways to penetrate new accounts, giving us other entry points into new enterprise customers.

The compelling nature of the Decru® encryption products are beginning to provide entry to new accounts where we have not been able to get traction in the past.

As Steve mentioned, Decru® jumped to almost 3% of revenue this quarter.

And in addition, the financial serv -- in addition to financial services and government accounts, Decru® is beginning to win deals in telecom, education and technology institutions.

Another new area for us is the virtue tape library, which sells into a very different part of the enterprise.

While we found the sales cycle to be longer, we're learning quickly the different skill sets required to speed success and we saw good increases in units shipped this quarter, selling over a petabyte of storage in just the second quarter after its launch.

We'll continue to monitor and incubate this emerging opportunity.

NetCache contributed about 3% of total revenue again this quarter.

A good portion of this revenue is coming from the deferred revenue line of our balance sheet.

We'll continue to recognize this revenue in future quarters from the deferred revenue account, even after the sale of NetCache assets is complete.

Please note that we will also continue to support our existing NetCache customer service contracts for the life of their contract.

As we indicated in our press release, we expect the impact on earnings for this transaction to be negligible.

In fact, in this conference call we just increased our revenue targets for the year, even as some of the NetCache revenue will go away.

IBM is part of what makes up the difference.

IBM is making steady progress in understanding how to sell NetApp systems and having competitive success in their own right.

As Steve mentioned, they've grown to almost 3% of our business.

Partners like IBM also bring NetApp increased credibility and effectiveness at penetrating enterprise accounts.

Our relatively new partners, like SAP, continue to grow in influence.

We're winning in more SAP accounts and getting bigger deals in those accounts than ever before.

Our relationship with Microsoft® continues to deepen.

This quarter our equipment was installed in Microsoft® training centers worldwide for demonstrations, training, customer evaluations, and modeling of customer environments.

Our indirect channel accounted for 56% of total revenue this quarter, growing about 6% sequentially and up 46% compared to Q1 of last year.

Investments and programs to develop more resellers are paying off, with these new partners becoming very effective at selling and installing Network Appliance.

Contribution for FileNet increased 9% sequentially from the fourth quarter, providing 11% of total revenue this quarter.

We expect the indirect channel to continue to grow faster than the Company as a whole.

Geographically, Europe hit the ball out of the park, up 54% year-over-year and over 6% sequentially.

The UK and Ireland were significantly above target, and Germany, despite being highly distracted for about a month during the World Cup, beat their goal, as well.

Asia Pac contributed 11% of total revenue, showing healthy improvement in several countries, and the Americas was 57% of total revenues.

The federal team was well above planned, even during the seasonally light summer months, and the East showed particular strength.

All in all, it was just a stellar quarter and I'm very proud of the team.

The Company is executing very well and we're managing our growth very effectively.

Not only are we successful today, we're looking out at a long time horizon and believe we are building even more competitive differentiation into our products and go-to-market strategies for the future.

Our next generation operating system, ONTAP® GX, is a perfect example.

Its architecture is based upon our forecast of what the storage industry will look like five and ten years from now.

We're the only vendor with the capability to seamlessly scale hundreds of systems that will appear like a single one.

GX is the evolution of 7G, the clustering extension of ONTAP® 7G, and we're getting great feedback on the first release of GX.

Symantec was one of our first customers and they are very happy with the opportunity for massive scalability and manageability the GX will provide them.

The release is stable and solid, and we'll begin a broader push into high performance computing and NFS environments this quarter.

To wrap up, I'd like to congratulate the Network Appliance team, one team, on a job well done.

I'm excited about the increased awareness of NetApp in the marketplace and the momentum we have generated.

At this point, I'll open the floor to questions.

And as usual, I'd ask that you limit yourself to one question at that time and then get back in the queue, so we may address everyone on a timely basis.

Operator?

Thank you, sir. [OPERATOR INSTRUCTIONS] Sir, our first question is from the line of Richard Framer with Merrill Lynch.

Thank you.

I'd like to ask a question on services margins, please.

They were a little bit better than at least I was modeling.

I heard you mention the increased productivity and that that might not persist into the future, but would you just help us understand a little bit better what's driving the services margins and how they'll change going forward?

Sure, I'd be happy to.

I think there's two forces at work here.

First is the just general productivity that we're seeing across the services organization, both in the break, fixed, repair area, as well as professional services.

So the productivity will continue.

The productivity improvements we're seeing, I think, are going to continue for some time.

I think what we were alluding to with respect to being a little conservative on the margins has to do with the fact that we're going to probably continue a -- on a very aggressive pace hiring there, particularly in professional services.

And as we bring new people on board it takes them six to nine months to get up to speed where they can generate revenue, so we pay their expenses during that period while they don't generate any revenue.

But to the productivity point earlier, eventually they start producing revenue and once they get on board and get up to speed, you know, that gross margin starts to come from a negative position and up to a standard industry average.

Thank you.

And sir our next question is from the line of Dan Renouard with Robert Baird.

Hi, thanks.

My question is on your new FAS6000 series.

Dan, you talked about a hundred units, or maybe a little bit over a hundred units this quarter.

How should we be thinking in terms of success -- relative success of that product in the October quarter and beyond?

Would a doubling of that or are you thinking even bigger numbers in terms of units, or is there some sort of a revenue contribution we should be thinking about?

That would be helpful.

Thanks.?

Yes, I would think doubling is certainly the right kind of goal.

Let me point out to you that the software release that went out with the FAS6000 was not at the -- what we'd consider to be generally deployable level -- general availability level.

That was the first release of our operating system on a 64-bit architecture, and so not only were customers looking at new hardware, they were essentially looking at a new version of the OS, which I think slowed down accepts.

Most of our customers like to have a particular, you know, level of support from NetApp -- not support, but recommendation from NetApp as to when it's deployable.

We achieve that, as I recall, August 3.

So, yes, I would expect to see the 6000 increase dramatically.

I'm particularly interested in the 6070.

I kind of personally think that the 6030 is going to subsume the 980 over time.

But the 6070 is a unique price range and class, and the ASPs in the 6070 are roughly double of what we've seen historically on our high end.

And by the time it's clustered, it turns out to be -- you know, the two systems in tandem are about a $0.5 million ASP, so if we can get a doubling of those, we're going to see so pretty good upward leverage.

Great.

Thanks.

And sir, our next question is from the line of Bill Fearnley with FTN Midwest Securities.

Yes, thank you.

Had a question for you with IBM.

When you talk about the traction with IBM, could you compare and contrast your traction with the IBM direct sales force and how's the traction with the IBM reseller channel verses your expectations in the relationship?

Thanks.

This is Tom.

First of all, on a retailer channel side, we're finding many of IBM's largest resellers are aggressively picking up our product.

IBM's excited about that.

We're hoping to train those folks.

Some of them buying some stuff directly from NetApp.

In fact, some were doing both before.

But IBM is very, very excited about the acceptance rate and so are we.

Secondarily, with a sales force as big as IBM, it's going to take us a while to thing -- to get the whole thing globally, but some of the interesting points.

We paid hundreds of system architects, that's very useful.

We've got to a number there account execs on some of the biggest accounts in the world for IBM, and they're actively pushing the NetApp technology and we've won a couple of those already.

So we feel like we're -- you know, I always believe you can judge these things in the first six months by the attitude of the executives and the teams that you're meeting with.

The attitudes are terrific.

In every country -- I've been on the road a lot, and every country I go to I visit with IBM and I find that they're extremely interested in having a go-to-market plan together and our teams are working great together.

So I -- this is going better than any of us thought it would go at this point.

This is Dan.

I want to add a little bit to that.

There's been lots of rumors and innuendo about the channel conflict, particularly through the indirect channel.

That was -- what a conflict there was [inaudible] was very small, but what there was was largely a result of the fact that IBM did not have our entire product line.

Remember they've been in a process of rolling out the individual components over time.

That process comes to a completion in the next month or so, when they introduce their version of the FAS6000.

At that point we'll have product line parity, and so the indirect channels really are no longer going to have a reason, right, to try to come to NetApp directly, and I think that's going to bring a lot more harmony to those field relationships.

Another thing I would say is our largest resellers -- Dan gave you that our reseller business is really doing well, but -- in fact, we were just voted the number one vendor to [inaudible-multiple speakers] But anyway, I've met with a couple of the key execs.

They're having their best years ever, explosive growth in some cases with NetApp.

And they've said to a man, or to a person running those company's the the IBM relationship has helped raise the visibility of NetApp in the market.

They're just finding that the market understands what we are and that we're going to be here and be big for a long time, and it's helped them crack major enterprises.

So you know, market visibility was an issue with us for many years.

I don't think it is anymore and I think the channel partners would be the first to say that the IBM relationship has helped that.

Thank you.

And sir, our next question's from the line of Ben Reitzes with UBS.

Hey, good afternoon.

Thanks a lot, guys.

You guys raised guidance for the year about $80 million according to my math, maybe about three or four points above where you were before.

You know, the quarter was about $5 million above the Street.

So you've raised guidance, you know, a little bit there in terms of growth.

That's pretty good.

Can you just talk about exactly why again?

Is it Decru® and IBM or what did you see, because it seemed like a pretty in line revenue quarter versus our expectations, but obviously a little on the Street, but you raised guidance.

So I'm just wondering what you exactly saw?

Sorry if you said it earlier, but if you could put it to three our four factors, that'd be great.

I think the net is, Ben, it's across the board, I mean depending which dimension of the business you want to look at, right?

All of the TOs are very strong, several are already ahead of plan, they're forecasting continued success going forward.

You look at the product lines.

We're really pleased with the way some of the new ones have ramped up, like Decru®.

We got a lot of optimism around the 6000 going forward.

IBM's ahead of plan.

You know, we had forecast they'd do 3% of the year earlier.

I think it's probably going to be closer to four at this point.

I mean, the base business is just very strong.

You look at all the upsides around it and you go, hey, these things are all starting to click, so I can't point to a single item.

If IBM's up 1% over the forecast, Decru's® up 1% of the revenue over the forecast, the base business is up 1% over the forecast, I mean, you're there, you know?

I would just keep it simple.

We are winning big deals, big opportunities we weren't even in before.

We're getting invited into big deals that we weren't invited into before.

Dan and I just finished a whirlwind tour this quarter.

He went one way, I went the other.

We covered the world pretty well and when we sat down to talk about it, we both said the same thing, it is astounding the level of interest at a CIO level and understanding how we can be an alternative to their current vendors and what exactly we can do.

I've had big companies say to me, you're not thinking big enough.

If we didn't have our current vendor, how would we deploy [inaudible]?

We used to have all those conversations.

So I think when you say that 70% of the business is enterprise, that surprised some people.

You look at the ASPs rising.

You look at the professional service and the deferred revenue.

We're selling into very, very big accounts, and when you win those, they're going to be around a long time, so that gives you some confidence.

Thanks a lot, guys.

And sir, our next question is from the line of Tom Curlin with RBC Capital Markets.

Hi, good afternoon.

Can you just walk us through the tax situation and the IRS review, please?

The -- you want the -- let me make sure I understand your question.

Do you want our guidance going forward, what our tax rates going to be, or do you want to understand the status of our tax audit?

Yes, the tax audit and just how it relates to the Netherlands structure and what specifically is the point of contention?

Okay, so we haven't started the tax audit yet, but what the audit's going to -- what will be involved in this particular audit is a review, as always, of our international tax entities as well as the domestic tax structure we have.

With the international tax entities, the question there is the same question that's -- we've seen throughout the industry, some other large companies in the tech world.

The issue has to do with the buy in of the foreign entity into the intellectual property and the ability to sell the intellectual property in their particular jurisdiction, so this is going to get real complex really fast.

The question here is what value should they pay for the right to resell the intellectual property and right to resell those products?

We think we're on very solid ground, with a lot of precedent and court precedent on our side and we're not expecting any significant problems here, but --

Just relates to the ma -- how you estimate the appropriate transfer payments between those entities and NetApp proper, I guess?

Yes, at the end of the day that's the issue.

Okay.

Thank you.

And sir our next question is from the line of Keith Bachman with Banc of America.

Hi, guys.

Thanks.

Could you help a little bit on the NetCache transaction?

Help explain how it works and more specifically, when should we be modeling that business to go to zero, because my understanding is there will be residual revenues in that business over the next few quarters?

If you could just add some color there, that'd be great.

Yes, this is Dan.

Basically what we did was sell the rights to our product line to cash -- or to Blue Coat and, you know, we're going to try to transition our customer base over to them, as well.

Now they're going to continue to sell the current product.

We have on our balance sheet, obviously, as you point out, the deferred revenues associated with software support and also maintenance, and we retain the obligation to support those customers that currently have contracts with us.

So essentially it's a sale of the product line, but we retain the support obligations is really kind of the way to think about it, and clearly they'll try to converge product lines like over time.

I think the duration -- Steve, help me here -- is probably about 30 months is roughly what we have, you'll see some bleed-off of a component and it'll decline over time.

It's kind of a waterfall kind of effect, right, so you'll see it slowly decline in terms of percentage of -- or dollar value of business per quarter.

But you'll see some component from it for roughly about the next ten quarters.

That's correct.

Hey, Steve, just to clarify, will you continue to see product level over of NetCache flow over the next few quarters?

I'm sorry, I couldn't understand your question.

You were breaking up.

No, product level sales over the next few quarters.

No, we're essentially tran -- we're essentially exiting that business over the next few quarters.

I think you should expect that we'll have revenues in this current quarter, but obviously by time the transaction closes, the objective would be those revenues wind up in the future being revenues to Blue Coat.

Right.

I think what you'll see, the first thing that'll step down is the product revenues themselves.

The SSPs and the service contracts will continue, as Dan said, over a period of about 30 months roughly.

It also turns out that NetCache has a disproportionately high amount of deferred revenues in their revenue line, so they had more, if you will, more deferred revenue dollars per total dollars of revenue, so that means that the fall off is not going to be as precipitous as many of you, I think, have modeled.

Okay, great.

Thank you.

You bet.

And sir our next question is from the line of Chris Whitmore with Deutsche Bank.

Thanks.

Good afternoon, guys.

Just a question on channel inventory levels.

There's been some debate about excess inventory out there in the channel.

Can you quantify your channel level -- channel inventory levels and what you do to measure them?

Thanks.

Yes, it 's approximately zero.

Virtually everything -- all business we do is configured to order, even through the channel.

With the exception of the SMB business and a little bit of OEM inventory for the Fujitsu relationship in Japan, there's essentially no inventory in that channel whatsoever.

It's all a build to order and customizable for each single system.

That's always been true,by the way, so I'm not sure why there'd be --

Yes, we don't have any build to stock products except for the new SMB product.

And sir, our next question is from the line of Paul Mansky with Citigroup.

Great.

Thanks for taking the question.

Dan, I believe last quarter you gave us a break down of the contributors by [convertible].

If you could please do that again, as well as maybe paint some additional color around your strength on the federal side?

Haven't had a chance to listen to HP's comments tonight, but I think pretty much everybody else has talked about the sweetness on the federal side.

Maybe what you're seeing specifically there.

The federal business was great.

I mean our total global government business was 10%.

I've got to tell you, the federal guys had, my recollection, was higher than 40% year-over-year growth in bookings and took down the single largest order in the history of NetApp at $12 million plus.

Our federal business has just been on fire.

They've just done a wonderful job.

Many of the other guys have seen a slow down as a result.

Anyway, the kind of vertical performance goes roughly as this.

High tech was down a little bit in the mix, it's about 15%.

Financial services up in the mix, they're now at 13.

Global governments, which includes =-- is really primarily our U.S. federal, but also includes international governments, defense organizations, et cetera, is about 10% of our total.

Telco is about 8% of the mix, you know, and then the others are each around three to four, like energy manufacturing, health services, et cetera.

Great, thank you very much.

Appreciate it.

And sir, we have a question from the line of Harry Blount with Lehman Brothers.

Hi, guys.

Dan, you were alluding to strength kind of across the board in a number of different vectors.

I want to try to attack it a different way.

Can you maybe talk about your competitive win rates and the partnerships, if you saw strength in any particular area?

Highlighted SAP, just wondered if there's any others, as well as the competitive dynamics?

Let me take the competitive side and I'll flip it back to Dan.

This is Tom.

On the competitive side, our Oracle® relationship continues to be an amazing strength, the success we've had with the on demand business being hosted on us has resulted in a tremendous push into -- with them into the number of markets, so that's done very well.

The SAP relationship is really taking hold.

In Europe it's done spectacularly well.

But even the United States, we're starting to get significant success from investing in partnerships.

IBM is also investing in a nice deliverable around SAP, which is going to help us.

The IBM relationship touches all of these, I would think.

And our relationship with Symantec is also very, very strong.

Dan mentioned there our selling into Symantec, but we sell with Symantec, especially with KBS we've had some tremendous wins with them.

And I think those partnerships -- FileNet had been a strong partner, I assume they'll be -- [LAUGHTER]

Used to be a strong partner, given what happened.

So I'd say VMware is a very good partner.

I think EMC's done a good job of leaving them alone.

Most of their solutions revolve around iSCSI and NAS, which plays to our strength, and they're a very good company for picking up market share and we're doing a lot with them all over the world.

The leverage is just being compounded on a quarterly basis, as people are getting used to our solutions there.

We have a lot of references there.

We're doing a lot of big speaking engagements.

I'm one of the keynotes at OracleWorld again, my seventh one in two and one-half years, and Dan's been doing a lot of these.

So we're getting a lot of visibility with those particular partners.

yes, I'd add one more to that list, Harry, is Microsoft®.

We've had really a significant change in the nature of that relationship over last, roughly, six months.

After a culmination of some executive meetings, they actually sent the message out to their field that NetApp is a fine partner, not a competitor.

That's what allowed us to move our technology into their, I think they call them MTCs, Microsoft® Technology Centers, around the globe, and that has unlocked a lot of joint selling activity with the Microsoft® reps.

They're still very neutral but it used to be they had a negative bias towards us.

Now we're welcome into the deals, especially as it relates to Exchange.

Exchange has been a hot application area for us and the sequel server right behind it.

Relative to competitive engagements in terms of frequency, the vendor lineup as you would expect, pretty much commensurate with market share with the exception that we don't -- IBM has dropped in the mix.

I think that's a good thing.

That's a reflection [inaudible-sound interruption] we're doing more partnering than competing, but they were never very high.

The top five stay pretty constant, right?

It's EMC, Hewlett-Packard, and Hitachi, through the various channels, et cetera.

Win rates have actually gone up a little bit with -- against EMC and Hitachi and I think that's more of a reflection of the high-end and also some secondary storage deployments in the kind of mid range -- rephrase that, ATA deployments in mid-range primary application environments.

Did you decipher all of those adjectives?

I did.

And that's been a big benefit for us.

So yes, win rates are up, but not all that much.

I mean, overall the pipeline is up.

We're into more deals.

Great, thanks.

And sir, we have a question from the line of Aaron Rakers with AG Edwards.

Yes, congratulations guys on a great quarter.

Just wanted to circle back on the gross margin on the services side going forward.

I know you talked about 30% in this upcoming quarter, but maybe you can help us understand with your hiring plans and as you get utilization rates up where we see the longer term gross margin play out for that services business?

And also, you had mentioned that hiring was a little bit slower than anticipated in the quarter.

Do you guys continue to expect to hire 300 persons per quarter throughout the remainder of this year?

Thanks.

So let me start with that one on the services side.

First of all, let's define long-term.

If long-term is within two years, then you're not going to see that margin move much over the next two years.

This is a supply and demand question and a function of how much demand there is for our services from enterprise customers and how many people we need to support it.

Right now the bookings exceeds -- the bookings growth rate exceeds the revenue growth rate, which means we are actually falling behind in terms of delivering those services.

So, our plan is to continue to hire service personnel to respond to that demand and help our customers consume our technology and deploy it more rapidly, I don't see any end in sight for that, so we're going to kind of balance in in the low 30s, right?

I would expect over the next couple of years, you would not see it exceed 35%, and we're just going to keep scaling it up as rapidly as we can.

Relative to total hiring for the Company, yes, you should expect to see us hire in the vicinity of about 300 people per quarter.

Thank you.

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

Hey, guys, good quarter.

I expect the upgrade to the FAS3000 over the course of the rest of this year.

Are you comfortable with your plans in place that we don't see a repeat of last year, particularly given that it may impact the sales of the FAS900 product family that remains.

I am slow, but I am a good learner.

I only have to screw it up once to make sure we don't do it again. [LAUGHTER]

Yes, if you look at the product line, you know, with the 6000,even the SMB product this quarter, that's basically arranged on a single architecture that goes from $5,000 to $10,000 ASP's all the way up, as Dan indicated, to clustered machines at $0.5 million dollar ASP, and then you throw the GX on top of that --

Which has a $1 million ASP.

-- which so far has got a $1 million ASP and can grow from there.

But as far as the mid range is concerned, certainly the introduction to mid-range technology, since it's more technologically current, has a chance of cannibalizing the previous high end.

But I think we've got a lot more scalability in our product offering this time than we did last time.

Last time the top of the product line was a 980.

Now the top of the product line is a 6070, with clustered GX on top of that

So the opportunity of us introducing a mid range product that takes the high end away I don't think is quite nearly so likely this time around.

But clearly we need to be concerned about that.

We need to be balancing that, not only from a market demand but also an inventory control issue, as well.

So I think we're going to be pretty diligent on the point, but that's not going to slow us down in terms of introducing new products.

In fact, I think our rate of product introduction is actually increasing over time.

Okay.

Thanks.

And sir, we have a question from the line of Kevin Hunt with Thomas Weisel Partners.

Alright, thanks.

I actually had a couple of things.

In terms of the NetCache, to follow-up on that question, did you -- when is that actually going to close and when should we expect that step function down?

And then, can you give us any color on that large deal you talked about?

How big it was?

What vertical it might have been?

The large deal was in the federal sector, was over $10 million.

On the NetCache side, you know, the deal closing is not necessarily under our control.

I believe it will happen somewhere between this particular fiscal quarter.

Right.

I'm not sure I can get a lot more precise than that.

And at that time, you know, the product revenues will -- I think the right assumption is there won't be much in the way of product revenues next quarter.

Okay, and what -- and then just going back to the federal deal, the big deal there, is that something where you can see continued deals of that size?

How should we be thinking about that?

You know, we did our largest deal in our history in Q4 with a $10 million around Decru® and this quarter we had two orders that both beat it.

And we had multiple orders in the $5 to $10 million range, so it wasn't -- and they're not in any -- and they're not in the same verticals.

It's just people getting more confident in our technology, wanting to deploy it faster and in many cases, they want to get off of an architecture just too expensive to them because of complexity.

And so they give us the whole range of application, including tier 1, tier 2, and that's an explosive number for us.

And another of them is they're takin -- in almost every case, they're taking all the NetApp software, and when we go to really find out what we -- why we won, they love the fact that they can get higher utilization.

They love the fact they can recover simplicity -- in a simple way and they don't have to add a lot of people to the equation to solve major problems.

And that's what happened.

Okay, thanks.

And our next question is from the line of Katie Huberty with Morgan Stanley.

Hi, thanks, guys.

Just to circle back around on the competitive question, now that you've sold a good number of the 6000 boxes and that's somewhat of a new market for you, do you have a sense of whose systems you're replacing in those deals?

Well, clearly in that price point, you know, the big traditional monolithic vendors are there, and for us to be winning in that space, clearly we need to be taking away from them, so I think we know who they are.

In addition, I think a big part of our business is the growth of secondary storage, [inaudible] continuous applications, disk-to-disk backup.

So the need to consolidate that in a big way is another attractive opportunity for the 6000.

But in the primary space, clearly we're competing against the big monolithic vendors, just like the product was originally intended, but we're also seeing other market opportunities in the secondary space, as well.

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

Yes, thanks very much.

Tom, in those large deals you were just talking about where folks are tending to take a lot of NetApp software, is the add-on software revenue as a percentage of the mix of these deals larger than your corporate average of 24% or so?

No, it's about the same.

It's just that they look at us for a primary application, then they buy snap parts for the fail over.

They then -- they tend to also want to really move aggressively with -- all of the things you get out of 7G really is fundamental to why they're going with NetApp.

The discussion's more about how they can take advantage of NetApp software and the fact it's a single architecture and implement -- another thing Dan brought up was the success for ADP.

I don't think people really understand how compelling that is at a customer level to be able to move apps that they probably are doing directly attached today and move them to our network storage and have the confidence that they can have a double disk bay or not go down is bringing all kinds of new apps on in these same accounts.

So once they understand the whole NetApp story, we're taking away in many cases what they were doing with their other vendors, but also taking stuff off of direct attach on the network and they're becoming religous about the fact they can do this without adding people.

Yes, if you look at our -- base a deal mix, if you will, by a size of system, it turns out it's relatively consistent from low-end system to high-end system.

At the low end, the hardware costs less, you add less software, but the ratio's still about three to one and as you scale up, turns out you're buying a whole lot of hardware.

You know a $10 million deal is $7.5 million of hardware.

And guess what, you add on $2.5 of software, that's a lot of software.

But guess what, the ratio's still three to one, and it stays relatively consistent throughout the product line.

I want to underscore what Tom said.

You know, the RAID-DP thing has really started -- you know, customers have really started to figure it out.

That's what's allowing them to deploy more ATA-based storage into primary application environments.

They're now gaining enough confidence in RAID-DP with ATA, they say they don't need the performance in a lot of those applications.

It's production storage.

I mean, this is not secondary storage.

They see no performance penalty.

They see no cost penalty by having dual-parity protection and they get a really cheap solution based on ATA.

It's just a -- it's a very compelling value proposition.

Two other things.

Disk-to-disk is becoming very popular for NetApp.

As you know, we're doing great.

The more you can rely -- the issue in doing data consolidation is recovery.

You've got to keep a consistent recovery time.

If you're coming from disk rather than tape you can do more consolidation.

Huge pay back.

Secondarily, people often times use our disk-to-disk for recovery of information.

They say, wait a minute.

With RAID-DP I can also use that as my DR.

So you see many, many of our up brand systems, DR to our other stuff, and they weren't even thinking that way before.

They were thinking DR would be too expensive.

Everybody has a plan, nobody implements, that's classic DR.

In our case, many of our up brand systems are DR to us.

Thanks.

Actually, just a follow-up on that RAID-DP point, do you notice that the ATA mix stays the same in high-end 6000 verses the 3000 and on down?

I think we're seeing a phenomena we haven't experienced in the past.

As Tom indicated, a lot of the 6000's appear to be going out ATA heavy.

And you would ap -- at least in some of the early adopters, they're using that as a primary consolidation for their secondary storage in the disk-to-disk model that Tom was just talking about.

Building one great big clustered 6030 is probably a cheaper solution than several ni -- several near stores, gut you've got to get big to do that, right?

So former -- it's a form of consolidation and the 6000 becomes the focal point for it.

So, I don't know if we're going to see that continue in the mix going forward, it's still pretty early.

But certainly we've seen a disproportionate of ATA in the 6000, especially 6030.

Alright, thank you.

Congratulations.

Thanks.

[OPERATOR INSTRUCTIONS] Sir, we have a question from the line of Brent Bracelin with Pacific Crest Securities.

Thank you, two questions.

First question, you talked about the 70% of the bookings tied to enterprise.

What was that mix a year ago for comparisons?

And then I had a follow-up on store vault.

What has been the initial feedback on kind of the low-end store vault?

And what are you expectations to kind of accelerate the ramp in that adoption of that product?

Here you go, enterprise penetration.

Year-ago enterprise penetration was roughly about 60%.

Actually I think in Q1 of last year -- and I'm doing this from memory -- it was 58.

Yes.

And it was trending up through the year and the year finished a little over 60, but it was 58.

Anyway, the point is it's made significant progress in that it's gone up sequentially every quarter, so we're happy with the progress.

The store vault -- you know, we actually had a little revenue in store vault.

It wasn't material.

It doesn't make the round off there hardly, but you know, it's off to a great start.

The feedback from the channel is great, the feedback from the customer community is great.

And my guess is we'll start seeing some revenue contribution from that next quarter.

You know, I want to caution not to get too bullish on that.

We're still trying to figure out what that market is, how to reach it, have we got the right product, et cetera, so we don't have much of the store vault revenue built into our guidance going forward.

Okay.

That's helpful.

Thank you.

And we have a question again from the line of Clay Sumner.

Thanks, a follow-up on IBM.

I would assume that they're tending to sell mostly NAS at this point, but I don't know.

Do you expect them to sell a lot of SAN and where are they relative to your expectations there?

Actually, our IBM mix looks a lot like the rest of our mix.

You know if you look at the -- take IBM on the equation, we sell more SAN product through the channel than we do through our own direct organization.

That's one of the things we're trying to bring back into balance this year.

And that's because I think our channel partners understand the SAN environment better than our own direct guys in many cases, so they're just more proficient at it.

IBM has that same type of proficiency.

So you look at their mix, it's actually a little higher in terms of SAN and iSCSI than it is in NAS, right, relative to what we see from our normal direct organization.

But overall, those could be considered round-off errors, as well, right?

They're 3% of revenue, so it may not be a statistically valid sample.

But so far, SAN is higher in their mix than it is from direct.

Thank you.

And ladies and gentlemen, this concludes the question and answer portion of today's conference.

I'd like to turn it back over to Dan Warmenhoven, Chief Executive Officer, for any further comments.

Well, again, thank you very much for joining us today.

You know, we look at this as one of the best well-rounded performances and probably maybe the best financial performance of any quarter I can certainly remember in the last few years.

Every single metric headed in the right direction this quarter, so we feel pretty good about where we're at and looking forward to having the opportunity to share the results with you the results of Q2 about three months from now.

Thanks and 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.

Good day.