NetApp Inc (NTAP) 2007 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Network Appliance second quarter earnings conference call. [OPERATOR INSTRUCTIONS] I'd like to turn call over to Tara Dhillon, Senior Director of Investor Relations.

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 uncertainties including statements regarding our expectations for operating results for our Q3 and FY '07, our stock repurchases and hiring goals, our attention to pay down our debt, the timing of and benefits to be derived from product introductions and technology advances, including our FAS3070 and ONTAP GX products, our expectations regarding our market share, the growth rate of our indirect channels, and the outcome of our IRS tax audit. 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 the 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 third quarter and then Dan will share his thoughts while we wind up with everyone here for Q&A. Steve?

Thanks, Tara. Good afternoon, everyone. Net achieved another record quarter with strength across all major areas of our business. In particular, the U.S. federal team had a stellar quarter, most of Europe beat our expectations and our FAS6000 kicked into gear this quarter. As I walk through the results with you, all numbers I mentioned comply with GAAP unless stated otherwise.

Total revenue for the second quarter was $652.5 million, up 35% compared to Q2 last year and up 5% sequentially. Foreign currency effects added about 0.6 of a percentage point to this quarters results on a sequential basis and 1.6 percentage points on a year-over-year basis.

The combination of product revenues and software subscriptions were $563.5 million, growing 33% year-over-year and over 4% sequentially. Add-on software and software subscriptions accounted for about 36% of total revenue this quarter. This is a combination of add-on software products that were about 23% of total revenue and software subscriptions which increased to 12.6% of total revenue.

Revenue from IBM accounted for about 3% of total revenue and Decru was 2% of total revenue. For the full year, we continue to expect IBM to contribute between 3 and 4% of total revenue and Decru to continue between 2 and 3% of revenue. Revenue from services which includes hardware support, installation, professional services, and educational services, was almost 14% of total revenue, up 10% sequentially and up 53% over Q2 of last year. Our services organization continues to build out of its practice and solution areas which will drive faster than corporate average growth rates in service revenue. Service maintenance contracts increased 9% sequentially and 51% year-over-year, professional services grew 18% sequentially and 63% year-over-year.

Non-GAAP gross margins were 62.6% this quarter, the highest level in 4.5 years. Non-GAAP gross margins for the combination of products and software subscriptions finished Q2 at 67.4% up 1.8 percentage points over last quarter. This increase was driven by a combination of factors. First, while still very competitive, the global pricing environment was less severe than we had anticipated. Product mix was also favorable. We saw a jump in the number of system heads sold without bids with both the V series and the FAS6000 products contributing to this phenomenon. The FAS6000 series saw a strong jump in unit sales, 1/3 of which were heads only as customers upgraded their existing 900 series system. Finally, favorable manufacturing necessary variances contributed about 0.4 of a percentage point to gross margin versus last quarter.

Now, we expect to pass most of this favorable margin variance back to our customers, so you should expect product margins to modestly decline going forward. Non-GAAP service margins of 32.6% also increased significantly this quarter due to the continued growth in service contracts revenue and improvements in productivity. Given the demand for our services, we plan to increase our rate of hiring in our services organization in the third and fourth quarters so you should expect these service margins to pull back slightly and finish between 30 and 31% for the balance of FY '07.

Turning to non-GAAP expenses, our operating expenses totaled $290 million, or 44.5% of revenue. Expenses increased 5% sequentially and came in on our target spending plan for the quarter. Total employee headcount increased by 417 people, ending the quarter with 5632 employees. Employee additions were extremely back end loaded with over 50% of the new hire starting in the third month of the quarter. A total of 656 people have been hired so far in '07. That's our fiscal year. Given the opportunities we see for growth and market share expansion, we're now planning to hire a total of 1,400 to 1,500 people by the end of the fiscal year with the bulk of these hires concentrated in sales, engineering, and professional services.

GAAP operating expenses include the effect of intangible amortization and the effects of FAS 123R as well as the benefit of a one-time gain of $25.3 million on the sale of our NetCache assets. At $118.6 million, non-GAAP income from operations finished at 18.2% of revenue well above our targeted range and almost entirely due to higher gross margins. Non-GAAP other income, which consists primarily of interest income, was $14.2 million. Non-GAAP income before taxes for the quarter was $132.8 million or 20% of revenue.

Our effective non-GAAP tax rate remains at 18%. On the subject of taxes, I'd like to clarify the status of our tax audit. We are currently in the initial phase of a routine IRS audit and they've asked us to provide data on a broad range of topics. Contrary to what you may have read, there have been no specific claims or actions by the IRS related to intellectual property buying payments by our overseas entities. As we stated in our 10-K, the possibility exists that this could be challenged based on what we've seen at a few other tech companies; however I'd like to make it very clear that if this were to be challenged, NetApp would contest any proposed material assessment to the full extent allowed under the tax law and we strongly believe that we would prevail at any such contest. If there were an assessment, it would be a one-time discrete charge and any associated tax payment would likely be offset by our large NOL carry forward. It would not impact our historical or our future non-GAAP tax rate.

Now, back to the P&L. Non-GAAP net income totaled $108.9 million or $0.28 per share. GAAP net income totaled $86.9 million or $0.22 per share so please refer to the table provided in our press release and on our website to see the reconciling items between GAAP and non-GAAP.

Now, moving on to the balance sheet, cash and investments totaled $1.38 billion, an increase of approximately $107 million over Q1. We repurchased approximately 4.3 million shares of outstanding common stock at an average price of $33.79 per share for a total cash outlay of roughly $144 million. There's approximately $41 million remaining in our previous stock repurchase authorization and as announced in today's press release, our Board has authorized an additional 800 million for stock buyback purposes. Next quarter we expect to repurchase roughly $200 million worth of stock.

Our cash generated from operations was a record $229.6 million this quarter, up 124% over the second quarter of last year. Capital purchases were 43.7 million and depreciation amortization totaled $25.9 million. Cash and investments exclude $190 million of restricted cash associated with our fourth quarter foreign cash repatriation. The debt on our balance sheet related to this repatriation is currently $193 million. We paid down approximately $78 million with this debt during the second quarter and we plan to pay off the remaining balance within the next two years.

Deferred revenue increased $75.4 million this quarter to to $818.6 million, a 10% sequential increase and again, up 53% year-over-year. This continued increase in deferred revenue is driven primarily by increases in software subscription purchases and hardware maintenance contracts. The average duration of these contracts is just over 31 months. Accounts receivable, day sales outstanding were 56 days this quarter compared to 55 days reported last quarter. DSO's were relatively unchanged as we saw order momentum increase steadily throughout the quarter. Inventory turns remain solid at 17.3 times, the same as last quarter.

Now before I turn the call over to Dan for his comments, I'll discuss our target operating model for the third quarter and revised expectations for the full year. Our outlook is based on current business expectations and current 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 third quarter sequential revenue growth to be in the range of 7 to 8% over the second quarter which translates into a 30 to 31% year-over-year growth rate. I'd like to remind you that this takes into account the reduction in total revenue from net cash, now that those assets have been sold. In other words, our Q3 estimates reflect a reduction of about 2 percentage points in growth year-over-year and almost 2 percentage points sequentially due to the net cash sale. We expect total non-GAAP gross margins to moderate as we increase our hiring and professional services and as we pass along favorable variances back to our customers. And with the additional operating -- operational hirings, we're planning for the back half of the year, we expect to see our non-GAAP operating margin for the third quarter return to our target range of 15.8 to 16.4%.

Third quarter non-GAAP earnings are expected, excuse me, third quarter non-GAAP earnings are expected to be about $0.28 per share. GAAP earnings are expected to be $0.17 to $0.18 per share. We expect our diluted share count to continue to decrease by 2 to 3 million shares per quarter over the remainder of FY '07. Given the strengths we see in our business we are revising our target for FY '07 revenue growth upwards to a range of 33 to 34% growth over FY '06. Non-GAAP earnings per share are expected to be between $1.10 and $1.11. With the inclusion of FAS 123R and GAAP earnings, are very difficult to estimate given the volatility of some of these variables including the impact of our stock price. With that said, our GAAP-- our target GAAP range is estimated to be $0.73 to $0.76 per share based upon the information we have in the assumptions we made today.

Now please note that since Topio transaction has not yet been closed our guidance does not include the impact of Topio. That said, Topio is small in size and in the early phase of revenue development. As a result we expect the impact of Topio's purchase to be negligible on revenue and depending on the timing of the close, dilutive by just under $0.01 for each of the next two quarters. At this point I'll turn the call over to Dan for his update. Dan?

Thank you, Steve. By all measures this was another terrific quarter. Our core business shows strong growth and our newer businesses and product lines are starting to gain traction. We have strong execution around the world and continue to gain momentum and take market share [Inaudible - audio difficulties].

The NetApp value proposition is clearly exemplified again this quarter when IAC released its second quarter market share data for open systems network storage. NetApp was ranked number four in terms of revenue but for the first time achieved a number one position in petabytes shipped. Without a doubt customers get more storage for less with Network Appliance, and with our bundled NetApp software including flexible volumes they don't have to buy as much storage capacity up front as they do from our competitors to fulfill their project needs and a recent merger study indicated storage administrators managed twice the amount NetApp storage per person compared to HP and EMC Systems. The customers also have significant savings in overhead admin costs. Our petabytes shipped this quarter increased modestly growing just 2% sequentially to 74 terabytes. APA accounted for 52% and fibre count 48% of the total.

The FAS6000 series really took off this quarter increasing over 150% in terms of units shipped but as Steve mentioned fully 1/3 of that increase was systems units without disks which carry a higher margin but no associated petabytes of storage. This means customers were buying FAS6000 heads to upgrade their older FAS900 Systems, we also saw a 12% jump in the number of V-series units shipped which are also diskless systems.

Another interesting dynamic was an increase in the number of add-on shelves sold. When we launched our 3000 series of FlexVol's last year, customers no longer needed to over provision their storage so they only bought the amount of storage necessary for their more immediate needs. It appears that customers are beginning to reach the maximum utilization point of those units and are therefore starting to add more storage shelf to their systems. Add-on shelves purchased after the fact give customers the flexibility to spread the cost of storage acquisitions out over time, realize lower costs as disk drive prices decline and more closely align their purchases with their actual storage usage.

Our total storage systems shipped actually declined slightly this quarter. This was primarily due to to the 900 series product, particularly the 980 finally shown with significant slowdown. Units of the NearStore 200 also declined significantly as customers move to ATA based FAS3000 units for increased performance. The FAS3000 series units shipped increased to 50% of system units sold and we also saw growth in our average selling price. In Q3 we expect to just launch FAS3070 to make up the difference in units as the 900 series continues to wain. The FAS270 increased modestly again this quarter. With the challenges the industry is having with FAS technology we have pushed back the launch of our next generation low end and will continue to sell the FAS270 until we see additional maturity in FAS silicon infrastructure. Please don't think the current risk profile is appropriate for our customers and we'll keep you posted as we monitor evolution in this area.

When competitive deals are decided on a technical or a total cost of ownership basis NetApp is extremely successful. Our competitors incumbency is usually our greatest challenge and we are increasing this place in other vendors but can be a slow process with customers who are resistant to change. To help speed the process we announced our intent to acquire Topio. A company that provides software for heterogeneous data replication and recovery in any server or storage environment and across any distance.

We believe our secondary storage value proposition helps us get our foot in the door with new customers and acquiring a Topio technology will allow us to provide customers with the ability to mirror their incumbent primary storage and NetApp storage and get all of the data management vested and reduced storage requirements that come with NetApp functionality. This way they get to experience NetApps ease-of-use and at the same time radically reduce the amount of storage they need for the development test environments by using our FlexClone software which makes virtual clones and data sets rather than physical copies thus reducing most ebb and test storage needs by 80% or more compared to other vendors.

Topio also brings heterogeneous SAN replication which should further stimulate the growth of our SAN and iSCSI business. This quarter our block based protocols were included in 38% of our storage business which excludes security and caching and of this, 28% of our business includes SAN, 16% included iSCSI and there is 6 percentage points of overlap between the two. On the ultra high end our scale out technology data on tap GX, is generating a lot of interest from the high performance computing environments it's targeted for and it's currently being tested by many customers. These customers are eagerly awaiting the new release of GX which provides very high levels of aggregate throughput and single file throughput by incorporating our flagship 6070 system with file striking. The ability to have a single file spread across multiple processors. The release is scheduled for this current quarter.

Our new ultra low end SMD appliance also showed modest gains this quarter as additional buyers VARs were qualified and we worked through some early supply chain challenges. After closing one of the largest deals in NetApp history last quarter, Decru was down slightly but still had a very solid quarter contributing 2% of revenue. On a virtual tape library took awhile to get started since it sells into a different part of the enterprise but it has exceeded our plan for this past quarter and also closed it's first $1 million deal.

NetCache in it's last quarter at Network Appliance again contributed 3% of total revenue as customers use the opportunity to make their final purchases and renewals of their service contracts with us. Now that the sale of NetCache assets is closed, the contribution of revenue for this business will decline drastically next quarter and all future revenue will be in the form of deferred revenue from our balance sheet as we continue to support our existing NetCache customers for the life of their service contracts.

IBM continues to make steady progress, as Steve mentioned they again contributed 3% of our business this quarter and had a healthy increase in their software tax rate, getting closer to our corporate average as their field begins learning how to effectively sell our data management value proposition. Geographically, this quarter's profile looks exactly like last quarters, I'm sorry, second quarter of last year. 60% of revenue came from the Americas, 29% from EMEA, and 11% came from Asia-Pac. Business in most areas in the world is strong and most notable is our U.S. federal team which contributed over 14% of revenue this quarter. Our indirect channel is up almost 11% sequentially, which was also aided by the federal business, which is largely to resellers to a total of 60% of revenue. Contribution from Arrow and Avnet increased 16% sequentially, generating a record 12% of our revenues this quarter.

For several quarters now, we focused our investments on developing our indirect channel and with the leverage it provides we continue to grow faster than the overall corporate growth rate. The leverage we get from our technology partners continues to expand every quarter. At Oracle OpenWorld a few weeks ago you may have heard [Sopra Cott] introduce Tom Mendoza as keynote by telling the audience that this is, "Oracle voted with their dollars and the Oracle data center is a commercial for NetApp". Traffic and lead generations event increased 10 X over last year, and we're also increasing our visibility and success in Microsoft environments. This quarter we closed some of our largest exchange projects in our history including a 200,000 seat installation at a major international oil company. We also completed the installation of NetApp systems in the Microsoft technology solutions centers around the globe.

To wrap up I'd like to just reiterate how pleased I am with the continued strong performance from the NetApp team. We remain focused on rapid growth, capturing market share, and being the most innovative company in the storage space to help solve customer challenges. I'd like to invite you to our fiscal year '07 analyst day do learn more about NetApp and our plans for fiscal year 2008. They'll be held in New York City on March 13, 2007, and you'll receive additional information from our Investor Relations team in the near future.

At this point I'd like to open the floor to questions. And again I ask that you limit yourself to one question and then if you have a second to return to the queue so we may address everyone in a timely fashion. Thank you, Operator?

Yes. [OPERATOR INSTRUCTIONS] And your first question comes from the line of Richard Farmer of Merrill Lynch. Please proceed, sir.

Thanks. Dan and Steve, wanted to ask you about the margin leverage that you had in the quarter, both gross and operating margins came in higher than at least we were modeling and I think what most people were looking for. You mentioned the benign pricing and the favorable mix with a higher percentage of heads and the manufacturing variance as well, if I heard you correctly, but the question is how much are those factors likely to persist going forward and to what degree are you going to look to drive back down to the more 16%-type range or are you now in a position where you're more comfortable realizing some sustained higher margins up at this 18% level?

This is Steve here. So, yes, there were several forces as I mentioned that basically contributed to the outstanding gross margin performance. Most of those forces, we think, well not persist in the case of the the less the VR pricing environment or we will end up passing the favorable variances that we can control back to our customers. Our intent is not to milk the gross margin at this point, but to provide competitive solutions to our customers. So, if I were you, my advice would be that I would model a slight reduction in gross margins going forward, probably not down to the 60% level, consolidated company. I think that our margins are too strong for that right now but certainly 0.5 point to 1 point from where they are would be a reasonable reduction.

This is Dan--.

I meant -- when I said that I meant 16, not 60, so I'm talking about the operating margin level there, but I appreciate the comment. Thank you.

Yes, this is Dan. I think that we missed an opportunity to get more aggressive this past quarter, and I'd like to see that not happen again. I'd like to take part of that gross margin, use it for special circumstances, try to penetrate new accounts, help customers out of stranded assets whatever it may be and use that as a way to further our sell our campaign.

You'll notice that the expenses as a percent of revenue is unreasonably consistent at 44.5, and you go back several quarters it's plus or minus a tenth of a point and what I'd like to do is see us hold that level but use the additional gross margin to lower prices and be more aggressive at the point-of-sale.

Thank you.

Your next question comes from the line of Harry Blount of Lehman Brothers. Please proceed. Mr. Blount, your line is open.

Hi, can you hear me now?

Yes.

Okay, great. You guys obviously, by taking up your guidance for both the quarter and year, are feeling that you have a fair amount of visibility and I was just hoping that Dan, you might be able to give us a little bit more perspective. You ran through a lot of your product sets momentum around some of the new products, the VTL, et cetera, But maybe if you could give us a little bit more perspective and depth either by vertical or application where you seem to see more visibility now than you have in the past.

Harry, I'm not going to be a lot more specific, but when you look at the total pipeline we've got, I think we feel pretty confident that the total volume of opportunity we have there is adequate to cover an increase in the revenue forecast as we just indicated. I can't point to a particular product or vertical or anything else. All the geos are very strong. I think you'll see vertical performance flop around the mix. I mean this was the big quarter for federal because it's the end of the fiscal year. I wouldn't be at all surprised to see next quarter be the big one for financial services. Europe will be up in the mix next quarter. It always is in Q3. We see more year-end budget flex there but there's no single thing you point to that says that's the driver. I think it's a combination of many small factors and in aggregate as I said we look at our pipeline with business direct is very good.

Great. Thanks.

Your next question is from the line of Paul Mansky of Citigroup.

Great. Thank you. Was hoping you could spend a minute talking about one of your largest customers, specifically, Yahoo, where there's a sizeable infrastructure upgrade under way. Does your participation their play into your revenue in margin guidance today?

No, if anything, I'd say Yahoo this past quarter was slightly below their norm. Their big infrastructure revisions are not yet under way.

Does that play into your fiscal year revision?

Oh, no, not at all.

Okay, great. Thank you.

Your next question is from the line of Laura Conigliaro of Goldman Sachs.

Yes, given the fact that all of the parts of your business seem to be working quite well right now and you made some comments just before about the pipeline also, shouldn't you be able to carry a 30% type growth level into next year as well or why shouldn't you, and also can you just give us a little more clarification on the pricing that was asked about earlier, that is you indicated it was less severe. Can you give us some observations as to why you think that's the case?

Yes, Laura, it's Dan. I'll start with the outlook first. First of all I've never actually forecasted anything, and that really is beyond our visibility of horizon. Our typical sales cycle is measured in a few months, right? It's even a long sales cycle these days is six which only carries us to the end of the fiscal year, so we have really very little to base visibility on beyond that. And I think, even two quarters out, our ability to predict is somewhat cloudy. That's an area where it really is a crystal ball read as opposed to quantitative analysis.

On the pricing pieces, we've seen, this industry is continuing to lower prices as a result of the drop in disk prices and the increasing mix of ATA, et cetera, And what that led to is essentially a fairly orderly decline in prices, customers keep getting price decreases which are -- they find satisfactory and yet none of the vendors have had to resort to enormously deep discounting in order to satisfy the customers objectives. So, I see it as an orderly market I guess is the way to put it. Competition is strong. Don't get me wrong, and on a particular comp case it can get really very very aggressive, but the bulk or core of the market seems to be at a state where the natural price declines have allowed us to provide greater value to our customers and still hold our margins at the same time.

To Dan's point, Laura, the point we made was that the pricing environment was less severe than we had anticipated. It was still extremely competitive. This is a very competitive market, but we had anticipated it being even more so.

Your next question is from the line of Bill Fearnley of FTN Midwest.

Yes, thanks. Could you give us some more granularity here in the 6000 strength? Do you have a lot of beta units still out there in the FAS6000 or are you getting take up on test units and what type of ramp should we expect with the units here for the remainder of FY '07 and does that contribute to your upside in your guidance as well? Thanks.

I think all of those factors are in play, as Dan indicated, we saw a fair amount of upgrade activity of the 980, or all the products through the 6000, so that would be, most of those 980s are not in test. They are actually in production. So that would be an indication that customers are accepting this product into that production environment, and we certainly see people doing some tests and people evaluating the new software, but I would say that the majority of these systems are going directly into significant operations and into production. I would say that there isn't a slow adoption rate or a slow test cycle on this product. I think it's fairly aggressive.

And are most of them going into current NetApp customers or are you expanding the installed base with new customers here with this product gap?

A little bit of both. In fact, I'll ask Tom to comment on a customer who is in the bay area, we just displaced, a number of our competitor systems are running SAT in a fairly large SAN performer.

Yes, I don't want to get into the specifics of the customers, but Dan and I were talking about this last night. We see an interesting move, long term sales efforts I guess, but some real successful or good news, we accepted it usually in tier two first and then we come right up and we take -- and in a number of cases now we've taken it all and our upper end product is the genesis of that I think. What the customers are saying to me now is they feel confident, they may not give it all to us up front but they know that we can take it all, we can do all of the tiers that they need and Dan said we recently with one $4 million deal here in the Bay area, we swept the floor of our major competitor. Had another one in Southern California, it was the same thing, another one in the Midwest. So we're starting to get confident that once people understand what the value proposition of NetApp is they are going to want it in a big way and I think these numbers are a result of that.

Thanks.

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

Hi, thanks. Can you just comment on the federal business which was up strong? There's been a lot of mixed signals in the market, a lot of people conjecturing that federal was relatively weaker. Can you just talk about what you're doing specifically there at NetApp to drive federal performance and kind of what you envision going forward in federal for NetApp? Thanks.

So we have had a terrific team for years in NetApp federal. That team has been together now about five years, they've done just a remarkable job of building a right partnerships with the major systems integrators, of working all of the particular technical design and architectural angles with the various buyers in the federal community, and it's just been a textbook classic case of just excellent salesmanship. We are now, I think, gaining enormous momentum in the federal space.

I think of it as three separate kind of units. In the intelligence community, we have a large cache right now of qualified, cleared individuals to work with our Intel customers as well as very tight relationships with the systems integrators with the primary contractors there, that continues to do extraordinarily well, and what I call the light military side is the kind that's open for public bid. You may have heard that we just were awarded a portion of the Navy/Marine Corps Internet infrastructure and I think that announcement came from EDS yesterday. This is now being dual sourced as opposed to sole sourced as it was prior, and, we continue to gain traction with not only the Navy and Marine Corps but the Air Force, the Army, and so on.

And then the third segment is the civilian agencies and it would get really broad coverage there. They act much like enterprise buyers. They start off with a small deployment and get some comfort, then move up and we are gaining some momentum there as well. So, again, not a single component you can point to but it's been great business development, great customer development, great partner development, and it's gaining enormous momentum.

I think one of the easiest recruiting jobs we have in our salesforce is into federal right now. The federal force has doubled over the last few years and it's with people coming with tremendous contacts in customers, tremendous reputations, and they want to be part of NetApp. I'm seeing much bigger opportunities.

Dan just mentioned NMCI. That was sole source EMC for many many years and the customer EDS decided to look for other alternatives for their exchange environment, and yesterday it was announced that NetApp and EMC will be splitting that business going forward and we're on that contract. They also announced they're taking Decru for their encryption. Decru is having tremendous success in the federal and I think the full solution set of what we provide is coming to bear, so we feel very bullish going forward with federal.

Thanks.

Your next question is from the line of Rebecca Runkle of Morgan Stanley.

Thanks. Just a quick continuation on the federal commentary. Could you give us some sense of linearity in the quarter and whether or not you saw typical seasonality as it relates to federal, i.e. most of the business was done in the first couple of months in the quarter? Did it continue into the October time frame?

Well, yes, this is Dan. This quarter, in aggregate, looks much like every other Q2, August is dead, so activity picks up in September, federal always has a big September and if you aggregate it together across the Company, typically, only half of our bookings are achieved in August, September. The other half are in October, which is pretty typical for Q2.

The major businesses that we see some of the last minute buying spill over into our fiscal October for two reasons. One is our fiscal October actually starts in September, and number two is that some of those orders get delayed as they come through the systems integrators. So you don't see the sharp spike in our fiscal September like you might on a calendar alignment, so, it really had a normal profile, just like every other Q2. Big surge, but it was between September 15, and October 15, in federal.

Your next question is from the line of Aaron Rakers of A.G. Edwards.

Yes, thanks, guys and congratulations on another good quarter. I guess, my question is on the 6000 series solutions. Maybe you can help us understand how far along the path we are in regards to upgrading your installed base of your 900 series customers and also, if you could talk a little bit about where we're at in terms of IBM ramping with that new platform. I believe they started shipping that in early September, maybe just any type of color there and where we are with IBM on that product?

Yes, this is Dan, and in our last fiscal year and through the first half of this fiscal year, I think we shipped about 2000 or so 980s and that's just in the last six quarters; right? If you go back to the origin of the 980 and I don't have that data handy, it's probably double that, it's probably 4000. We're talking about the number of 90 -- I'm sorry, 60 -- 70's shipped being like a couple hundred so we just scratched the surface of it. It's probably less than 5%. What was the other question?

Yes, the other question is just in regards to IBM actually pulling some of that 6000 box.

Yes, I am not sure we have any orders from IBM yet. The 6000 just recently got to their product line is the NF 7000 and I haven't looked at the unit mix. I did not expect much because their typical sales cycle is longer than the amount of time remaining in the quarter from the time they got it out. I will say I'm very very pleased with IBM's performance in the field and I'll also point out to you IBM typically does about 40% of their total bookings in the fiscal fourth quarter for them which is the fourth calendar quarter which is our current third fiscal, and I'm really expecting IBM to be a fairly large contributor to our bookings performance this quarter, and they've done a great job and we continue to partner well and I think it's on the right track.

Thank you.

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

Yes, thanks. A lot of positives highlighted, so a pretty good quarter here so I just wanted to know what worries you and in particular what you think the challenges are for NetApp going forward. You mentioned Decru was down a little sequentially. You mentioned that you have NetCache going away and perhaps still you had a surge of business there and that's not going to repeat sequentially and then potentially, any other challenges that you see out there that you might want to touch on that you're navigating through, perhaps your hiring needs look pretty high?

Yes, I'm not particularly concerned, this is Dan. The Decru thing, let me just address that one for a second. Last quarter, they had a $10 million single customer order that caused their revenues to surge in one quarter. There was no order, anywhere in the Company this quarter of over 5 million. So, I mean, the Decru business is a much more distributed and a much healthier business and that's represented by far more customers doing buildouts so that's a much better foundation.

I'm not particularly concerned about any single product component. I'm not concerned about the NetCache business going away. My only concerns are on execution. I think the future of our success is in our own hands and I think it's a question of can we maintain the competitive intensity and the sense of urgency to go seize the opportunity we have right in front of us.

We hired about one out of every three people at NetApp last year, were here less than a year so we've hired a tremendous amount, we got to make sure they stay on the same page. We have a very strong culture and 75 to 80% of people coming in are coming in through references of employees or friends so we have a feeling that we're on the right track.

There's a tremendous enthusiasm here and we have to make sure that we all execute together so that the customers feel like we're providing the same value at 3 billion as we did at 1 billion or better and that's what we're committed to doing. So it's not like we're sitting worried about -- the issues you're bringing up are not the things that we're sitting here worried about because our business is very very healthy on all areas , all geos, and the product mixes are going the way we want. Now, we just got to make sure that the customers continue to feel that we get better value than our competitors and it will continue.

Thanks a lot, guys.

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

Hi, guys. I wanted to go back to the 6000 if I could. Did you say what the 6000 was as a percent of sales this quarter, percent of total filers? Any kind of metric that lets us know where you are?

No. I did not.

Are you willing to?

If I were I would have done it already.

Okay, second part of that then, if that doesn't count as my first question then--. Is can you refresh us on as the 6000 ramps what the margin impact there is going to be?

Actually, the margins on the 6000 look very consistent with the rest of the product lines. In aggregate they look almost identical to the aggregate in the 900 series. They have a different profile, right? They've got more disks attached but also carry generally more software attached so it blends out pretty well.

So no real impact there as that product ramps?

No.

Okay, thank you.

Your next question is from the line of Chris Whitmore of Deutsche Bank.

Thanks, good afternoon. Hoping for some color on the 3070 product. I know you just announced it, but was wondering if you have gotten any customer feedback for that product? And secondly, will IBM be taking up that product as well?

Okay, so the 3070, clearly we're pretty excited about that. It's the new high end of our mid range product, you may have seen the press releases and the announcements we did and the various studies that compared it to the high end products of our competition where we compare very favorably so I think we're pretty excited about this product in both the SAN markets, the NAS markets, the overall 3000 family is quite healthy and I think this is just going to extend the appeal of that product offering. As far as IBM is concerned, IBM will be taking it. Leave it to IBM to do that announcement but it will be part of the IBM product portfolio.

This is an incredibly attractive product from both a performance and price performance viewpoint. I think we introduced the 3050 just about less than a year and a half ago, and already, you have to consider the 3070 to kind of be a replacement.

I mean we're not withdrawing the 3050 but from a price performance viewpoint this becomes a compelling value proposition to the customer opportunity I think was formally interested in the 3050. So we essentially took a really strong workforce in the product line and just made it bigger, faster, and badder.

How does that impact either ASP's or margins going forward?

I don't expect it to change dramatically.

Thank you.

There's more performance for almost the same price.

Yes, it's certainly a new benchmark for us in certainly the mid range modular area. The 3050 clearly you can see from our volume and our growth that's a very very successful product and a here's a product that will use a far superior price performance to that one so I think it just enhances our competitive position in a significant way in virtually all of our markets at once.

Your next question is from the line of Clay Sumner of FBR.

Thanks very much. Your add on software products look like they were roughly flat sequentially while the maintenance was up strongly as you described. Can you just talk a little bit about the factors behind that?

Sure. As we said for some time, Clay, this add-on software number is going to fluctuate around roughly the 35% of revenue range. We are going to be moving pieces of functionality from the add-on category to the base configuration in a system. We do that based on a variety of issues that have more to do with marketing than anything else and I don't know that I'd read a whole lot into the change or lack of change in add-on software here.

One point I will make a note of, and that is that the FFP portion has increased slightly, and will continue to increase and reflect the phenomenon of the FFP's coming off the balance sheet, so I think that there could be some minor increase in that over time, but the base rate of add-on software, truly add-on software is probably running at the high watermark right now.

Okay, and maintenance? Does it have anything to do with the net cash maintenance renewals or any reason that was up?

No. Nothing to do with that. That would be all deferred.

Okay. Thanks.

Your next question comes from the line of Tom Curlin with RBC Capital.

Hi, good afternoon. On the entry level products just given the SAT/SATA issues, how long will you wait before you decide to just rollout with an upgraded version using fibre-channel and SATA drives?

Well, clearly we're selling a product today that has both fibre-channel and SATA capability, so from our perspective it isn't like a hole in the product line that we need this technology to fill. SA/SATA was a technology that we wanted to demonstrate leadership on and just our observation that it's not going to meet the expectations of our customers at this point in time, so when it's ready it's ready. I don't feel any compelling reason to rush this to market. Our mainstream competitors don't offer products in this space and the 270 is healthy for us, it generates good margins and it certainly has a lot of customer appeal.

Do you worry about conflict between the store bought series and and the 270 though?

No, I really don't worry about that whatsoever. The store bought, once the customer -- an enterprise customer in particular takes a look at it, they will conclude that is not the right solution for them, and most of the differences have to do in two separate categories. One is around serviceability. That product is not supported through the NetApp Global Services organization.

There is no access to the NetApp website and typical parts replacement is 24 hours, I mean, it's just not enterprise class box. Second one is around upgradability. There is absolutely no upgradability of that product. What you buy is what you got and you're done and you got to think of this as a fixed box, low cost, low overhead in the structure, in terms of the support structure and the rest and that's how you get the price down for the small and medium business customer but if an enterprise customer buys that box he's making a big serious mistake.

Okay, that's very helpful. Thank you.

One more comment on the 270. As Tom said it's a very strong product, but our tradition is that we do not introduce new products in Q4. And our fiscal Q4 starts in February, so my guess is the decision not to introduce the SAT/SATA and replace the 270 means it doesn't come out before July.

Summer of 2007.

Yes, we don't want to upset our fiscal year, and so, maybe our drive is May but the point is it's after this fiscal year is over.

Okay.

And make no mistake, we've got fibre-channel and SATA offerings in that space today, the business is growing, it's good margin and if the new technology was ready, great, it simplifies our product design but it's not ready and I don't feel exposed by our major competitors either now or even in the time frame that Dan talked about.

The highest availability product and the product line based on field performance was the 270. It is an absolutely rock solid product and they replaced it with one that we're uncertain about in terms of it's overall availability is not a good move so we decided to do [Inaudible] away.

Thanks very much.

Your next question is from the line of Brian Freed, Morgan Keegan.

Hi, guys, good quarter. Thanks for taking my call. It sounds like the mix between SATA -- well between ATA and fibre-channel drives hs kind of plateaued here, and been relatively stable over the last few quarters. Do you view this as kind of a point of equilibrium between the two technologies within your customers and as storage capacity needs continue to grow, does it bode well for ongoing revenue trends?

I think that there's a number of dynamics in play. I don't think that the fibre-channel ATA mix is a leading indicator of the overall success of Network Appliance as a Company. I think there will be things that will oscillate. Our federal business tends to be relatively SAN centric which would probably lean more towards fibre-channel. On the other hand, our secondary storage business is very ATA centric. So, I would expect to see some oscillation around the current balance point as time goes on. I don't necessarily see a trend that's going to take us dramatically in one direction or the other but I would expect it to not be so constant quarter to quarter.

I have a little different perspective on that and really if you think about what's the real choice the customer is making, it has to do with performance and competence, and that as their competence level goes up and the availability of ATA drives, my guess is they are going to push it more on to areas where they don't need the performance. We'll see how that plays out. That's really speculative but I think customers like low cost and where it performs adequately for their application needs I think they are going to move it.

Okay, thanks.

Your next question is from the line of Glenn Hanus of Needham & Company.

Thanks for the question. Could you maybe comment on with the very strong performance, how much you view that as your own competitive strength right now and taking a little bit of share, versus the market environment being perhaps on the margin a little bit healthier or not?

I don't think there's any doubt it's because of our strength in the market. I experienced a nine week trip. Dan is on the road most of the same time, number of our executives last week heard a big deal, we've had a number of executive forums right in a row and what we are hearing back from the customers is that demonstrated value of NetApp is just now very obvious to them and we're starting to get tremendously higher shares of wallet in our existing accounts. It gives us much more visibility into new applications. They are moving a number of things off of direct attached to our ATA's that they wouldn't have done before to other vendors but they got confidence because of our ability to take a double disk failure without going down because of our ADP, all of these factors are playing in number one.

And number two, is we've been investing in our salesforce aggressively and telling you that now for about 18 months and that is definitely playing off. Our coverage model is just getting better, so we sit around here and say well, if we can get more coverage, if we can get more distribution and focus on that end, there's nothing stopping us from continuing to take share from our competitors. The customers believe that we have higher value than they do, and we're very very -- it's just clear when you talk to them. It's not like we're debating anymore, so that's basically what I see. I don't see it at all as the market is all of a sudden getting healthier. I don't see the other people doing that much different. I think our Company is winning more.

I will say also that there is a, I think architectural trend that customers are adopting that plays to our strength. As they move towards utility computing, they also move towards a utility storage infrastructure that can be used for a variety of different environments and the unified storage message and the ability to mix and match high end systems and low end systems and the same kind of infrastructure really does play right to our strengths and I'm sure you see it in the customer review today, we really like to get to a consolidated, tiered storage model with a kind of a simple architecture that's easy to manage. And that's kind of what we offer.

The other thing I would say, data replication, data recovery is such an important topic to customers today and the fact that we have one set of software, regardless of what platform you are, you can do the same data replication off of every piece of NetApp gear and go to another NetApp and still have the same consistent file system resonates more now than it did six months ago, much more than a year ago, and that brings a level of confidence of putting new apps on NetApp that probably wasn't there a year ago and a higher degree of certainty than they will at our competitors because with the competitors you have to introduce much more complexity.

Okay, so market strength, basically unchanged and sort of outlook for market growth perhaps next year kind of like this year from what you're seeing?

I think that's fair.

Thank you.

And your next question is from the line of Andrew Neff, Bear Stearns.

Sure, just a, this is something that's been addressed but just as you talk about the competitive environment, your growth rates are well above some of your competitors, and you talked about different reasons for that, are you expecting them to take steps to come after you? What do you think they are going to do and how are you preparing for that?

I think it varies, Andy, by who the competitor is. I personally think that most of the server vendors who own the share are still very server centric and though I don't expect them to play in the utility infrastructure kind of model, so I think, now it's just going to keep moving in our direction and I think the other horizontally focused, fire share, they got to do everything in their power to become more aggressive and it's not a cake walk right now. You shouldn't walk away thinking this is easy. There's a lot of street fighting going on out there, and it's a very very competitive market. I think they'll do everything in their power to try to gain share just like we're doing.

We've been in four or five year war with EMC and I think they are NetApp killer number seven now, if I'm numbering them right so they've been doing everything they could, but they've changed tactics here about well, two or three months ago to start going public with where they're number one and they are putting out these fud papers which are fairly easy to dispute as an aside but the fact of the matter is they are trying to get their customers thinking differently because it's not going so well for them. That, to me, is very very positive.

I can't tell you how many customers say it's just amazing to me how much attention they are focusing on a company your size versus their size and that typically happens when the other guy has a better weapon. So if they had better weapons they wouldn't need to focus as much on us. So the fact of the matter is they are going to come out with campaigns. They've done this forever. They can keep doing what they are doing. We have to focus on our company, our customers, and our business and I think these are going to go real well.

Thank you.

And our final question is a follow-up from the line of Harry Blount of Lehman Brothers.

Thanks, guys. Slipped in just under the wire. Basically, actually going to try to slip two quick ones in. One is the competitive win rates, just you guys have historically talked about that wanted to see if you've seen any kind of change in trend on those competitive win rates, and then the second one, I know I'm opening a can of worms here a little bit, Steve, but on the option dilution, if my calc is right you had about $0.17 of option dilution first half of the year, the guidance kind of implies $0.18 to $0.20 option dilution, back half of the year. Trying to understand if that is mostly related to anticipation of higher stock price and/or when we might be seeing peak of the dilution.

This is Dan, on the competitive front, the win rate hasn't changed significantly. I think what we have seen is more deal activity. So, on a percentage of outcome it's about the same but in terms of total size of the pipeline, it's grown, it's grown largely because our regular channel partners as well. The performance of Arrow and Avnet this quarter was really strong, as I said, up 16% sequential. That is partially tied to the federal business, but almost all of our federal business is indirect. You look at the channel partner performance, I got to tell you, that's really what's increased the pipeline quite dramatically.

Arrow and Avnet are just two of the bigger distributors, but our overall channel partners both domestically and internationally have had a great quarter.

Yes, Fujitsu Siemens had another terrific quarter, so if you just look all around the globe, it's just breadth of pipeline coming in.

This is Steve. So let's be clear on these option expenses, as you know it tends to be a little bit of a hot button for me. But--. Made an understatement. But I think it's been very clear. The Company has consistently over the past several years, in terms of units of equity outstanding, only increased the dilution by 3% or less every year. Okay? So the dilution you're referring to, the dilution that's associated with the option expensing, the FAS 123R implementation.

Correct.

Right, now the higher the stock price, there are so many variables there Harry with respect to the volatility of the stock price and the term under which people are going to hold their stock, the stock price itself, it is a really really difficult item to project, and again, we can talk all about the economics we want but frankly, I don't think the economics are properly reflected in stock option expense and the higher the stock price goes, the more expense we're going to incur.

The other aspect you said is it just stock pricing, your question. The answer is no. Our hiring profile is a little non-linear. We're a little back half loaded in terms of number of heads we're going to bring in and most of the grants go to new hires.

Great. Very helpful. Thanks.

And at this time there are no further questions. I'd like to hand it back to Dan Warmenhoven for any closing remarks.

Ladies and gentlemen thank you very much for joining us today for the Q2 conference call. Again, I'd like to remind you all that we are planning a analyst day in New York on I think it's March 13, 2007, and we hope you all will join us there and also please plan on joining us in February for the Q3 conference call. Thank you and have a great holiday period.

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a great day.