NetApp Inc (NTAP) 2008 Q2 法說會逐字稿

Good day, ladies and gentlemen. Welcome to the Network Application Q2 2008 conference call. At this time, all participants are in listen-only mode. We will conduct a question and answer session towards the end of this conference. (OPERATOR INSTRUCTIONS) I would now like to turn the presentation over to Tara Dhillon, Senior Director Investor Relations. Please proceed.

Thank you. Good afternoon, everyone and 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 earning's release, the financial tables, and the reconciliation between GAAP and non-GAAP numbers. In the course of today's conference call we will make forward-looking statements and projections that involve risks and uncertainties including statements regarding our expectations with respect to our Q3 pipeline, bookings distribution, and our growth opportunities, our operating results for fiscal Q3 2008, the growth of the virtual server market, customer demand for our product and service offerings. Actual results may differ materially from our statements or projections. Factors that could cause actual results to differ from our projections include but are not limited to customer demand for products and services, increased competition, and any decline in general economic conditions. Other equally important factors are detailed in the Company's 10-K and 10-Q reports on file with the SEC and available through our website all of which factors are incorporated by reference into today's discussion.

With me on today os call are Dan Warmenhoven, CEO; our President Tom Mendoza; Steve Gomo, CFO; Tom Georgens, EVP of Product Operations; and Rob Salmon, EVP of Worldwide Field Operations. Steve will review this quarter's financials and discuss our revised financial outlook for the second quarter. For the third quarter, excuse me, and then Dan will share his thoughts before we wind up with everyone here for Q&A.

Thanks, Tara. Good afternoon, everyone. As you can see in our earnings release, NetApp returned to healthy growth and solid execution this quarter. I will illustrate this with some additional color about our results. Note that all numbers are GAAP unless stated otherwise. Please refer to the table in our press release and on our website to see the reconciling items between non-GAAP and GAAP numbers.

Total revenue for the first quarter was $792.2 million, up 15% sequentially and up 21% compared to Q2 last year. Foreign currency effects added 0.7 of a percentage point sequentially to revenue growth this quarter and augmented the year-over-year growth rated by 2 percentage points. The combination of product revenue and software entitlements and maintenance revenue was $658.5 million, up 15% sequentially and 17% year-over-year. Revenue from add-on software and software entitlements and maintenance was 40% of total revenue this quarter. This compares to 41% last quarter and 40% in Q2 of last year. Add-on software was about 25% of total revenue, and software entitlements and maintenance were about 15% of total revenue.

Revenue from services which includes hardware support, professional services, and educational services, was 17% of total revenue, up 13% sequentially and up 50% over Q2 of last year. Service maintenance contracts increased 12% sequentially and 50% year-over-year. Professional services increased 19% sequentially and 59% year-over-year. Non-GAAP gross margins were 62.2% of revenue this quarter, up 4 basis points from last quarter. At 67.6% of revenue the combined product and software gross margin demonstrates the continued competitive strength of our solutions. Non-GAAP service margins were a strong 35.5% this quarter, up substantially from the 31.7 recorded last quarter due to a slower pace of professional services hiring. We expect service margins to remain in the mid-30s for the rest of FY '08.

Turning to non-GAAP expenses, our operating expenses totaled $367 million or 46.3% of revenue. Expenses increased less than 5% sequentially and 26% year-over-year. As a percentage of revenue, all functional categories of operating expense declined from Q1. Total head count increased by 38 people on a net basis ending the quarter with 6,852 employees. Limiting the additions to our employment base was a key ingredient for the rapid return to our target business model operating profit. Going forward, our hiring will balance our intent to support future growth with our business model objectives.

GAAP operating expense includes the effect of prior period merger related costs like intangible amortization from acquisitions and the effect of FAS 123-R. Non-GAAP income from operations totaled $126 million or 15.9% of revenue. Non-GAAP other income which consists primarily of interest income was $15.1 million. Non-GAAP income before taxes was $141 million or 17.8% of revenue. Our effective non-GAAP tax rate remains at 17.5%. Non-GAAP net income totaled $116.4 million or $0.32 per share. GAAP net income totaled $83.8 million or $0.23 per share.

Now I would like to turn our attention to cash flow performance. Generating significant amounts of free cash flow is the Cornerstone of the NetApp business model. We define free cash flow as cash from operations less capital expenditures. This quarter our cash generated from operations was $228 million, up 13% sequentially and down just slightly from the very strong Q2 of last year. Capital expenditures were $37.6 million so free cash flow totaled $190.1 million, growing 14% sequentially and 2% over Q2 last year. Expressed as a percent of revenue, second quarter free cash flow was 24% virtually the same as last quarter and 1 percentage point higher than the average of the last three fiscal years.

Moving onto the balance sheet, cash and investments decreased by about $347 million from last quarter to $983 million due primarily to our aggressive stock buyback. This balance, however, excludes approximately $81 million of restricted cash and investments associated with last year's foreign cash repatriation, $300 million of restricted cash related to our secured revolving credit facility, and about $8 million worth of restricted cash related to security and rent deposits. The current debt on our balance sheet of about $48 million is related to the repatriation and is expected to be repaid in full by the fourth quarter of this year, this fiscal year. The debt associated with our credit facility is $250 million and is entirely a long-term liability.

As I just mentioned, the Company conducted a significant stock repurchase this quarter. We repurchased a total of 17.6 million shares, 16.8 of which were recorded in the second quarter. The remaining 774,000 shares will be recorded in Q3. We purchased all these shares in three tranches for a total outlay of $500 million with an average purchase price of $28.40. There was approximately $700 million remaining in our stock repurchase authorization.

Accounts receivable day sales outstanding were 49 days compared to 53 days last quarter and 51 days in Q2 last year. Last year's Q2 DSO has been recalculated to include the reclassification of $34 million worth of sales tax from accounts receivable to other current assets which we described to you in detail last quarter. Revenue turns were 19.2 times this quarter -- excuse me, inventory turns were 19.2 times this quarter, better than the 18.2 reported in Q1. I expect inventory turns to remain at similar levels in Q3. The total deferred revenue balance increased $68.7 million this quarter to $1.22 billion, a 6% sequential increase and a 49% increase in the balance year-over-year.

Before I turn the call over to Dan for his comments, I will discuss our target operating model for Q3. Our outlook is based on our current business expectations and current market conditions and reflects our non-GAAP presentation. We're making forward-looking statements and projections that involve risk and uncertainty. Actual results may differ materially from our statements or projections for the reasons Tara cited earlier. We expect Q3 revenue to be between $872 million and $883 million which represents about a 10 to 12% sequential increase from the second quarter and about a 20 to 21% year-over-year growth rate.

In Q3 we're expecting gross margins to decrease by 1 to 1.5 percentage points due to an increase in the IBM business mix as well as some selective pricing actions that we're taking to spur additional growth. In addition, we plan to add about 300 to 350 employees next quarter with an emphasis on sales-related activity. As a result, we're forecasting our margin to finish between 15 and 15.5% which is below our target range. This will result in second quarter non-GAAP earnings of approximately $0.33 to $0.34 per share. GAAP earnings are expected to be $0.23 to $0.24 per share. We expect our diluted share count to decrease by about 2 million to 3 million shares in the third quarter depending on the stock price. At this point I will turn it over to Dan for his comments. Dan.

Thanks, Steve. I am very proud of the NetApp team this quarter especially from the perspective of sales execution and expense management. We returned to our target operating model faster than we had originally expected, so we're in an excellent position to resume investing in our growth going forward and are entering Q3 with a healthy backlog and a solid sales pipeline.

In Q2 our business rebounded nicely almost everywhere in the world. One notable exception was North America. Outside of our U.S. federal subsidiary. Our federal business was very strong, contributing a record 17% of total revenue, up 49% over a year ago. However, the rest of North America was sluggish, especially in our largest accounts. Total America's revenues increased 17% over last year contributing 58% of our total revenue. When you exclude the federal business, the remainder of the U.S. business grew only 9% over Q2 of last year. This weakness can be largely attributed to our 22 largest U.S. commercial accounts, our top enterprise accounts which were down, down about 4% compared to Q2 a year ago. The U.S. excluding federal and the top 22 TEAs grew at 16% year-over-year.

Outside the U.S. we're experiencing strength in both our European and Asia Pacific regions. Europe was 30% of revenues, the same percentage as Q2 last year with particularly solid performance in Germany and Northeastern Europe tempered by some softness in Western Europe. Asia Pacific contributed 12% of revenue, up 30% over last year with strong performance from Australia. The direct channel contributed almost 38% of revenue, about the same as last quarter but was up only 11% in absolute dollars over Q2 a year ago. This is highly correlated with the weakness we're seeing in the largest U.S. enterprises. However, our indirect channel did quite well again this quarter, accounting for 62% of revenue versus 59% a year ago. This correlates to our strength in federal where over 90% of our business is indirect.

Both Aero and AvNet had their largest NetApp quarter ever with a combined revenue contribution of 19% of total revenue. IBM was up from last quarter in absolute dollar terms but roughly flat as a percent of revenue and still less than 5% of our total. The IBM business continues to gain momentum, and our fiscal Q3 is their year end, so we would expect to see an uptick in the current quarter followed by a seasonal decline in our fiscal Q4.

Looking at our performance from a product perspective, we also have several very positive indicators. The Company posted impressive growth in petabytes shipped this quarter, up 24% sequentially and 86% year-over-year to another record, 138 petabytes of storage shipped. Fiber channel drives accounted for about 38% and ATA about 60% of total petabytes. The ATA figure includes a small percentage of SAS drives.

Total storage system units shipped also grew nicely, up 15% sequentially and up 27% year-over-year. Our low end products were up the most, aided by the launch of the FAS2020 and FAS2050 series. Our low end products accounted for nearly half of all storage systems shipped. The mid-range products were not far behind in units, and our mid-range storage systems continue to generate almost two-thirds of our revenue. At the high-end our FAS6000 series units grew 9% sequentially and approximately 15% sequentially in revenue. The percent of our storage bookings have included block-based protocols, was 41% this quarter. Within this, 31% had a fiber channel SAN interface, about 15% included iSCSI, and 6% included both fiber channel, SAN, and iSCSI on the same purchase order.

While block based storage was down slightly in the mix from 44% last quarter, the business remained strong. It is up 9% sequentially in absolute dollars and we're in a range that we're comfortable with. Over the past few quarters we increased our emphasis on NFS in order to maintain a balanced focus on all protocols as well as to ensure we maintain our leadership in the mass market. We're seeing more and more customers choosing NAS and database environments because of the cost savings and management simplicity. But customers also use NAS for advanced scaleout solutions. Given the additional emphasis we recently placed on NFS, with the availability of NFS version 4.0 and of DNFS, it isn't surprising to see block-based business decline a little bit in the mix.

Our scaleout operating systems ONTAP GX also had a good quarter and it contributed to the strength of our NAS business. Units shipped were up 15% from last quarter although off a fairly small base.

Our emerging products continue to produce mixed results. The highlight this quarter is our virtual tape library product line which continues to do very well. Our storage security products were up this quarter. The store vault SMV product was down in the mix this quarter, but had some very encouraging deployments. Replicator X, our heterogenous data replication product is doing well on both business continuity and application development and test applications.

As more than two-thirds of our corporate data existing as a secondary copy, D Duplication has emerged as an important part of data protection solutions. We believe NetApp is the capacity leader in D duplicated storage, and our D Duplication technology has become our fastest-adopted feature. The customers need D Duplication for more than just backing up, and NetApp is the only vendor who offers it in primary as well as data protection, business continuity and archival environments. We don't believe D Duplication requires a separate appliance. We provide it today with our snapshot technology and also in our near store software bundles. We believe D Duplication is rapidly becoming a core requirement for all enterprise storage systems.

Our partner ecosystem is providing greater returns in our investment every quarter. We just had our best revenue quarter ever with Microsoft installations, and our business with SAP is on track for 50% growth over last year. If you visit Oracle OpenWorld this week, you'll see a huge NetApp presence and Oracle itself has reached the 10 petabyte mark with NetApp Storage. Tonight NetApp is sponsoring the concerts featuring Billy Joel, Lenny Kravitz, and Stevie Nicks, and Mick Fleetwood. Let me know if you need tickets.

The most exciting part or opportunity we're involved with today is VMWare. We believe that server virtualization is the single largest industry changing phenomena of this decade. Gartner believes that by 2010 there will be 4 million virtual servers deployed, and customers who want virtual servers need virtualized storage to effectively support them. NetApp is the industry leader in virtual storage and we're the only vendor who provides D Duplication capability for primary VMWare environments. VMWare drives customer customers to rethink their IT architecture. With this disruptive change customers implementing virtual servers are especially well suited to reap the benefits and cost reductions found in NetApp storage. The Apps that we'll see running on top of VMWare will be the likes of Oracle, exchange, SQL Server, and so we'll be able to leverage the primary work we've already done with our largest partners.

To give you an idea of how committed we are to this opportunity, we're building a new organization around it. We've launched a new unit focused on driving business in conjunction with VMWare. We've asked the Senior Vice President that built our SAN and iSCSI businesses from the ground up to lead the effort to capitalize on this next big emerging market opportunity.

In summary, despite the uncertainty around the U.S. commercial market, we feel we have a diversified set of business drivers that will continue to drive our growth over the coming quarter and years. Our indirect channel continues to expand. Our international business is doing well, and our partners are stimulating more business for us every day. Combining this diversification with a comfortable backlog and a solid sales pipeline as we enter Q3 is the background for the guidance that Q3 will have similar annual growth as we had in Q2. We expect to see normal seasonal patterns plus continued softness in large U.S. enterprises which may also seep into the U.K. Given the external economic uncertainty, we believe it is prudent to hold off on providing any Q4 guidance until the end of Q3.

As I've said before, we're optimistic about our future growth potential, but we do not foresee getting back to a 30% growth rate in this fiscal year given the macroeconomic environment although we certainly have not surrendered to that objective for the longer term. At this point I'll open the floor to questions. We request you limit yourself to one question and then return to the queue if you have an additional question so we may address everyone in the allotted time. Operator?

(OPERATOR INSTRUCTIONS) Your first question is from Harry Blount with Lehman Brothers.

Hi, guys. Quick question, you guys, Steve, at the very end of your commentary you indicated that you see a little bit of a back step in op margins as you focus on investing for growth and some pricing actions. I don't think I've heard you guys talk about pricing actions on a call in awhile, so can you talk about perhaps, what you're seeing in the environment that may cause you to take some more aggressive actions than maybe you have in the past?

Sure, Harry, this is Steve. I think we see some opportunity. Basically we've been doing some -- a lot of analysis around our go to market techniques and the end markets type of thing. We see some opportunity, particularly in the indirect channels to be a little bit more aggressive with some of our pricing and take some share in some of the selected segments, so I don't want to give away the marketing program here, but that's basically where it is oriented, at indirect channels in certain segments of the market.

Harry, this is Dan, in the direct business it is much easier for to us discount as appropriate to go into business, but in the indirect channel especially through a two tier model it is much more difficult, so you got to have the prices set much closer to what the street and user price would be in order to drive velocity.

Got it. Basically the nature of the question is if it is a change in the competitive dynamics or not. Sounds like it is more you guys initiating than vice versa?

Absolutely. We think we have an opportunity to expand our presence, especially in the mid-market, kind of the fortune 1,000 to 10,000 class, and that's mostly indirect business.

Harry, this is Tom. We also have had a number of meetings with our top channel partners around the world basically saying if we do what, we hope to accelerate your business. They've come back with some very, very good ideas, and we've kind of thought through what we would do to help them, and we're executing those ideas.

Thank you.

Your next question is from the lane of Laura Conigliaro with Goldman Sachs. Please proceed with your question.

Can I first just follow-up on the pricing thing, and that is you're basically going to use margin to engage in selective pricing. Is this predominantly aimed at your traditional competitors or is it more of some smaller, newer companies, and to what extent do you think this pricing will also help to stimulate sluggish demand? And I guess the other thing that I wanted to ask about was your reference, Dan, at the end to possibly seeing some U.K. softening indicators, and I am wondering considering how much the U.K. exposure -- how much the U.K. is exposed to the financial services market are you actually seeing some of that at this point, and you're just assuming that it might fall into your business at some point going forward? Thanks.

Laura, I don't think it is targeting competitors as much as targeting more channel partners, getting their productivity up and going after a particular market segment which is the medium tier, medium-size enterprise. Some of it shows up in a form of bundling which is essentially a repricing of sorts but a channel bundle. Some of it shows up in incentives in the form of rebates that they can earn on certain thresholds of achievement, and that all shows up in the margin line, but it is not aimed at competitors as much as it is aimed at providing a more attractive solution for our channel partners, both improving their margins and also getting their velocity up.

On the U.K. it is mostly a concern about -- we're not seeing anything specific yet, but as you pointed out, the U.K. business is heavily weighted towards financial services, and they have a tendency to have a fairly close correlation to what happens in the New York financial community. So we're expecting to see the pipeline in the U.K. kind of soften up a little bit near the end of the year.

Your next question comes from the line of Paul Mansky with Citi Investment Research. Please proceed with your question.

A couple questions if I could. First and foremost, obviously the fiber channel business as a percentage of the mix, understand what's going on there given the -- given what's happening in financial services, but iSCSI dropping down as a percentage of the mix, can you wrap a little bit of color around what's driving that? Also, and the follow-up there maybe talk a little bit about the consolidation in the market that was announced last week, specifically Dell acquiring EqualLogic.

This is Tom. On the iSCSI segment, I think if you look at our iSCSI business, it is really broken down by market segment. In the upper market segments we're actually doing quite well, and our market share is actually quite strong. It is actually the lower segments where some of this growth is being reported and it's where our channel reach hasn't quite gotten us in the past. Some of the ideas that Steve was talking about expanding our channel reach and being aggressive to create channel partners to go after that combined with the fact we just refreshed our low end product and we now have a product offering that extends down there, that's really something that we're going to go after next. If you look at the segments, if you go with the standard price bands, the price bands $50,000 and above, our market share is actually quite strong and remaining strong. Below that, there has been a fair amount of growth there. We just haven't been able to capitalize it either because of product readiness or the channel, and it looks like we're trying to remedy both of those problems with new product introductions and now the channel programs to go with it.

Pretty strong iSCSI offensive in the program this particular quarter wrapped around the new 2020 and 2050 series, fairly aggressive bundled pricing, et cetera, to go right after that segment.

And then on the Dell entry into the market?

I don't really have a comment on it. EqualLogic was an interesting company, and registration, we'll see how it all plays out.

I think Dell was in the market, right? They were selling other partners products, so now they have got the EqualLogic product, and I think it will be interesting. I think it will be interesting how they rationalize the go to market on the channel side versus the direct salesforce and how that works out, and I think it will certainly be interesting for one of our largest competitors who have a big dependency on Dell. I think it is probably safe to assume that this isn't good for them and time will tell how bad it turns out to be.

We've been at this, Tom Mendoza. We've been out there iSCSI is an important part of our solution offering for quite a while, and we've done very well at it. I think it is also interesting to see if it expands the market to where everyone starts really thinking iSCSI is the way to go for lots of different applications to add consider before and obviously if they do we'll have a chance to compete in a more broad fashion.

Maybe if I can just ask it a slightly different way, did the Dell announcement have any bearing on your strategy in that lower end of the market or is that a strategy that was already in place unchanged subsequent to that announcement.

That strategy was already in place and was wrapped around the 2020 and 2050 and most of those programs were launched before there was any news about Dell acquiring EqualLogic. There was no change in our program as a result of that.

In fact, that launch, I believe, was on September 10, and our press tour and our communication around that was every bit as much about channel programs as it was about the product itself.

Thank you.

Your next question comes from the line of Dan Renouard with Robert Baird. Please proceed with your question.

Thanks. Could you give a little bit more detail around the VMWare division you and -- I shouldn't say VMWare, server virtualization division, just functionally how was that structured? Who does it report up to? Are there direct quotas, quota carrying reps? Maybe just frame the organization within NetApp and how it will interact with your various groups, divisions and geographies. Thanks.

Okay. So I don't know if there is that much mystery. I think the first statement that we clearly recognize, A, that VMWare was a major disruptive force in the enterprise, and it is something at the top of mind with our customers, and perhaps equally important is that we believe that there is components of the NetApp value proposition as it exists today which are unmatched by any of our competitors. There is a really sense that there is a sense of urgency here and that the time is now whether it be our D Duplication, our thin provisioning, our flexible cloning, our ease of use, our unified storage, all of those things come into play around VMWare driving superior cost of ownership and more rapid deployment.

Wanting to capitalize on that, we actually took one of our most senior people, a person who has led a number of key initiatives in the past and they're going to lead basically a Companywide initiative that encompasses all of the components of the Company, whether it be engineering, marketing, sales, service, and really be able to take advantage of this opportunity as it sits today, and effectively what we're doing is taking somebody who has actually kicked off our fiber channel business and our iSCSI business and has a long track record of success and influence in the Company and basically giving him the leadership to drive it. Specifically to your question this is Tom Georgens, it is going to actually report to me, but nonetheless it is going to be very very cross functional and there will be direct and indirect reports across the entire Company as far as this initiative.

This is Rob Salmon, I'm on the other side, on the field operations side, and to Tom's point this is absolutely a joint initiative, and we're excited about it. Rich Clifton that Tom already mentioned has led some of the things that we're most excited about at Network Appliance and some of the most successful go to market strategies we have. We really have a true joint initiative between product operations and field operations that we're very excited about. We announced internal recently. There is a lot of enthusiasm about it internal and with our partner community, and Rich has a lot of respect from our partners as well.

Thank you.

Your next question comes from the line of Chris Whitmore with Deutsche Bank. Please proceed with your question.

Thanks. I was hoping to get more color on the weakness you're seeing amongst the largest accounts, the large U.S. enterprise customers? Is it concentrated in any particular vertical or is it fairly widespread?

This is Dan. It is led by the financial services sector as you might imagine, and they're quite substantial. Other companies are still as well. Texas Instruments has been a big customer for a long time. It was a challenge this year. There is a variety of other stories outside of financial services, but across the board they're down on a composite sense 4%. I don't see any pattern other than the financial services meltdown, and I would encourage all of you who are part of the financial services, especially broker-dealer organizations, please keep that among yourself. Once you start exporting that set of problems to the rest of the economy, everybody is going to go in the tank. It is not a competitive issue. It is strictly financial services is just squeezing down.

So if I look at your revenue guidance in the context of getting more aggressive on pricing, it doesn't look like you're expecting an acceleration in the growth rate despite getting more aggressive on pricing. Does that suggest you're expecting the environment to deteriorate next quarter?

No, not at all. On a larger account size, I think they're just in a budget crunch, and everything slows down at that point in time. We think the opportunity to extend the growth is in the mid-market, and I think you've seen that in certain other vendors results as well, and we are going aggressively right there, and that's what the pricing is all about. Tom.

We're sitting here after a couple of quarters where things are starting to go well again as we talked about, and we're seeing more activity, but when you read the paper every day we're like you. Every day is another bad day for somebody, and we're just saying, look, let's be cautious, let's be aggressive, grab share as much as we can, people looking for all type of solutions, but we're telling all the companies the same thing. We have got to make sure that -- we got to execute at such a high level that regardless of what happens to the economy we'll do better than the other guy. You all know that the economy, we just have to see how it goes. If it goes well, and we don't get, like Dan just said, doesn't happen as bad as people think, that would be great news. If it does we just want to be prepared to execute at a high level, take the actions now as opposed to later.

Operator.

Your next question comes from the line of Brent Bracelin with Pacific Crest Securities.

Thank you. I actually had a follow-up on U.S. commercial. As you look at the FAS6000, that is typically a higher end larger customer product. Looks like it did rebound in the quarter with units and revenue up sequentially. What were the trends you saw in October and November? Are there any signs of life in U.S. commercial and then looking beyond just the U.S. commercial market, do you expect kind of seasonal rebound your business year in the second half of the year like we've typically seen over the last few years here?

Let me talk about the U.S. commercial. By U.S. commercial I am going to talk about all U.S. nonfederal business. People have different definitions to the term commercial. If you took out our top 22 accounts, what's left grew at 16% year-over-year. That's not too shabby. That really is a reflection of we see the strength in the kind of the medium-sized enterprises, and that is pretty consistent across the U.S. It really is the larger accounts that have difficulty. The growth of the 6000 units was driven largely by federal and certain fairly substantial customer acquisitions outside the U.S. For instance, you'll notice that SAP announced their business by design. That's based on our infrastructure and it's largely based on 6000. There is a lot of drivers around the 6000 of substance, and it is not just a U.S. commercial product. Does that answer your question?

Yes. Then just globally as you think about seasonality and kind of budget flushes outside of the U.S., do you expect to see some sort of seasonal benefit over the next two quarters?

We see generally a very strong performance on Europe. They seem to have a surge in our fiscal Q3 correlated with the end of the calendar year. We've gotten certain indicators like the pipeline looks very good. If you look at the most recent wave 10 of the Info Pro survey, it shows that there is an increase in interest in spending of their -- the interview base. I think it is about 400 customers interviewed includes financial services which all show significant increase in spending on NetApp in the near future. There is indicators, but we're assuming it is going to be a fairly traditional kind of year, strength in Europe, nothing in surging in North America.

Okay. Thank you.

Your next question comes from the line of Aaron Rakers with Wachovia.

My question is around last quarter you had talked a little bit about bookings and backlog, and I think you even threw out a few metrics around bookings being up 27% year-over-year, backlog building at the end of the quarter. My question is going into this quarter DSOs down. How much of this quarter was a result of just the deals that had kind of slipped or the backlog that wasn't converted entering or exiting last quarter? And also if you can on the pricing comments, you made a reference to gross margin being down, but then you also referenced IBM growing as a larger percent. If you can give us some flavor around that 1 to 1.5 percentage point decline in gross margin, what is attributed to IBM versus pricing, that would be helpful.

Okay. Let me start with the IBM mix versus the pricing. About roughly two-thirds of it is pricing and roughly one-third of it is the IBM mix in terms of the margin decline. If we want to talk about backlog, we're not prepared to provide any more information with respect to it except to say that as we exit the second quarter and Dan pointed this out, we think our backlog is in a very healthy position.

Okay.

Your next question comes from the line of Clay Sumner with FBR. Please proceed with your question.

Thanks very much. Steve, I guess following up on the last question, the last quarter you had said that don't pay so much attention to the 11% revenue growth because bookings grew in the high 20s, so that was clearly an indicator that the business was still growing pretty strongly. Can you say if that bookings growth slowed? Are we talking about an incrementally slower growth environment or roughly on track with where we were in the July quarter?

All I can tell you is that the disparity between revenue growth and order growth is not nearly what it was last quarter, and so I don't think you'll be overly misled by the rate of growth in revenues.

I should remind you, guys, that bookings don't directly relate to revenue in the near term. So much of it goes to the contra programs or to deferred revenue or professional services backlog or a variety of other things. It is very difficult to correlate the two directly. Bookings are a leading indicator. The bookings are up in a manner very similar to last quarter on a year-over-year basis.

Okay. Thank you.

So was deferred revenue.

Your next question comes from the line of Bill Shope with JPMorgan. Please proceed with your question.

Thanks. Is there any way you guys can help us quantify your exposure to financial services as a percentage of revenue for this quarter and how that compares to your exposure in the past?

I don't think we've done the math this quarter to be honest with you. We did the bookings number and not necessarily the revenue number. Financial services in the mix? I would have to get back to you. I don't have it.

I don't have it in front of me either.

Any sort of rank order versus other verticals? Is it one of your top two, top three verticals?

Typically it has always been number two in the mix. If you add all tech together, that is generally still number one, somewhere in the high to mid teens, and financial services is right behind it typically in the 14, 15% range and the federal at the 10 to 12, and my guess is that the financial services this quarter, is closer by 12 or 13, it's down a couple percent.

That helps. Then quick question on working capital management. Not sure if you guys touched on this, but your payables came down quite a bit this quarter. Was there any supply chain hiccup here or is this just -- is there something else driving that?

No. Just the, basically the normal timing cut off and whatnot and when the paychecks get cut and go out, so that's going to fluctuate a little bit each quarter so there is nothing unusual going on there.

Thank you.

Please hold for your next question. Your next question comes from the line of Kevin Hunt with Thomas Weisel Partners. Please proceed with your question.

Thank you. I wanted to clarify, I think, Steve, you had said something about the gross margin going down from a change in the IBM mix. I didn't hear if it was decreasing or increasing and I just wanted to understand why it was changing, if it is, whatever direction it is going.

IBM receives larger discounts in general. Therefore we recognize lower gross margins from a transaction through IBM. It also has got lower expense structure. If you look at operating income, it is pretty neutral, but on the gross margin side it has lower gross margins than any other channel we work with.

Next quarter in Dan's commentary he mentioned that we're expecting to see IBM step up their business level with us because it is their December quarter, and there is always a strong quarter for them, so they're going to increase as a percent of mix but the impact they have on gross margins.

I just misheard you. I didn't hear if you said increase or decrease. That's it. Thanks.

Okay.

(OPERATOR INSTRUCTIONS) Your next question is from the line of Shebly Seyrafi with Caris. Please proceed with your question.

Thank you. I think some of the bearers on your stock may make light of the fact that your deferred revenue growth of 6% sequentially was less than your 15% overall revenue growth and they may say that you drained the backlog to hit your number or beat the expectations. I just want to see what you have in terms of visibility to guide the way you're guiding which is quite aggressive. You talked so far about strength in Europe. I am wondering if the federal strength is continuing. Maybe you can elaborate on why you're so confident and why you're providing such good guidance.

Shebly, this is Dan. I will reiterate what I said in my opening remarks. We have a comfortable backlog. That backlog is largely product backlog as well as professional services. Those are items we can convert to revenue this quarter. We have a very healthy pipeline of sales activity, and assuming that something doesn't happen in a changed sense in terms of macroeconomic, we will convert a normal piece of that pipeline into bookings and therefore revenues this quarter. The problem with predicting the future is it hasn't happened yet, and we're forecasting based on what we see as our current situation and the order pipeline that we're looking at. Assuming nothing material changes, we should see a performance consistent with the forecast we gave you.

Now, that said, in Q3 we generally see Europe up in the mix, federal drops off. Our Q2 contains the end of the federal fiscal year in September, and that's why they surge. They do in fact have a year-end buying phenomena. That will not recur in Q3. But we factor all those things into the guidance we gave you. Our expectation is that unless something dramatic changes in the global economies, we will be able to meet those expectations.

I am just trying a find a list of drivers, Europe being one, FAS2000 uptake perhaps being another, can you just continue the list of drivers guiding, leading you into this guidance?

I believe that next quarter's growth rate will be consistent with this quarter's growth rate, and it will come from a different set of drivers than what we had this quarter. That's all I can tell you. We're looking at a bunch of large numbers meaning large pipeline activity, et cetera, and trying to factor that down to what we think is the most likely revenue outcome. I would not if I were you try to get too granular about going underneath that in any particular form.

Okay. Thanks.

Your next question is from the line of Kaushik Roy with Pacific Growth. Please proceed with your question.

Congratulations on the snap back in operating margin, and you're guiding 15 to 15.5 in Q3, but is that your new target going forward or can we still expect 15.8 to 16.4? Is that your long-term target for operating margin?

Our long-term operating margin target has not changed. It is still 15.8 to 16.4.

So maybe starting Q4 onwards you can get to that level or--?

Well, we'll let you know next quarter when we guide to Q4.

Fair enough. Thanks.

Your next question comes from the line of Katie Huberty with Morgan Stanley. Please proceed with your question.

Hi, there. Great quarter, guys. If we believe some of what the economists are saying on Wall Street now, there is a risk of a full blown U.S. recession over the next couple of quarters, so can you just talk about some of the levers you have and are willing to pull in order to sustain earnings growth in that scenario and specifically are you willing to step up share repurchases even more and/or start to think about cutting direct salesforce head count?

I will not cut direct salesforce headcount unless I see a real collapse in the opportunity out there. We're all about growth. We're going to try to find it any way we can get it. All you have to do is look back on our performance in 2001 to figure out what our strategy is going to be. If there is a collapse in the general economy, we'll resize the Company appropriately and keep the emphasis on growing our top line. Gaining share and pressing forward. I don't expect us to increase the share buyback. This particular quarter it was particularly aggressive, and I don't think we'll be doing that at that kind of rate again in the near future, so we've got the traditional levers, right, drive for revenue growth is objective number one in all quarters.

To build on Dan's point, we convert that incremental revenue at a pretty high rate to operating profit and to the fund of operating expenses, so it's all about growth here because the combination of margin and growth is what drives this engine.

Thanks.

Your next question comes from the line of Bill Choi with Jefferies. Please proceed with your question.

Thank you. Just some clarification on the pricing action. Is that limited to the low end 2000? Have you introduced the new products or has that been -- the pricing action extended to FAS3000 and 6000 and when we look at terms of product gross margins going forward your guidance suggests that product gross margins could fall below 60%. Can you help us think about either product gross margins specifically going forward or overall gross margins over kind of the fiscal '09 timeframe? And then I have a follow-up?

I think you have a problem with your math. Product gross margins don't fall below 60 in any scenario that we've ever forecasted. Product gross margins right now are what, 65, 66%, and should be coming down -- even higher than that, they should be coming down a couple points, so I encourage you to recheck your math on that one. In answer to the repricing, when you reprice some systems, there is spillover effect to others, disk price as a for instance, expansion shelves, whatever it may be, and therefore we have over 1,000 products in the product line, right, and they're all knitted together to form a particular system, so there will be ricochets into all kinds of other things. The 2020 and the 2050 were priced appropriately going to market. Those are brand new. Those didn't have to be touched. A lot of software products were moved around. Disk prices were moved around, a variety of other things like that.

To build on Dan's point, we're coming off two quarters here, this one and the previous one where our product margins are record highs over the past five years, so we have room to move, and we're taking advantage of that to spur some growth in some of the segments Dan was alluding to earlier.

Okay. I guess I was thinking very specifically to the product hardware which--?

Our product gross margins this quarter were 67.6% which were higher than any quarter in fiscal year '07.

Okay. I have another follow-up, then. On the two-tier distribution model, it was very strong, probably the highest it has been as a percent of total revenue. Can you just talk about level of inventory, whether you believe that sell through will be there or what kind of inventory levels you should be looking at for that segment?

We don't have any stocking in the channel whatsoever. There is no inventory out there. Everything is build to order. The flow is from a reseller right on through our two tier partner if there is one in the mix, like Aero and AvNet right into our order processing, and we ship it out.

On accounting parlance we're on a sell-to model.

Okay. Thanks.

Your next question is a follow-up from the line of Dan Renouard with Robert Baird. Please proceed with your question.

Hi. Can you guys talk a little bit about head count and how you're planning to grow the business? You're obviously coming out of the July quarter you had cut back on head count and that showed up this quarter, and then going forward you were talking about 300 plus heads which would be from the hiring over the last 60 or 90 days. Should we be expecting that level of head count additions for the January quarter somewhere on the order of 300 plus or minus? Is that reasonable for us to assume?

No, Dan, I would hold off on that. We're right now from a control standpoint, we think we can afford the 300 to 350 next quarter and achieve the guidance we gave you. Again, we haven't projected what the next quarter after that or out quarters are going to look like, and if we knew that, we would have a better handle on it and probably give you some interpretation of what we might do, but right now let's just see how it goes. We stand ready to respond to the economic conditions in our growth rate.

Okay. Thank you.

You bet.

There are no further questions at this time. I would now like it turn the call back over to management.

Thank you very much for joining us this afternoon. We look forward to having you join us again on February 13, of 2008, as we report the results for our fiscal third quarter. Have a wonderful holiday season, everybody. Take care.

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect.