NetApp Inc (NTAP) 2008 Q4 法說會逐字稿

Good day, ladies and gentlemen.

Welcome to the fourth quarter 2008 NetApp earnings conference call.

I'll be your coordinator for today.

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) As a reminder, this conference is being recorded for replay purposes.

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

Please proceed.

Good afternoon, everyone.

Thank you for joining us today.

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

In the course of today's call we will make forward-looking statements and projections that involve risk and uncertainty including statements about our intent to continue to grow our sales capacity, our projections regarding our First Quarter and first half fiscal 2009 financial results including our revenues, margins and earnings, our expectations regarding future revenues from the IBM channel, our expectations regarding Data On Tap GX and our future releases of Data On Tap, our expectations that we will continue to hire and our expectations that we will achieve our previously announced fiscal 2009 financial goals.

Actual results may differ materially from our statements and 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, any decline in general economic conditions.

Other equally important factors are detailed in our accompanying press release, as well as our 10-K and 10-Q reports on file with the SEC and also available through our website.

All of these factors are Incorporated by reference in today's discussion.

With me on today's call are Dan Warmenhoven, our CEO; our President and Chief Operating Officer, Tom Georgens; our CFO Steve Gomo; and our Vice Chairman, Tom Mendoza.

Steve will review the fourth quarter FY '08 financials and targets for the FY '09.

Tom will discuss our Operations, Dan will share his thoughts and then we'll wrap up with Q&A.

At this point, I'll turn the call over to Steve.

Thanks, Tara.

Good afternoon, everybody.

NetApp delivered solid results again this quarter with record levels of cash generated from operations.

As I walk through the commentary on our financials please note that all numbers are GAAP unless stated otherwise.

See the reconciling items between non-GAAP and GAAP, refer to the table in our press release and our website.

Total revenue for the fourth quarter was $938 million, up 6% sequentially and up 17% over the fourth quarter of last year.

Foreign currency effects aided sequential growth by 0.5 a percentage point and improved the year-over-year growth rate by 3.8 percentage points.

Revenue for the full 2008 fiscal year was $3.3 billion, up 18% over FY '07.

Product revenue of $630 million was up 4% sequentially and up 7% year-over-year, accounting for 67% of total revenue.

Add-on software which is a subset of product revenue was about 23% of total revenue this quarter down slightly in the mix from last quarter.

The combination of an increase in channel business and an increase in the mix of low end products drove this effect.

Revenue from software entitlements and maintenance was $136 million or 15% of total revenue.

Software ENM continues to grow nicely up 9% sequentially and 37% year-over-year.

The combined total of add-on software and software ENM was 38% compared to 40% in Q3 and 40% in Q4 of last year.

Revenue from services which includes hardware support, professional services, and educational services was 18% of total revenue, up 14% sequentially and up 51% over Q4 of last year.

Service maintenance contracts increased 11% sequentially and 52% year-over-year, professional services increased 23% sequentially and 55% year-over-year.

Non-GAAP gross margins were 62.2% of revenue this quarter, up 0.2 of a percent from last quarter.

Non-GAAP product gross margins were up 0.6 of a point sequentially to 60.4%.

Non-GAAP software ENM margins were up 0.5 point to 98.5 while non-GAAP service margins declined by 0.7 of a percent and in the quarter at just under 40%.

In the First Quarter, we will be implementing a recording format change for the way we reflect warranty costs in the gross margin section of our income statement.

Going forward, our warranty costs will be moved from service cost of goods sold where we have historically recorded them to the product goods, to the product cost of goods sold area.

The change will have zero net impact on total cost of goods sold and total gross margins but will simply shift dollars between product and service margins.

Had this change has been made this quarter, non-GAAP product margins would have decreased by about 1 percentage point while service margins would have increased by about 5 percentage points.

Again, this reporting change will not affect total gross margins and it will not impact any other aspects of our financial statement.

Turning to non-GAAP expenses, our operating expenses totaled $437 million or 46.6% of revenue.

These expenses increased 9% sequentially and 17% year-over-year.

The largest sequential spending increase was in sales and marketing as a result of our increase in sales capacity, our brand and awareness investment, and services hiring.

During the quarter, headcount increased 522 people on a net basis ending the quarter with 7645 employees.

Going forward, our investment in operating expense will continue to emphasize sales coverage to enable us to grow faster.

GAAP operating expense includes the effect of prior period merger related costs such as the amortization of intangibles from acquisition and the effects of FAS 123R.

Non-GAAP income from operations totaled $147 million or 15.6% of revenue in Q4.

It's worth noting that the non-GAAP operating margin for the second half of FY '08 was 16.1% and within our target range.

Other income which consists primarily of interest income was $12 million in the fourth quarter, non-GAAP income before tax was $158 [billion] or 16.9% of revenue.

Our non-GAAP effective tax rate remains at 17.5%.

Non-GAAP net income totaled $131 million or $0.38 per share.

GAAP net income totaled $90 million or $0.26 per share.

Now I'd like to highlight our cash flow performance.

The combination of strong profit, a large increase in deferred revenue, and focused receivables management generated record results.

Our cash from operations was a record $293 million, up 2% sequentially and up 39% over Q4 of last year.

Capital expenditures were $63 million this quarter.

We define free cash flow as cash from operations less capital expenditures so free cash flow totaled $230 million down 1% sequentially and up 46% over Q4 of last year.

Expressed as a percent of revenue, Q4 free cash flow was 24.5%, above our average of 23% for the last two fiscal years.

Turning to the balance sheet, our cash and investments totaled $1.16 billion, an increase of about $37 million over last quarter.

This balance excludes approximately $243 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.

It also excludes about $73 million of auction rate securities which have been reclassified from short-term to long term investments.

During the quarter we paid off the final $29 million of debt related to our cash repatriation two years ago and removed the associated restriction on $63 million of cash.

The debt associated with our credit facility is $173 million and is classified entirely as a long term liability.

We continued to buyback stock this quarter, repurchasing a total of 2.9 million shares at an average price of $20.86 for a total outlay of $59.4 million.

Over the course of this fiscal year, NetApp has spent about $903 million to repurchase about 33 million shares.

There's approximately $497 million remaining in our stock repurchase authorization.

Turning to DSOs, accounts receivable DSO, day sales outstanding, were 56 days compared to 48 days last quarter and 62 days in Q4 of last year.

Last years Q4 DSO was recalculated to include the reclassification of $43 million worth of sales tax from accounts receivable to other current assets.

Inventory turns were 20.3 times this quarter, down from the record 22.5 times achieved in Q3 but nonetheless a very solid number.

The total deferred revenue balance increased $169 million this quarter to $1.51 billion, a 13% sequential increase and a 37% increase in the balance year-over-year.

Before I turn the call over to Tom, I'll discuss our target operating model for Q1.

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

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

Actual results may differ materially from our statements or projections for the reasons cited previously.

At our Analyst Day in March, we said we expected Q1 revenue to decline from Q4 by between 5 and 10%.

This equated to a range of $837 million to $883 million, which was calculated from the mid point of our Q4 revenue guidance of $930 million.

We've narrowed that guidance range modestly revising our First Quarter target range to 845 million to $875 million.

You'll notice that the mid point of Q1, of the Q1 range remains unchanged from what we said at Analyst Day, and it is consistent with our full year FY '09 forecast.

Also consistent with our Analyst Day discussion, we expect non-GAAP gross margins to be approximately 61% for the full fiscal year including the First Quarter.

We also indicated that we expect our non-GAAP operating margin to average 11% in the first half of FY '09.

This is still our plan.

With the timing of our investments in headcount overlaid with our quarterly revenue profile the First Quarter will be below 11% and the Second Quarter is expected to be above 11%.

Q1 operating margins are planned to be between 9 and 10%.

That said, we're anticipating that these front half investments will begin to generate revenue in the second half of the fiscal year.

We therefore remain confident that we will execute on our Analyst Day target for average second half operating margins of 16%.

For Q1, non-GAAP EPS is expected to be approximately $0.20 to $0.23 with GAAP EPS between $0.09 and $0.13.

Our diluted share count is expected to increase by about 3 million shares in the First Quarter depending on stock price.

For the full year 2009 our expectations for revenue remain between 3.79 billion and $3.95 billion and non-GAAP earnings per share estimates remain at approximately $1.40 to $ 1.46.

GAAP earnings per share should finish between $0.92 and $0.98.

Now with that I'll turn the call over to Tom for an update on our operations.

Thanks, Steve.

As our financial results highlight, NetApp posted a strong finish to the year.

Feedback from customers reinforces that we provide them with the most comprehensive storage and data management solutions with the lowest cost of ownership.

Our value proposition is the most compelling in our history and we are making good progress in selling our solutions to a broader set of customers.

As we outlined at our Analyst Day in March, our highest priority item remains diversifying our revenue streams.

To this end, significant effort is being focused on expanding our customer base, especially our presence within the storage 5,000 which is what we call the 5,000 largest buyers of storage in the world.

We divide the storage 5,000 into three categories.

Highly penetrated accounts, under penetrated accounts, and new to NetApp accounts.

I'm pleased to report that business from under penetrated accounts grew 35% sequentially in Q4.

We finished the year with over 100 net new to NetApp Storage 5,000 customers and a couple thousand new mid size enterprise customers.

Geographically, Europe continues to out pace the other regions growing 20% over Q4 of last year, contributing 35% of revenue again this quarter.

Asia Pac pulled back to 10% of total revenue, up 16% year-over-year but down from its record Q3 performance.

The Americas grew 12% sequentially, to 55% of revenue despite our top enterprise accounts being down modestly during the quarter.

Our diversification efforts are starting to have significant impact since excluding our top enterprise accounts, our U.S.

commercial accounts grew 16% sequentially.

The Federal group was also strong contributing 11% of total revenue.

Another positive indicator of our revenue diversification is our channel business.

The investments and programs we've implemented in the channel over the past two quarters again drove increased business through our partners.

64% of total revenue came through indirect sources.

We're pleased to see our indirect channel continue to out pace our overall growth as a means of getting valuable, sustainable leverage from our partners.

Arrow and Avnet had another record quarter growing to 18% of total revenue.

IBM was below 5% this quarter reflecting a seasonally lighter first fiscal quarter.

For the full fiscal year, IBM contributed over 4% of revenue and brought us into more than 900 new to NetApp accounts.

As we highlighted at our Analyst Day, we expect IBM to grow to 6% of total revenue in fiscal year '09.

Units shipped remain robust with a 17% sequential increase, and the third consecutive quarter of double digit sequential unit growth.

While our high end and mid range unit accounts both increased and the mid range still represents over 50% of our systems revenue, the low end has been particularly strong.

Entry level unit shipments increased 33% sequentially and 67% over Q4 of last year.

This acceleration is due to a continuous stream of product introductions throughout the fiscal year, as well as a concerted effort to enable our channel partners.

We spoke in prior calls about the investments we were making in channel programs in this segment.

The acceleration of our unit counts, new customer acquisition, and proportion of channel business are all positive indicators of our progress.

Despite these investments and a measurable shift in our product mix towards low end systems with lower initial software attach rate, we have maintained our solid gross margins.

Our SAN presence continues to expand as bookings included a fibre-channel and/or an iSCSI component rose to a record 47% of our storage business this quarter.

The 34% including fibre-channel and 17% including iSCSI.

Our SAN business also got a big tail wind in the third quarter with the Storage Performance Council's independent benchmark proving that NetApp's FAS 3,000 SAN performance is significantly better than the comparable EMC CLARiiON product especially when the premium software features are enabled.

It should be noted that our rapid growth in SAN is not necessarily indicative of a major shift in product mix but rather it is evidence of broader customer adoption of unified storage, the ability to simultaneously support SAN and NAS protocols.

NetApp is the only vendor to support unified storage across our entire spectrum of platforms.

Despite the strength of SAN, NAS protocols were still present on 67% of our storage bookings.

Total petabytes increased 16% sequentially and marks our First Quarter shipping over 200 petabytes.

The shift towards cheaper, higher capacity ATA drives continues as customers seek denser, greener and more cost effective solutions, while archiving and disc based back up are major drivers, technologies like our RAIN BP enable the use of SATA drives in primary storage applications without sacrificing reliability.

One of the most compelling areas of NetApp innovation over the past few years has been the storage efficiency features we've brought to market.

Technologies like thin provisioning, efficient replication, zero space cloning of data sets, and Deduplication help customers take significant costs out of their environment while at the same time taking advantage of our unique and comprehensive data management functionality.

In terms of de Deduplication indication, with over 6,000 systems actively running deduplication on over 100 petabytes of physical storage we believe we have the largest installed base in the industry.

While back up and to some extent archival are significant drivers of this technology, NetApp is the only enterprise vendor that supports and widely deploys dedup on primary storage in production environments.

The question of storage efficiency and its impact on the growth of the storage market is as old as the industry itself.

We have heard this argument with ATA drives, cloning, and thin provisioning where we pioneered these technologies years ago, but growth remained robust in the subsequent periods.

Arguably deduplication is different because of its unprecedented adoption and applicability to our existing installed base; however the industry has repeatedly proven that demand is elastic and reducing the cost per bit of storage generates increased long term demand.

NetApp intends to continue to innovate and promote storage efficiency technologies as a vehicle to gains share, cultivate customer loyalty, and expand our addressable market.

Our platform for future innovation continues to progress well, while still small, sales of our GS platform grew 75% over fiscal year '07.

Although GX is typically focused on performance and archiving environments, we are also experiencing expansion into more traditional verticals such as financial services.

Q4, we did indeed announce our latest version of -- our latest energy version of Data On Tap and there will be one more release of GX coming soon, then all subsequent major releases of Data On Tap will be based on the converged energy and GX platforms, an integration that is already under way, with specific emphasis on a nearly transparent upgrade path.

We continue to see the data set of transformation due to server virtualization as a significant growth driver for NetApp.

The map of the matter of rearchitecting to deploy virtualized environments combined with the need to think end-to-end about servers, networks and storage to realize its full benefits creating a cleaner sheet of paper as IT professionals have seen in a long time.

This creates an enormous advantage to those vendors who can enable and accelerate the success of these projects while rendering vulnerable the legacy incumbent solutions that are not particularly well suited for virtualized environments.

While industry data is hard to find our internal data indicates that server virtualization projects are a primary entry point for us into new accounts and within existing accounts our attach rate to servers running VMWare is growing at a very high rate.

Not only are our customers shifting their have WMWork loads to their NetApp storage we're also winning new deals for deployment of our systems into newly virtualized environments.

As you can see, our efforts to grow and diversify our business continue at a brisk rate.

We have focused on growing our footprint in the Storage 5,000 and innovating to remain the visionary leader of the storage market.

I believe we have a huge opportunity in front of us and we will continue to drive hard towards capitalizing on it.

I look forward to updating you on our progress in August, but before I wrap up, I'll turn the call over to Dan for his remarks.

Dan?

Thanks, Tom.

And my thanks to all of you for joining us today.

In spite of the slowdown in the U.S.

economy and the sluggishness of the economy, the NetApp team finished the year very strongly.

We expect to keep the momentum going into the New Year and our forecasted revenue level in Q1 of fiscal year 2009 reflects a 23% to 27% increase over Q1 of this past year.

Both our revenue and operating margin forecast for the upcoming quarter are consistent with the guidance we provided in March at our annual Analyst meeting.

Fortunately, it appears we did not effectively communicate our operating margin outlook with the guidance we provided in March of 11% operating margin in the first half of fiscal year 2009 is not reflected in the current estimates published by the sell-side analysts.

Our expectations for fiscal year 2009 have not changed since our Analyst meeting.

What we attempted to articulate at the March meeting was that we believe we have an opportunity to gain share.

We intend to invest in sales capacity and coverage to seize that opportunity.

Over time there are instructions that cause IT professionals to completely rethink how they support their business.

We saw one of those disruptions after the bubble burst in 2001 when suddenly customers were scrambling to gain efficiencies and dramatically reduce the cost of their infrastructure.

Our value proposition was and is right in that sweet spot.

In the aftermath of 2001, NetApp enjoyed several years of 30% plus growth as we capitalized on an economic downturn.

At the same time we continue to invest in innovation and to rapidly bring to market the most compelling solutions with the best value.

Our goal is to help customers do more with less and they resonated with that value proposition and chose NetApp.

Today I believe we have a similar economic situation and we have the right arsenal of solutions to capitalize on two broad trends that are racing through the IT world today.

The first is server virtualization and it's being deployed with an amazing speed around the world.

NetApp offers the optimum solution for virtualized server environments and the best at virtualized storage infrastructure in the industry so we cannot afford to wait.

We must seize the opportunity now but we are hiring salespeople now while the opportunity is all around us.

The second major trend is back up redesigns.

With the explosion in the volume of data and shrinking back up windows, customers are facing huge challenges for protecting their data.

In many cases that problem is exacerbated by the virtualized server infrastructure they implemented to increase their efficiency.

More and more customers are choosing to use this opportunity to upgrade their back up infrastructure and move away from tape.

NetApp provides the most compelling back up and data protection solutions in the industry to solve these customer requirements.

Above all the macroeconomic sluggishness in the U.S.

causes customers to rethink their big expensive solutions from traditional vendors and move to modular virtual storage that takes up far less physical space and requires less power to operate and less manpower to manage.

Given our current situation, we intend to invest in increasing sales coverage through more quota bearing salespeople or direct salespeople, more of those who will assist the direct partners and we intend to invest in awareness so that more potential customers consider NetApp to solve their needs.

Because our win rates are higher when we get considered but we need to get considered more often.

That said, I should also point out much of that investment was made in the quarter we just completed.

In the past quarter our total expenses grew at almost 9% over the prior quarter.

On the upcoming Q1, we expect expenses to grow around 3% sequentially.

We will balance this investment with a committment to return to a 16% average operating margin in the second half of fiscal year '09.

With the momentum Tom described, NetApp is certainly on track to achieve the fiscal year '09 financial goals we set at our Analyst Day and with the investments we're making I look forward to return at even higher growth rates in the future.

On behalf of the entire NetApp team I thank you for your support and your interest in NetApp.

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

As is our practice, please limit yourself to one question and then return to the queue so we may address everyone in the allotted time.

Operator?

(OPERATOR INSTRUCTIONS) Your first question will come from the line of Keith Bachman from Bank of Montreal.

Please proceed.

Hi, guys, thanks for taking my questions.

In the interest of keeping it to one question I wanted to focus on Asia Pac, Dan, I think you or Steve had said it slowed down a little bit.

Interesting HP last night had shown some slowdown in Asia Pac too.

Was just wondering if you could add a little color into what you're seeing in that particular region?

Thank you.

Hi, this is Dan.

The region is not uniform.

We see it kind of broken up by country by subregion.

I should point out that the 10% of revenue that came from Asia Pac in this quarter is exactly the same per certainty age we've had in each of the two prior fiscal years in Q4 so I'm not sure you can make any pattern recognition out of it here.

For us in particular, both Japan and China have been kind of slow on especially a year-over-year basis, and we see real strength in Australia, India, and Asia.

So it's not mixed.

It's not the uniform but it's quite mixed.

And so Dan if I could just push you a little bit, was there any kind of difference in linearity in Asia Pac and/or how do you think about it for the upcoming quarter if I could?

Asia looked like a traditional Q4 for us so it was consistent in terms of linearity and patterns of prior Q4's and with the rest of the world and they grew in a mix, they had a pretty good run through Q1 through Q3, I think up to 13% of the mix.

I expect it to bounce back.

We seem to have seasonality in Asia Pac just like we do in Europe which is traditionally strong in our Q3.

Asia Pac was weak in Q4 and I think we'll see it bounce back in the upcoming quarter.

Your next question will come from the line of Min Park with Goldman Sachs.

Yes, thank you.

Some of the investment strategy you outlined in your Analyst Day it seems that a number of your competitors are also bulking up on sales and marketing to grow after the higher growth segments, such as SMB and emerging markets.

So to what extent are you beginning to see heightened competition in the field and how do you think it will play out on the pricing side?

Well, the competition is intense and it's been intense and I'm sure it will remain intense, but I don't really see it as a dynamic being any different.

If you look at our gross margins, you look at our win rates I think we feel very very confident about where we are.

I still believe that our issue is less whether we win or not and the price at which we win because I think those remain robust so we just need to get ourselves into more deals so we can transfer our win rate into more opportunities.

So overall, I don't think that anything is really any different.

I don't want to say it's benign out there, it's competitive but I don't think it's any different today than it was a year ago.

Thank you.

Your next question will come from the line of Clay Sumner from FBR.

Please proceed.

Thank you very much.

Dan, this time last year, you opened the call or maybe it was Steve saying that you guys did not build at that time the normal seasonal level of backlog and that as a result the July quarter was going to be a bit below normal.

Just curious if you saw any similar challenges in this years Q4 or are you better positioned this year with respect to more normal backlog?

We're in the more normal backlog position, we feel pretty comfortable and that's all reflected in the guidance.

Great.

Thank you.

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

Yes, thanks for taking the question.

I guess I want to dive into some of the balance sheet and cash flow metrics a little bit.

In particular, the inventory was up quite a bit sequentially quite a bit, and would love to understand what's going on in the drivers behind that, and then also on the DSO, also kind of the highest level we've seen in a little while.

Can you talk about linearity in the quarter and how should we think about DSO trending as we look into fiscal '09?

So this is Steve here.

So our fourth quarter had basically the normal seasonality for fourth quarter virtually the same as we saw a year ago and the year before that, so it's very back end loaded like all of our fourth quarters are.

That helps explain the inventory a little bit because we make sure that we have plenty of parts and sub assembly sitting around to fill those orders at the end of the quarter and if we over shoot a little bit we don't really care.

We just want to make sure that we can satisfy customer demand.

As far as the accounts receivable are concerned, if you go back a year ago, our DSO was about 62 days so actually DSO performed extremely well.

Our collections were basically off the chart this quarter and the currency of our accounts receivable is at all times record high.

Right, I understand that but if I look at the inventory over the last few years, I mean inventory has either been flat to down at the end of the April quarter relative to a 17% sequential increase so I guess I'm wondering, was there a change in terms of the order patterns that supported what appears to be a little bit of a sharper increase than what we have typically seen?

So if you look at by contrast though, the 22.5 inventory turns we had last quarter was an all-time record for us as a Company.

So at the current inventory turns level above 20 it's actually higher than in two prior quarters last quarter, so I still think that the inventory position is actually in pretty good shape.

So I wouldn't indicate that that is a sign of unsold product or anything like that.

I think that a number over 20 is pretty darn good in this industry and we've only done two of the last four quarters.

Thanks, guys.

Your next question will come from the line of Tom Curlin with RBC.

Can you walk us through what's happening with add-on software and maybe to some degree the other software category in terms of the software?

It seems like that's decelerating year-over-year.

Is that driven by the mix of high end versus low end business or pricing strategies?

Just what's happening with that stuff?

Okay, so I didn't quite get all of that question.

You were a little soft but I think the question was about software and software attach rates.

Well, just I guess to get real specific, the add-on software category is decelerating year-over-year last couple of quarters and it was I believe down a little bit year-over-year this quarter.

Yes, I think there's a couple of factors that are at play there in terms of the add-on software.

I think part of it is the product mix, moving to the low end, part of it is the way we bundle hardware and software in some of our low end pricing, in terms of how we put our low end bundle together.

So I think there's a number of factors that as a result of our product mix and the strength of the volume of our low end platforms, that is having some impact in terms of how we report that data but overall, gross margins are really solid.

Unit growth is really solid and those are things that we really look to.

How we price our add-on software and how we bundle it and how we break it out could be impacted by the overall mix change but as we look at our attach rates overall, across all of our platforms, those are still quite good.

This is Dan.

Just to underscore what Tom said, we find an interesting deviation I guess you'd say in how the systems evolve after they're deployed.

At the very high end our systems are generally purchased for one specific application and they don't evolve to add-on others.

As you move down towards the low end, customer may buy one specific application but then over time they add-on more software and expand its configuration in place.

Then as they become more general purpose in their deployment over time.

So as the mix moves to the low end, you would expect over time that our add-on software would increase but the amount configured in at the point-of-sale would actually decline.

Okay, thanks very much.

Your next question will come from the line of Katie Huberty with Morgan Stanley.

Thanks, good evening.

Steve, given the strength at the low end of the business and the shift to the channel, can you help us better understand how gross margins were flat over the last couple of quarters?

What were the positive influences?

Well, I think the spending and the manufacturing areas obviously been well controlled.

Variances are running as planned.

There's no unusual things happening there, and the pricing environment is pretty much what we anticipated and modeled, and as Tom pointed out there's no surprises there, so those are some of the big elements that drive this.

Unlike servers I should point out, the server business has the characteristic of the smaller the machine the lower gross margin, the bigger the machine the higher gross margin and that is not the case here because of the amount of storage which gets configured into those systems.

Our gross margins across the low end to the high end of the product line are remarkably similar.

If anything, our largest configurations whether maximally configured at the 6,000 end can have lower gross margins than the low end.

If I could just pile on to that one as well, in prior calls, we actually talked about our efforts to expand our channels and expand our coverage in the low end of the market and we actually gave some indication that you start to see some impact on our gross margin as a result of both channel programs and the mix, and one of the reasons why we emphasize that in this call is we've been particularly pleased we've been able to drive very very high volumes there and we haven't really lost anything at all on the gross margin line.

I think we've been pretty pleased with that.

I think the that that MSE or mid size enterprise or commercial sector, whatever you want to call it I think has been robust not only for ourselves but some of our competition and I think now that we've got the right products and the right programs we've been able to go at that much more aggressively than we did in the past and we've done it without sacrificing our gross margin.

Your next question will come from the line of Scott Craig with Banc of America.

Hi, thanks, good afternoon.

Just a question around the headcount.

Sorry if I missed this, so from a clarification standpoint, how many people are we looking at adding next quarter and then as a follow-on to that, when I look at the productivity metrics and I realize this is a pretty crude productivity metrics but if I look at revenue per employee, it really hasn't been growing probably over the past few years, and to me that would seem to be an easy way to get some leverage through the model from an expense standpoint, so is there anything being done to address the productivity side of things and how do you guys actually view the productivity metrics from an internal basis because all we see is really high level numbers?

Thanks.

So I shared the high level numbers with the employee population every quarter and we do it specifically as revenue per employee, take the revenue for the quarter divide it by ending regular headcount and I would beg to differ with you.

My chart that I'm going to put up on the wall tomorrow in front of all employees shows that this past quarter we achieved at least a four year, I haven't got back any further but four year record, and the revenue per employee trends up every quarter during this fiscal year.

So I don't accept the premise of the question.

The other answer is that we expect to hire between 500 and 600 people in the upcoming quarter.

Your next question will come from the line of Ben Reitzes with Lehman Brothers.

Yes, thanks.

Good afternoon.

Dan, just wanted some more dynamics on two issues.

First, you mentioned the sluggish economy in the U.S.

so if you could just kind of talk about what you're seeing in the U.S.

especially as you go into the next quarter, is there something that makes you incrementally concerned on the revenue side and in terms of that growth rate, and characterize that obviously HP last night saw slowing in the U.S.

so it's no surprise but just any more dynamics?

And then just on the HP front, I mean they've been able to grow in the mid range storage 17% last night and in that range, for several quarters, your product revenue, I know it's not apples-to-apples has decelerated depending on how you look at it on your P&L and it's gone down each quarter on the product side on the income statement, but I was just wondering if anything changed competitively as well in addition to the U.S.

question?

How many questions would you like me to answer or maybe I should rephrase, which question would you like me to answer?

Dan, if you can do both, it would be great.

Okay, I'll take the first one.

In the U.S., in particular, no, we don't see any change in the overall economic condition.

I mean sure the background noise that we had in March was probably more negative than the background noise you hear now.

People were expecting we're already in a recession and I think the subsequent GDP data shows that we're not.

So maybe there's a slightly better attitude on the part of the customer community but not enough to be material.

We anticipated that the forecast for the international monetary fund published in March or in late February probably would be the one that would be the scenario that would probably prevail which is that the U.S.

would go into a very slow growth mode or very minor recession mode like 1 or 2% contraction in the first half of the year and then come out stronger in the second half and that appears to be now what the overall scenario looks like.

That was the backdrop for our revenue forecast and I think we're feeling like that's still tracking to plan.

Your next question will come from the line of Bill Fearnley with FTN Midwest.

Good afternoon, guys.

Could you guys provide some more color on the competitive win rates?

Is there any difference here between the larger and the smaller competitors and as importantly, are you seeing anything change here with the decision cycles, what did you see in the last quarter and how does that color your view towards the upcoming quarter, the decision cycle?

Is there any lengthening there?

This is Dan.

We don't see any particular change in overall competition.

Certainly, some of the ones that in the newer categories like the virtual tape category for instance has got more players so that's a newly emerging category and there's lots of players trying to gain share, you just saw some other moves by one of our largest competitors literally today.

So but with the exception of a lot of what I would consider to be fairly new segments, the core markets have stayed reasonably constant over time and I don't think the win rates have changed significantly either.

And even that's independent of which category you're looking at by price band for instance.

The share positions in this arena move very very slowly and depending on the data we'll share on the lower end price points of the 2000 family here recently, but nothing very material in terms of the overall change.

We're talking about share changes per year of 1% or so among the various vendors.

The only market that we saw the slowdown that we comment on Analyst Day was financial services and everyone has seen that and I think the decision-making there is about what we expected though.

I actually think they're starting to get a handle on where they're at and starting to move forward a little better than they were before.

I think they froze for a little bit because they weren't sure what they were seeing but our activity levels have remained exactly what we expected and I also think the partnerships that we have with various solution vendors like SAP, Oracle, Microsoft and VMWare are helping us because around those solutions, as long as it's solving a problem people are still moving forward.

It's just basic infrastructure stuff especially in the financial sector, I think was slowed down but we saw that and anticipated it and forecasted it.

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

Thanks.

Wanted to come back to the software question.

This time looking at deferreds that slowed somewhat materially over the past couple of quarters.

Is that a lagging indicator or a leading indicator of your business and what are your expectations for deferred going forward?

Should those improve as some of those units you put out there start to buy more software?

Thanks.

Hi, Chris, it's Steve here.

Yes, as I've mentioned I think several times, deferred is going to grow at a rate relative to the overall growth rate of the Company, and as the Company's growth rate has slowed from the mid 30s to roughly the 20% level, so too has deferred slowed and that's why the growth rate in deferred is this quarter we reported what, 39% growth instead of something in the 50s or something in the high 40s.

So I think that if the growth rate of the Company and our business level were to come back and we were to grow say in the mid 20s or 30s, you'd see those deferreds grow right back up there and start poking through the 40s and perhaps as high as the 50 levels again.

One other data point that I want to put out there too so that when you talk about software growth and hardware growth, there's a combination of factors.

There's new units sold and there's also upgrade activity and in the past two quarters we've seen a very very robust growth in the amount of new units sold.

So when I think about the underlying health of the business, the amount of new units that we're putting out there is a proxy for a bunch of things, it's a proxy for new customer acquisitions and it's also target for future sales of professional services, software upgrade, extended service contract, et cetera, et cetera.

So for us the underlying metric that we're really looking at in terms of the underlying health of the business is actually new units sold.

And we had a very very strong quarter with 17% sequential growth but we've also had three quarters in a row where we actually grew units double digits over the prior quarter.

One of the earlier questions talked about competitors also investing to increase their sales capacity and the fact is those competitors are much larger, have much more sales capacity to start with and the metric Tom just brought up is a reason we have confidence.

We talked about a year ago about channel expansion, that's worked out, now we've added some headcount sales, new accounts, sales activity is going very well, so we feel like we have the formula down.

If we had the right amount of headcount we'll be able to see the results.

Your next question will come from the line of [Wamsey Mohan] with Merrill Lynch.

Thanks for taking the question.

We've done some work historically with the rate of share gain in network storage for NetApp as being about 50, 60 basis points per year on the hardware front as per IDC data.

So do you see anything fundamental in your products or in the competitive environment that would suggest that your rate of share gain would be different either better or worse over the next two years?

I think there's opportunity for us to accelerate that rate of share gain and we've seen it happen actually in several small markets.

I will use one as an example, Australia which is a very small market, has 24.5 million people, probably 3% of the world's total market for IT, we got to about roughly 18 or 19% share position, we think last year and this year, our business in Australia was up about 75%.

It gets to a point where you move into the category of the preferred vendor if you will in certain areas and it can actually cause the market share gain to accelerate.

Now I should say, this has historically been a market which is as I've described to people the slowest moving market relative to change and adoption of new technology of anything I can think of in the entire IT world, even worse than networking technologies.

People move very very judiciously here because if it doesn't work for them, they have lost their data or put their business at risk and they're very cautious, and adopt new vendors very very carefully and make them work through essentially a progression of proving their capabilities before they'll move them to the next more severe and more demanding environment.

What that means is that changes we introduce in our particular time may not get widely adopted for a couple years.

Flex balls for instance which had enormous savings and increase in utilization for our customer community really takes about two years from the time we introduced it to the time it was over 50% of the installed base.

So when you see these kinds of low, slow rates of change; however I do think there's an opportunity for us with enough market coverage given our current position and the references we have, the targets we have et cetera, for us to actually get that dynamic to change quickly and economic stress is one of the things that causes that to happen.

Certain other phenomenon like the server virtualization, et cetera are adjacent opportunities that also provide us opportunities to get to happen.

So yes, I think if we focus on the right places at the right times like virtualization and back up, we can in fact move the needle a little faster than historically we've been able to.

One thing I would add to that is when you think about the 500 basis point increase in market share gain, you also have to factor in the fact that IBM is now 4% of our revenue and it grew to that in the last two years.

So when you think about 4% of all revenue, that's another $100 million of market share at our price and obviously more than that at Street price.

So in terms of the market share gain and NetApp technologies it's a little bit more than the NetApp branded number would indicate.

Thank you.

Your next question will come from the line of Shebly Seyrafi with Caris.

Thank you very much.

So I tend to get more concerned when your receivables grow more than 20% sequentially especially in fiscal Q4 looking at history, it happened in fiscal '05 and fiscal '07 before, some misses in fiscal Q1.

How back end loaded was fiscal Q4 this year and what's the risk that you decline perhaps double digits sequentially in fiscal Q1?

So the fourth quarter had the same, roughly the same seasonality or the same profile of order distribution and revenue distribution that we saw a year ago in the fourth quarter and the year before that.

There's really not a significant difference, save 0.5 percentage point type of thing.

I think that the key question here is do we feel confident about our guidance and are we satisfied with our backlog levels and our ability to achieve the guidance and we have to tell you, yes, we are.

Okay.

Your next question will come from the line of Brian Freed with Morgan Keegan.

Thanks for taking my call.

Real quick just to revisit the product versus software growth rates, relative to your peers, your gain in the hardware side of things appears to be decelerating, yet you continue to show a significant multiple market growth rate in software.

Do you think it's rational to decouple the two in practical sense or are they practically so coupled that it's better to look at them combined?

That's a tough one.

I'd say it probably makes sense we continue to look at them as we're currently putting them together, but probably a more interesting dynamic is that they spread it out over time is that we land the footprints today and we sell upgraded software later, and that's why our emphasis on the unit count is so darn important.

If the unit count was not growing that would be a proxy for we're not gaining new accounts, would be a proxy to the fact that we're planting the seeds for future business, but when the unit count is robust, then I feel very good about the likelihood of continued software growth.

So perhaps we're a little bit of a slowdown now, perhaps it's a sign of our top enterprise accounts at least in the U.S.

Not being as robust.

It could be any number of factors but the simple fact of the matter is as long as it's held in units then I think we're well positioned in the future to continue to sell software and continue to sell services.

Yes, if I read into your question a little bit, the question may have been around unbundling is that what you were referring to

Well if you just look at product revenue as a standalone segment, its growth is decelerated year-over-year and arguably some of your competitors would say that they're now growing product revenue faster than you guys and so I just wonder how you guys think of your product revenue growth versus your software revenue growth, particularly relative to market share?

And that category, I think of them as totally combined.

I think the analogous model here would be Cisco with their IOS, they sell hardware platform and they sell the piece of software on top but that software only runs on that hardware and that's exactly the case we have here.

Virtually all of our add-on software is actually Incorporated into the Data On Tap system and we enable it through license keys.

That which is totally independent from Data On Tap is actually a very very small percentage and it's not practical to think about unbundling of the software features from the hardware platform.

Essentially the hardware platform represents sockets that you can plug the other software components into and architecturally that would be very difficult to unwind.

So Tom's comment about that's why we track the platform so much is spot on.

When I think about the markets I think about the combined hardware and software together as a single unit, and I think any attempt to segment those two would probably cause you to come up with all kinds of meaningless answers.

All right

The one thing I would add is I totally agree the way you rephrased the question that the bundling of the hardware/software is a fact and I think that's just the way it is.

I think the other dynamic at play is how much of it is new sales and how much of it is upgrade business, and that's proven to be more volatile and if I look at new sales, that's been quite good, in fact our forecast for next quarter is especially positive given our guidance.

But our upgrade business has been probably slower than it has been in recent years and that could be a symptom of our installed base, our top enterprise accounts, or what have you and that's why we're trying to give you a little bit of insight into our unit growth because that really is a proxy for the growth engine of the business.

Okay, thank you.

Your next question will come from the line of Jayson Nolan with Robert Baird.

Thank you.

Dan, Tom, any update on your brand campaign?

I know these are always hard to measure but any early thoughts or incidental impacts in the market?

Yes, the early indications were really good based on, well as you said we have very thin data to look at.

One of the things you can look at though is the number of hits on NetApp.Com and those are up by quite a significant factor, so traffic on the website has been really good, initial feedback through web placement has been good, things of that nature, but it's too early to really conclude anything quantitatively.

Yes, the awareness metric that we put out there on Analyst Day is something that will only get measured on an annual basis and we need to let our activity settle for a little bit, so that's probably still some time away, but as Dan indicated the initial things about web traffic and referrals to our salesforce and things like that all look pretty positive.

Have you seen an ad?

I have the blue beating heart all over the place.

Your next question will come from the line of Kaushik Roy with Pacific Growth Equities.

Thank you.

It seems like your operating margin in Q1 has to be close to 9.5% to get to the $0.22.

Even last July when revenues were significantly lower than expected, it was 11%, so it seems like investors are not very happy about the stock is down 11% after-hours.

So I guess why are you bringing down your OpEx so much?

And then what are your hiring plans for the full year?

I mean, it seems like for full fiscal 2008 you hired a thousand people, and then in Q1, itself you're going to hire 550 people so if you can comment on that it will be helpful.

We hired 500 people this past quarter and we're going to hire another 500 in the upcoming quarter.

More importantly though, look at the quarter to quarter sequential numbers.

Given the revenue number, you're right, the 9.5 to 10 range is probably about the right zone, but the gross margins are roughly flat I assume in your model and according to Steve's guidance anyway, and the expense number is up about 3% as I mentioned in mine and it gives you 9.5 to 10%, depending whatever road you want to pick.

That incidentally is not inconsistent with the guidance we gave in the Analyst meeting in March.

We said the operating income, operating profit level for the first half would be 11%, so you are talking about 1% or so differential, that could swing really easily based on whatever the health of the revenue level is.

Okay, it seems like investors are not liking the operating margin.

It seems like you guided pretty much in line with the top line but operating margin is slightly lower than what people are--?

I can't speak for the investor community.

All I can tell you is we just reiterated exactly the guidance we gave in March.

If it wasn't well understood I'm sorry that we didn't get the message through but I can assure you the slides we put in the wall said it's 11% in the first half.

Okay, all right, thanks.

Your next question will come from the line of Glenn Hanus from Needham.

Hi, maybe shift gears to product road map a little bit, and maybe you can comment on deduplication on your VTL platform when that might come out if you view that as important, sort of when we're going to have the product refresh cycles, when to sort of think about that and maybe any comment on solid state tier zero storage.

Thanks.

Well, first of all we are not going to pre announce a new product and talk about any road maps or any of that.

What I will say about VTL is actually we have beta'd our deduplication technology with a number of customers so that's continuing to progress but beyond that I'm not going to add anything to that equation.

Clearly deduplication in the VTL market is a key requirement.

Our business has been quite successful without it.

Even this quarter our VTL units were up 47% year on year so deduplication isn't the only feature that matters but clearly it's important and we need to get that into our portfolio.

As far as the rest of the product line, I thought we had a pretty robust year in terms of platforms over the last 12 months and I expect that to continue, pretty much in all phases.

What about solid state?

I would just like to say stay tuned.

I think solid state technology and Flash technology is going to be relevant and increasingly so as time goes on and we intend to incorporate that into our products and leverage it as appropriate, but I'm not going to pre announce anything at this point.

Thank you.

Your next question is a follow-up from the line of Keith Bachman from Bank of Montreal.

Thank you, my question has been answered.

Your next question is a follow-up from the line of Aaron Rakers with Wachovia.

Yes.

Thanks for taking the follow-up.

I guess one of the things, myself and I think investors are going to try and get comfortable with is the expectations baked into your model to get you to that 11% op margin going into the -- for the first half of the year.

So are the assumptions calling for a typical seasonal type increase going into the October quarter which I would characterize as more of a midteens type sequential growth?

And again, update us on how long it typically has taken you to get new sales additions up and fully productive?

Well, Steve Gomo here.

The answer is yes.

Your sequential growth rate there, midteens is depending on I don't know where you're at right now but that's not off the charts from where we're looking at.

I think you have to remember that we started making some of these investments in sales and marketing this past fourth quarter.

Some of those are going to start to have some impact in the Second Quarter.

We've already started to see our traction improve in the channel programs, and at the low end we have some -- our normal cadence of product introductions are coming up, so we're confident that we can deliver the 11% in the first half.

And if I could ask one other thing, on one thing you disclosed was a pretty sharp increase in your block level SAN business this quarter and it looked like it was really driven by the fibre-channel side.

Can you help us understand the underlying dynamics of what's starting to drive that and why maybe we're not seeing iSCSI side of that grow as well?

I'll give you two answers to that one.

The first one is that especially iSCSI, I believe that we are not able to track it sufficiently, iSCSI is bundled into each system and it's really hard to tell how it gets deployed.

We have to wait until after it's installed to see how it's configured to actually tell if somebody is using it as an iSCSI server.

So it's very difficult to report on it in the sense of revenue as it goes out the door.

I think we're definitely under reporting on performance on iSCSI.

I believe and this is my personal belief, it's very hard to back up any hard data that many of our systems are being used as essentially unified storage solutions based on (inaudible) where I suppose NAP and iSCSI as the active interfaces through one internet pipe, but it's very difficult for us to capture those as they're being shipped.

On the SAN side, I think what you're seeing is there was a surge in terms of especially at the low end single systems which had both SAN and an ethernet Internet interface or SAN and NAS together.

As we report those numbers back to you we try to make sure we don't overstate the impact but on a superficial level, NAS came down and SAN went up but actually I think what happened is just because of SAN interface was configured into more systems, the allocation methodology caused one to look higher and the other low.

We're actually getting to the point now where I think the segmentations that the industry has followed are becoming less meaningful.

Currently 40% of our systems going out the door carry at least two interfaces and I think that's under stated because we can't track the iSCSI one.

So it's become much more difficult to figure out segment by segment what's exactly going on.

Yes.

I would concur with that.

I think what is unmistakable is that customers are using NetApp more in their SAN environments.

Are they buying dedicated SAN machines?

In some cases yes, but clearly the two trends that are out there is that a SAN environment where iSCSI where we believe we clearly outgrew the market but SAN where we dramatically outgrew the market clearly we're seeing more acceptance of our block space technology in the customer base but we're not seeing it necessarily in the form of dedicated iSCSI boxes or dedicated SAN boxes.

We're seeing it in the form of unified storage that's running multiple protocol both SAN and NAS at the same time and that's why we threw out the NAS number, that 67% of our systems despite all the SAN growth, 67% of our revenue had a NAS component to it as well.

Your next question is a follow-up from the line of Bill Fearnley with FTN Midwest.

Yes, thanks, Steve, could you go over the gross margin, the difference in gross margin treatment again and is your expectation in what happened in fourth quarter the expectation for what you think is going to happen going forward here for the next couple of quarters as well?

It went by pretty quickly.

If you could repeat it that would be helpful.

So let's forget the change in format reporting for just a moment and let's just stay in our current format.

In our Analyst Day we said that we expected to see about a 61% gross margin for all of next year and throughout the quarters and I would expect to see our First Quarter be somewhere, 61, 61.5, something like that, a little hard to call at this point, but I would plan in that range if I were you, and if that's the case, there won't be a lot of change in the various components that make that up.

What you'll see is a reclassification however, in gross margins from a lowering of product gross margin and an improvement from the service gross margins.

But now let's layer the change on top of that so now I'm going to come back and layer the warranty reporting change on top of that.

You can add about 1 point, excuse me, you can take about 1 point off the product gross margins and you can add about 5 points roughly to the service gross margins but your total gross margin will be unchanged.

Thank you.

Your next question is a follow-up from the line of Wamsey Mohan from Merrill Lynch.

Thanks for taking the follow-up.

Wanted to really go back to like July 2004 to see total software as a percent of revenue sort of at 38% so should we still expect fiscal '09 at 40% as stated at the Analyst Day given your efforts to increase your indirect business?

Yes, so this is Dan.

I believe for some time you're going to see that we've hit the ceiling, you're going to see the fiscal fluctuations are on a norm.

I always thought 40 was very high, but it kept coming in quarter after quarter at that level.

I think you will just see it fluctuate 2 or 3 points on the other side of about 37 maybe 38.

I feel that 40 is kind of a ceiling for us in terms of mix.

That says roughly especially when you take out the service component that software, add-on software is approaching the same dollar value in the mix as the underlying hardware and storage, and I think that's kind of just a natural barrier that will be very difficult to break through and you'll see oscillations around the mid point.

Okay, thank you.

Ladies and gentlemen, I think that concludes the call for today.

I would like to again thank you for joining us.

I would especially like to thank the employees at NetApp for a terrific finish to a very challenging year, and I look forward to updating all of you on our Q1 results on August 13.

We look forward to talking to you then.

Have a great day.

Thank you for your participation in today's conference.

This concludes the presentation.

You may now disconnect.

Have a wonderful day.