NetApp Inc (NTAP) 2009 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the NetApp first quarter of fiscal year 2009 earnings conference call.

I will be your coordinator for today.

All participants are in a listen-only mode.

We will conduct a question-and-answer session at the end of this conference.

(OPERATOR INSTRUCTIONS) Today's call is being recorded for replay purposes.

I would now like to turn the call over to Miss Tara Dhillon, Senior Director of Investor Relations.

Please proceed.

Good afternoon, everyone, thank you for joining us today.

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

In the course of today's call we will make forward-looking statements and projections that involve risks and uncertainties including statements about our projections for our second quarter and first half fiscal 2009 financial results, including our revenues, margins and earnings.

Our top line results for our second half and beliefs that there is and will continue to be increasing customer demand for storage efficiencies.

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 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 which factors are incorporated by reference in today's discussion.

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

Steve will review the first quarter financial results and our targets for the second quarter of FY '09.

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

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

Thanks Tara.

Good afternoon, everyone.

NetApp executed right on plan this quarter with revenue and earnings both ending just above the middle of our targeted range.

As I walk through the results please note that all numbers are GAAP unless stated otherwise.

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

Total revenue for the first quarter was $869 million, down 7% sequentially and up 26% over Q1 of last year.

Foreign currency effects aided sequential growth by about 0.5 of a percentage point and improved the year-over-year growth by about 3 percentage growth.

Product revenue of $548 million was down 13% sequentially and up 18% year over year, accounting for 63% of total revenue.

Add on software which is a subset of product revenue was almost 20% of total revenue this quarter.

Revenue from software entitlements and maintenance was $144 million or under just under 17% of total revenue.

Software E&M was up 6% sequentially and 34% year-over-year continuing to help fuel deferred revenue growth.

Total software, the combination of add-on software and software E&M, was 36% of total revenue compared to 38% in Q4 and 41% in Q1 of last year.

Tom will discuss the software dynamics in his remarks.

Revenue from services which includes hardware support, professional services and educational services was $177 million and 20% of total revenue, up 3% sequentially and up 50% over Q1 of last year.

Service maintenance contracts increased 8% sequentially and 48% year-over-year.

Professional services decreased 8% sequentially but increased 53% over last year.

Non-GAAP gross margins were 60.7% of revenue this quarter, down 1.5 percentage points from last quarter and just slightly below the 61% we had projected due to lower product gross margin and the higher contribution from our services business.

On our fourth quarter earnings call we shared with you that we would be implementing a change in the reporting format for our warranty costs beginning in Q1.

Historically we reported those costs in services cost of goods sold.

In our Q1 actual results and going forward, they are reported in product cost of goods sold.

This change has zero impact on total cost of goods sold and total gross margins.

It simply shifts dollars between product and service gross margins.

From what we have traditionally reported this reporting change reduced product margins by 1.1 percentage point and added about 4.8 percentage points to services margins.

Product margins were impacted by volume-related effects from lower Q1 revenue levels and a heavy low-end mix of products.

As a result non-GAAP product ross margin were 55.8% and non-GAAP services margins were 45%.

Non-GAAP software and E&M margins were consistent at 98.5%.

Turning to non-GAAP expenses our operating expenses totalled $444 million or 51% of revenue.

OpEx increased 2% sequentially and 27% year-over-year.

During the quarter, head count increased by 354 people on a net basis ending up with 7,999 employees.

While we were somewhat below our overall hiring targets in Q1, we were very close to our goal for hiring quota-bearing sales reps.

Our future investments and operating expenses will continue to emphasize sales coverage to help fuel top-line growth.

Our GAAP operating expenses include the effect of prior merger related costs, the amortization of intangibles from acquisition, and the effects of FAS 123(R) as well as the net gains or losses on investments.

Non-GAAP income from operations totalled $83 million, or 9.6% of revenue in Q1, and finished just above the middle of our projected range of 9 to 10%.

Non-GAAP other income which consists primarily of interest income was $9 million.

Non-GAAP net income before taxes was $92 million or 10.6% of revenue.

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

Non-GAAP net income totaled $76 million or $0.22 per share.

GAAP net income totaled $38 million or $0.11 per share.

Moving to our cash flow performance our cash from operations was $250 million, down 15% sequentially and up 25% over Q1 of last year.

Capital expenditures were $77 million this quarter.

We define free cash flow as cash from operations less capital expenditure, so free cash flow totalled $174 million down 24% sequentially and up 4% over Q1 of last year.

Expressed as percent of revenue, Q1 free cash flow was 20%.

Turning now to the balance sheet, our cash and investments totalled $2.1 billion which includes the net effect from the $1.265 billion in proceeds we raised from the convertible note that we announced on June 3, 2008.

This balance excludes approximately $200 million of restricted cash related to our secured revolving credit facility.

It also excludes about $72 million of auction rate securities which have been reclassified from short term to long term investments.

The debt associated with our credit facility is $131 million and is classified entirely as long term liability.

We continue to buy back stock this quarter both in conjunction with our convertible offering and on the open market.

We repurchased a total of 17 million shares at an average price of $23.58 for a total outlay of $400 million.

This includes the $274 million spent to purchase 11.6 million shares at $23.59 as part of the convert.

Turning to DSO, accounts receivable day sales outstanding were 45 days compared to 56 days last quarter and 53 days in Q1 of last year.

Inventory turns were 21.7 times this quarter, up from the 20.3 times achieved in Q4.

The total deferred revenue balance increased $55 million this quarter to $1.56 billion, a 4% sequential increase and a 36% increase in the balance year-over-year.

Now before I turn the call over to Tom, I'll discuss our target operating model for Q2.

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

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

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

We are targeting second quarter revenue to be in the range of 910 million to $940 million within the range we outlined for you at our analysts day in March.

We expect our non-GAAP operating margins to be in the targeted range of about 11 to 12%.

Non-GAAP EPS is expected to be approximately $0.27 to $0.30 per share with GAAP EPS between $0.16 and $0.19 per share.

Our diluted share count is expected to increase by about 2 million shares in the second quarter, depending on the stock price.

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

Thanks, Steve.

The diversification of our revenue stream has been a high priority for us both strategically and in near term investments.

In analysts day I laid down the segmentation we now use to track our diversification efforts.

We are looking at the top 5,000 buyers of storage in the world or S5,000.

In the March we achieved high penetration in just under 10% of those customers.

We had low penetration in about 17% and did not yet have a presence in more than 73% in the S5,000.

The percentage of our highly penetrated accounts has grown modestly mostly through the efforts in growing our lesser penetrated accounts.

The highly penetrated category includes many of our top enterprise accounts or TEAs, which had flattened out or declined as the economy slowed.

However, in the US non-federal market, our TEAs grew 11% over Q1 of last year for the first double-digit growth quarter in a long time.

This reinforces our belief that the lull in growth was a result of spending constraints not losses to competition.

Another contributor to the growth was expansion into new opportunities within existing accounts, especially in the area of server virtualization.

The growth and bookings from our Q1 '08 lesser penetrated accounts was very encouraging at 47% year-over-year reflecting the early results of our efforts to open new accounts and to expand in currently underpenetrated ones.

While the S5,000 remains our primary focus, on prior calls we also talked about our efforts to expand our market coverage to the mid-size enterprise particularly through the channel and driven by our refreshed entry level offerings.

In this segment we added 460 new customers in Q1.

Overall the percentage of bookings from net new customers, both S5,000 and mid-sized enterprise was at its highest level in three years.

This quarter EMEA contributed 32% of revenue up 27% over last year.

Asia Pac grew to 12% of total revenue up 14% sequentially and up 24% year-over-year.

The Americas contributed 56% of revenue up 26% year-over-year.

Within the Americas, federal contributed 11% of total revenue, again, this quarter.

Due to the contribution of US non-federal TEA accounts, which are all mostly direct, channel revenue dropped 61% of the total mix but remains very healthy.

Arrow and Avnet achieved a new record growing to 20% of new revenue.

IBM also had their best quarter ever with us contributing almost 6% of revenue this quarter.

On the products side, total storage systems shift were up 35% year-over-year.

Entry-level units continue their aggressive growth and were up 74%.

The high-end was also quite robust with units shipped up 36%.

This is clear evidence of the expansion of our product offerings both up and down market.

The mid-range growth was not nearly so aggressive but still represents over 50% of systems revenues.

Our latest mid-range product family, the 3100 series, starts shipping in July and Q2 will be the first full quarter of availability.

The continued strength of the entry level has had an impact on our software mix and to some extent our gross margins.

While overall attach rates remain constant in the platform categories, our software pricing is tiered meaning software products are priced based on the platform type.

In addition, the entry-level systems tend to have lower software content at initial purchase.

Despite the impact on our software mix, the rapid expansion of our entry level offerings are allowing us to win accounts early in the evolution of the storage infrastructure and position us well for follow-on business in term of hardware and software upgrades as well as professional services.

Our services business continues to outperform the overall Company growth fueled in part by higher attach rates of premium support contracts and our comprehensive professional services capabilities reflecting an increased enterprise penetration we've accomplished over the past few years.

From a protocol perspective, orders for the fiber channel SAN or an iSCSI component totalled 40% of our bookings this quarter with 30% including fiber channel and 16% including iSCSI.

6% had overlap with both protocols.

NAS protocols were 63% of our storage bookings.

GX operating system continues to grow beyond its high performance computing roots with new installations and financial services and media.

Bookings continue to ramp up 44% over Q1 '08 in advance of the conversions of the operating systems next year.

Q1 continue the robust pace of deployment of our deduplication technology with almost 13,000 systems installed and over 3,000 licenses added in July alone.

We believe that this is the largest footprint in the industry and NetApp is the only vendor that can deploy deduplication in all work loads and on all FAS platforms.

While deduplication may have a dampening effect on short term storage upgrades we are convinced they will be more than offset through customer loyalty, new account penetration and conversion of older non-deduplication capable models.

However, deduplication is just one component of a broader storage efficiency story that includes our Flex phone technology RAY-DP and thin provisioning.

Faced with escalating energy costs, budget pressures and a weakened world economy and green initiatives, customer interest in storage efficiency has never been higher.

Deployment rates on each of these technologies, not just dedupe are growing at a very high rate and we're seeing innovation from smaller vendors as well.

All of this is evidence that conventional solutions, particularly on the SAN side, are offering no meaningful relief on the storage efficiency dimension and customers are seeking alternatives at an increasing rate.

Our V-Series controllers had their best quarter ever, with units more than doubling over Q1 last year.

This quarter's V-Series highlight was the announcement of our ability to deduplicate EMC storage.

Before they offered that capability on their own systems.

Using our V-Series controller running our ONTAP synergy operating system, customers can now have deduplication and our other data management and storage efficiency products for their primary storage systems from EMC, HP, Hitachi and others.

This represents an important entry point for us into new accounts.

Another key entry point to new accounts, an expansion in existing accounts is the trend toward server virtualization.

In fact, many of you have probably probably seen recent NetApp installations supporting virtual environments implemented in your own firms.

This focus area continues to progress well and we expect the sector to get even more mind share with the imminent rollout of the Microsoft offering.

To wrap up, I'll just point out that the industry trends we've been talking about for a while, virtualization, storage efficiency, ethernet, and backup redesign are all being fueled by a challenging economy that forces customers to consider new ways to more cost effectively solve their storage and data management needs.

We believe that the industry is still in the early stages in each of these areas and there are ample opportunities for us to capitalize on in the future.

I look forward to updating you on our progress again next quarter.

Dan?

Thank you, Tom.

I'm very pleased with the results NetApp delivered in the first quarter of our new fiscal year.

Results which are consistent with the expectations with shared with you both in our analysts day last March and Q4 earnings release in May.

Likewise our expectations for the second quarter are consistent with those we shared with you on those two occasions.

Perhaps I should recap the basis for our outlook starting starting with the macroeconomic climate.

We do not see any significant changes in the general spending patterns of our customers or prospects.

While there is broad concern about the global economic environment, most enterprises continue to invest in their infrastructure to improve operating efficiency.

The projects they undertake play to our competitive strengths in areas such as server virtualization, improved storage utilization, ethernet attached storage and so on.

Competitively NetApp stacks up very well and we have not seen any significant changes in the competitive dynamics in the marketplace.

In March we outlined a plan to invest in sales capacity and awareness, so we could engage with a broader set of customers.

Earlier lead indicators from our awareness campaign is encouraging with more than double the number of unique visitors to our website, significantly increase sales inquiries and almost a 5X increase in global online search clicks for NetApp.

We've also executed well on our plan to hire incremental sales capacity and that is also showing early signs of driving future growth.

In terms of diversifying of our business, bookings from new customers were at their highest level in three years.

Of course, we still have work to do in expanding our distribution and sales reach but we're well on our way with the hiring we've done over the past few quarters.

We believe that we are growing faster than the markets we participate in and we continue to gain share.

We are benefiting from increased volumes from partners like IBM, Arrow and Avnet, we have also seen some improvement in our top US accounts.

Our unit volumes have grown nicely and we continue to bring innovations to market that will ultimately drive more business for NetApp.

I believe these factors will continue to drive revenue growth in the future.

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

At this point I will open the floor to questions.

Please limit yourself to one question and then return to the queue so that we may address everyone in the allotted time.

Operator?

(OPERATOR INSTRUCTIONS) Our first question comes from the line of Bill Shope with Credit Suisse, go ahead.

Can you give us any more color on the near term adoption trends in your virtualized server environments.

There is obviously some signs in the market of some slowing virtualization adoption which I do think is near term but I'm wondering if that's translated to the storage sight at all.

I definitely don't see any slowing.

What we're really seeing probably more systematic of our business and particularly large customers is that we're seeing the culmination of a lot of proof of concepts in our favor and going into production now.

So, if there is some short-term slowing of the business, I clearly don't see it.

In fact, in the accounts we're actively participating, particularly our big accounts, including a lot of them in New York City, we're actually seeing the conversion from proof of concept into production right now.

I don't see any slowing down at all.

I think clearly the Microsoft announcement which is imminent will be out there.

The other trend is I'm actually seeing a fair amount of desktop virtualization as well as server virtualization.

If anything, I would say that that activity is higher now than it was six months ago.

This is Dan, I would echo the same thing internationally in the past quarter I've spent time in both Australia and Far East and China and Japan.

I have to tell you, topic number one throughout the Far East has always been server virtualization.

I don't see it slowing down at all.

Okay.

Thank you.

Our next question comes from the line of Keith Bachman with Bank of Montreal.

Please go ahead.

Thanks for taking the question.

Dan , I just wanted to see -- or Steve, whoever wants to take it, if you could talk a little bit more about the product gross margins, even if I net out the change in the warranty, it looked to be a little lower than we were forecasting.

I know, Steve, you said there was some volume variance there that impacted it.

How do you see the trends in the product gross margins going forward?

And, Steve, if you could just repeat what the software add-on number was, that would be helpful,

Let us start with your gross margins compared to the fourth quarter level.

So on a nominal basis as reported they're down 4.6%.

1.1 percentage point of that is warranty.

About 2 percentage points of that is attributable to the volume of revenue that we had, and, I think I talked with a number of folks that came through here and told them to expect this, as business declines from fourth quarter levels as we expected in the seasonal for NetApp, we have cost of goods sold, elements of cost of goods sold that are fixed in nature.

Like standard revision, like scrap, et cetera, those are fixed so you would expect to see your gross margin decline as a result of that.

The final element is about 1.5 percentage points and that is mixed in configuration of the products we shipped.

So we were pretty close to what we expected.

We had expected most of that, we didn't capture all the mix and configuration changes in our forecast.

I would add one thing to that, Keith, neutral to the bottom line it is a lower gross margin for us.

The other component which I think was also factored into our thinking and we gave some guidance on last time, the low end has been particularly robust and (inaudible) configures as some of the higher end offerings, and as a result at least that initial purchase time, the software components are a little bit lower and it has no impact in terms of our software revenue mix.

And likewise, a little bit of gross margin as well.

Okay.

Great.

Thank you .

Steve, is there a way -- what was the add-on software

The add on software number was almost 20% of total revenue this past quarter, okay?

And then the software entitlement and maintenance was about -- was just under 17%, the grand total was about 36%.

Yes, thanks very much.

All right.

Our next question comes from the line of Louis Miscioscia with Cowen & Company.

Okay.

Thank you.

I was wondering if you could talk about your expectations for the full year.

I didn't see any comments in the press release, especially as obviously your OpEx should continue to go up as you're doing hiring and I wonder if it is going to start to get challenging to make some of the operating numbers you need for your guidance in the back half?

Right now we feel on the plan that we outlined back in March, and, we just don't have enough data to tell you whether or not anything will be different.

Right now we're assuming we're right on plan.

I would like to echo that.

As I reviewed this plan it really had two stages.

One was heavy investment on the front end.

Stage two is to reap the return on that investment in the second half of the year.

We have, I think, executed well on the front half of that, we've proven that we can in fact crush our operating margin, and yet we're very confident that that's going to return a significant growth in the back half.

With our gross margin levels, if the people we brought on board generate the levels we expect you'll see the operating margins snap right back.

I should point out that in the 13 years we've been public this is the first time management team has intentionally taken a gross margin down below 15 points.

We did that because we sensed there was an opportunity.

We're in the middle of execution of that.

We think that will come roaring right back.

If I can add a little bit of color to that, as well.

If you look at our guidance into this current quarter of Q2, is we're actually taking some relatively significant step function and a number of fixed expenses.

We have a new system on line.

We also have our merit increases go into effect.

We have some building.

So we're actually adding $17 million to our cost structure yet we're still adding a couple of points of operating margin leverage.

So if you go forward the second half of the year we don't have similar step function expenses going into Q3 and Q4.

So if we can deliver on the top line our ability to generate leverage below I think it is pretty clear.

I think the story about NetApp is really about if you believe our growth or not.

Clearly our investments and expanding our awareness and expanding our salesforce are really focused on that particular activity.

Okay.

Thank you.

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

Yes, thanks for taking the question.

I guess I want to dive into the free cash flow story for the Company.

You know, it looks like free cash flow from operations was fairly in line with what I was expecting.

However, CapEx is trending a little bit higher and also free cash flow, as a percentage of revenue, looks like it is at the lowest level that we've seen from the Company and relative to your guidance of 23, 24% range.

So I guess how should we think about free cash flow generation going forward and maybe also how that dove-tails into your expectations in terms of deferred revenue growth?

Okay.

This is Steve here.

So we were actually quite pleased with our cash flows, we saw cash flow from operations of $250 million.

What happened in terms of free cash flow was not so much from the cash that was generated on the operations level but really from the purchases of plant, property and equipment.

Tom just mentioned that we had some -- we have some unusual transactions that are going to generate some cost next quarter.

That is depreciation associated with large capital transactions.

We just got done capitalizing the last part of our SAP program, part of our Siebel effort, a whole bunch of software.

About $18 million to be exact of software capitalized this past quarter.

In addition we had some -- Tom referred to some building, some lab improvements that we did, which added another $15 million.

So, I would probably assume that the capital purchases will fall back around $25 million next quarter.

As far as the percentage of free cash flow percentage of revenue, remember that the problem is not the free cash flow or the amount of cash that is being generated.

It is in the earnings, right?

This is the lowest net margin quarter we've had in a long time as a result of the investments that we're making.

And when we're back on the business model you should expect the free cash flow to return to that level of 23, 24% of revenue.

And the assumption around deferred revenue growth was in that?

Remember, we also paid out the ICP this past quarter also.

Instead of comp.

That is one-time cash flow out.

Go ahead, I'm sorry?

Final part of that question was, what you're assuming in terms of deferred revenue growth given that it is a fairly significant driver of cash flow generation?

I think deferred revenue growth is going to be somewhat consistent with what we saw this quarter in terms of its year-over-year performance and if the growth rate of the Company steps up you can expect to see the growth rate of deferred revenue step up with it.

Thanks for taking the question.

You bet.

Our next question comes from the line of Paul Mansky with Citigroup.

Yes, couple of quick things.

First, with respect to head count plans for the current quarter, given that you were modestly below targets previously and maybe if you could refresh what you're thinking from an exit rate perspective on the fiscal year, and then just as we kind of model out some of the impact around deduplication, per the prepared comments, can you provide us what petabyte shipments were preferably broken out by interface, if you can?

Well, Paul, which question do you want us to answer?

How about since you asked the head count one first we do that one first, Steve?

Head count, so we exited -- as you just saw, we added 354 people this past quarter.

I would look for us to add about the same number of people on a net basis next quarter.

That is, by the way roughly consistent with our plan and I think that, we're going to be on our plan for quarter bearing reps.

Look for the same level of ads, give or take 20 people.

We have definitely focussed our hiring machine, though, on field personnel.

Where we're behind is primarily what you consider the headquarters of support personnel.

The question on drive interfaces, I did indeed leave that out in my prepared text.

It seemed like--.

It didn't seem so interesting.

Total petabyte shifts were 195 -- what would that be?

Petabytes.

And the mix was 63%, ATA, 33% fiber channel and 4% for SAS.

Thanks for letting me sneak that second one in there, I appreciate it.

The next question comes from the line of Min Park with Goldman Sachs.

Go ahead.

Yes, thank you.

If you look at the midpoint of your October quarter op margin targets of 11 to 12% and you combine that with quarter's 9.6% it implies a first half operating margin of around 10.6 which is a bit below your 11% target that you gave us at your analysts day.

So does this suggest you need a better second half of the year or is that difference really within your margin of error of your targets?

Steve, here.

That is definitely within our margin of error.

From the midpoint up, we round to 11%.

So at the high end of the range we're at 11.

And then I think that is well within our ability to call.

Thank you.

Our next question comes from the line of Mark Moskowitz with JPMorgan.

Go ahead.

Yes, sir, thank you, good afternoon.

The question as far as the low end shift you're having some really good trends there.

But in terms of the add-on software or your ability to maybe increase the monetization there after the initial sale, have you done anything in terms of improving your ability to share code rewrites or improvements in these installations so that you can actually have a faster attach rate down the road?

So I didn't follow the code rewrites, but there is no doubt that -- that just expanding our footprint is fundamentally good for the business.

The more footprints you have out there, the more subsequent, whether it be upgrades, whether it be software, hardware, professional services, you name it.

One of the things that we're doing in the category of expanding our coverage is also inside sales.

So the ability to go out and cultivate these accounts and actively try and upsell, whether it be software add-ons or hardware add-ons, as you go forward, so absolutely, I think that while these machines are a little bit lightly configured going out, our expectation is that over their life they will actually become a lot more configured and pretty much all of the add on business will be higher margin than the initial sale.

And whether it be our channel programs, our channel partners or inside sales we actively want to cultivate those accounts.

Not to contradict what Tom just said, but to give you some historical perspective on it, the low end business has always less highly configured in terms of software.

They tend to be more single purpose in their deployment as opposed to multi purpose.

As are the mid range and high end systems.

The real question is when they add something on, typically something like a mirroring capability or data projection.

It is not a new application service, and so that is a much more limited opportunity to upgrade them, as well.

So, I I think they are lightly configured to go out.

I think historically they have had some degree of add-on but I'm not sure that it's going to increase there.

Typically what we find is as people move from a low end system to a mid-range is when they really start adding on a great deal of software.

And so having those footprints Tom talked about is a great way of driving upgrade business in the future.

Thank you.

Our next question comes from the line of Katy Huberty with Morgan Stanley.

Thanks, Steve, I want to circle around to the hiring in the quarter.

What exactly caused you to change the hiring plans for the non-sales work force and is that a bucket of cost that you're willing to adjust in order to hit numbers in the back half?

Yes, Katy, part of it was execution.

We're trying to manage the ship here to land on that 9.5% which was the middle of the guidance range type of thing.

But frankly the other part was we just ran out of funnel.

We just didn't execute as well.

On some of those non-sales oriented functions.

We took all of our in-house recruiters and turned them into the field and that didn't leave enough candidate for the rest of the non-sales functions.

We'll get caught up but that was a decision to prioritize where the hiring machine was focused and it worked out well.

Okay.

Makes sense.

Thanks.

Our next question comes from the line of Ben Reitzes with Lehman Brothers, go ahead.

Yes, thank you.

Could you talk a little bit more about your capital strategy that you could maybe bring us back to the convert and obviously raising capital and then with today's buyback comments and announcement, just how shall we look at your balancing of acquisitions versus buybacks and how you're playing that, is some views out there that maybe you would have been acquisitive and now it looks like you may be buying back more stock and if you can just give any guidance between the two versus how you raised the money as well?

You shouldn't assume we're buying back more stock.

In fact, our basic policy has not changed.

Our stated objective in the past has been to buyback enough shares to both offset the effective dilution resulting from employee stock options and any historical acquisitions we have made.

And so I think those are both achieved at this point and on a go-forward basis we'll execute along the same lines.

The fact that we raised the cash is partially opportunistic and partially a result of the fact that our cash is stranded offshore.

The bulk of our liquid assets are actually sitting in the accounts outside the US company and cannot be used for anything like stock buybacks, or acquisitions, or whatever.

Even when we acquired Israeli companies by Tokyo, turns out they're primarily a US-based equities and use US cash.

US cash balance is getting very depleted.

Got $1 billion overseas and nothing here in the US and we decided it was time to put something on the balance sheet here.

Don't read into that, that we have a particular acquisition in mind or that we have any particular change in terms of stock repurchase in mind.

Neither one of those would be an accurate interpretation.

Thanks a lot, Dan.

Our next question comes from the line of Brent Bracelin of Pacific Crest.

Thank you, this is a question for Steve, really a follow-up on the gross margin question, as you think about the blended gross margin here, the lowest in a couple years, obviously you went through line by line kind of how that was impacted but as you think about on a go forward basis, the low end you're having good success with, sounds like IBM is starting to have some momentum, the services gross margins seem to be at the higher end of historical range.

Why wouldn't, particularly with the success of low end, why wouldn't there continue to be some pressure on the gross margin and if so, why is that a bad thing?

So I think that what you should expect to see next quarter sequentially, you're going to see a pickup in product revenue.

And as product revenue picks up that phenomenon that I described, the impact of the fixed costs is going to be diminished.

So we're going to pick up margin on products just from that very phenomena.

Remember, that was 2 percentage points this past quarter.

So I expect to get virtually most of that back next quarter.

And then the rest of it is going to have to depend on mix and configurations and everything else.

But don't underestimate that volume effect that we just saw.

This is Dan.

I would like to elaborate on that last question you asked.

Is low gross margins is that a bad thing?

The answer is no.

As long as the operating margin stays in the mid-teens kind of range.

If IBM is more successful that is a good thing, right?

And we think we can run an IBM OEM deal at historical operating levels because our sales expenses are much lower.

The fact that we're getting, more from channel, that's great.

Right?

So you run all these things together and our real goal is to deliver especially in the second half of the year, somewhere around 16% operating and if we get to the 60% gross margin level I'm happy.

If it comes from the right sources.

If it's, just deeper discounts, et cetera, then I'm not happy, right?

So the gross margin never all by itself is not just a pure indicator of performance; it's got to be looked at in terms of what's driving it up and down.

And in this case I think a lot of the effects are very good.

I'm thrilled with the success at the low end and success of the IBM business in particular.

That should be helpful.

Just to add to that, if the low end businesses stay robust, the high end businesses stay robust and both of those platforms have been refreshed relatively recently.

Just in the last month of last quarter, we actually did a refresh of our mid-range offering which is a sweet spot of our business.

I'm hoping to get some leverage out of that as well on a margin perspective.

That's what I was referring to when I referred to mix, you are going to see a full quarter of the 3100 as opposed to three weeks of it.

Yes.

Our next question comes from the line of Kaushik Roy with Pacific Growth Equities.

Dan, did I hear that right, are you still expecting 16% operating margins in the second half.

I haven't changed my view of what the long term business model of this Company is.

Although we intentionally took down the operating income level at the front end to fund some investments I still believe the right balance point between maximizing growth and revenues and earnings is in fact at the 16% point.

So, yes, I'm pretty focused at getting back here.

Did you give guidance for the October quarter, non-GAAP gross margin guidance?

I'm sorry, could you repeat the question?

Did you give the non-GAAP gross margin guidance for October?

No.

No, we just gave top line and bottom line.

Okay.

Thank you.

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

Go ahead.

Hey, good afternoon, the FAS 3000 upgrade it seems to me is heading in the order of upgrades that historically has worked well for you guys, that is, you got the low end out and now you're doing the mid-range, et cetera, et cetera, but can you walk through how significant an upgrade is that FAS 3000 and maybe just elaborate a little bit on what's been upgraded in that system and how that might drive that upgrade stock?

Well, clearly the product presentation can take a long time.

But I think the 3,000 is significant in a bunch of ways.

First of all, it is the first mid-range system that actually has both ends of the cluster in one box.

So I think from a space and cost efficiency it is actually a lot better.

Performance wise it is a lot stronger.

We recently did a product announcement, although focused on the engineering data center, the 3100 series of general purpose product, but we had other things that went with it, including flex cash for cashing.

We had an accelerator module that delivers higher performance for a number of really key work loads.

All in all we have done a lot from a performance perspective, we've done a lot from a cost perspective and somewhat in parallel with that and somewhat asynchronous, we also have the latest version of ONTAP 7G, our 7.3 release which also has a fair number of new functionality components to it as well.

Actually I should point out going forward our unit count may look a little weird.

Like Tom said, historically we packaged each of the processors in a separate box, each one is counted as a separate unit.

Purchase primarily though impairs these cultures.

The 3100 family has both components of the payer in one single box and will look like one node as it goes out.

When our unit count doesn't grow as fast as you might think, that's what I like, we'll try to help you peel that back to understand it, but the numbers are going to look funny when we go through this transition.

Does that -- and I know this is a follow-up but if I can slip it in, does that help gross margin a bit that maybe as you mentioned just given the units that lower -- well, I guess it would be higher ASP, right?

Because now it is sort of a dual controller configuration, I guess, how does it look in terms of ASP in terms of gross margin and that's it for me.

It is a product refresh.

So I think, the ability to justify our value in terms of performance and functionality is higher and whenever that happens that usually comes from a gross margin perspective.

All in all it is a product refresh and like I said, the high end has been refreshed since the beginning of the calendar year.

The low end is new as well.

So while the previous version of the product was by no means old, in fact, this is actually the second refresh of the product line, since I've been here, so roughly three years, so we're upping the cadence on the mid-range and this is our latest offering.

But as I indicated, the fundamentally different structure in that the vast majority of our systems now are clustered and this allows us to put both clusters in one box which is a lot more efficient and a lot easier to manage and a lot cheaper.

Thank you.

Our next question comes from the line of Brian Freed with Morgan Keegan.

Go ahead.

Good afternoon, thanks for taking my call.

You hinted at a growing pipeline of upgrades to people at legacy hardware look to take advantage of deduplication.

Can you give a little bit more color on pipeline growth as well as how customers are reacting to your decision not to support the old FAS models with deduplication?

Well, I think a decision is kind of an overstatement, I think that the further back in time that you go, the machines just don't have the memory capacity to support it.

However, let's be clear is that a substantial amount of our existing install base is indeed upgradable with deduplication.

So one of the things we're clearly seeing are customers getting greater efficiency out of investments they have already made with us.

I don't want the message here to be that everything we shipped prior in the past prior to this year is not upgradable.

But there are machines that are three and four years ago, that are out of production, just think of the value proposition.

You have an older machine, it might running 144 gigabyte drive, consuming a lot of power, consuming a lot of rack space and then you can come out and you can run terabyte drive and on top of that deduplicate it and have much more efficient rack space and power consumption, that is a pretty compelling value proposition and we're seeing upgrade business around that.

Thanks.

Our next question comes from the line of Bill Fearnley with FTN Midwest.

Go ahead.

Tom, in the last call you talked about the importance of unit growth.

Could you give more color on where the unit growth was by product segment and customer segment.

And where it's above where you were expecting.

Then if I could slip in a follow-up as well.

In the past, you commented on number of deals above $1 million any update on the trends in the $1 million plus deal range as well?

Thanks.

As far as the unit growth I think I went through that.

Low end was 75% year on year.

The high end was, was 35 or 36% year on year.

I don't have the mid-range number off the top of my head but I did say it was about 50% of total revenue.

So, I think the unit growth number, when you strip away all of the more detailed metrics, I think acceleration of unit growth is a good thing on a bunch of fronts.

The flip side, if you're not growing units you can pretty much assure yourself you're not getting new customers and you're not getting new footprints and you're not sowing the seeds for future success.

The year ago number is something that is really important to me and this is sequentially a down quarter so I haven't talked about the sequential numbers but the past two quarters, it is not three, but the past two quarters for sure, we have actually seen double-digit sequential increases in unit growth count.

And I'm pleased with this quarter as well on the year on year comparison.

Any product segment or customer segments that jump out at you when you look for instance at the low end growth of 75%?

The channel.

Well, I think the channel, certainly the strength of Arrow and Avnet and the fact that we've added 460 new enterprise customers tells me this product is being very well embraced by the channel.

We talked six months ago, nine months ago on these channels about trying to get, we've certainly seen competition out there reporting strength in what they call commercial markets or mid-sized enterprise or whatever you want to call it.

We made it a focus of ours to go after that now that we've refreshed the comments and I would certainly say that that's more than exceeded our expectations.

Commentary on the $1 million deals.

Not as strong as last quarter as you would expect because sequentially we're down.

But much stronger than the first quarter of a year ago.

Thanks, guys.

Our next question comes from the line of Wamsi Mohan with Merrill Lynch.

Thanks for taking the question.

Can you talk a little bit given the recent management changes at VMWare, can you tell me if your working relationship with them has changed at all?

And as a follow-on can you also help us with what your revenues were by vertical?

This is Dan.

I must say at first I read the news about the changes at VMWare and I was a bit shocked.

I will say, however, I really want to thank Paul, he placed the call to me before 1:00 p.m.

, the day he was announced as a new CEO, and I got to imagine that was a very busy day for him.

When we did connect, he actually reaffirmed every part of the relationship we had prior and even took some very visible actions to strengthen the relationship, and so we were very, very pleased.

I think it is going to be terrific.

The pipeline that we have with VMWare, and consequently the pipeline they have with NetApp is so significant that I'm sure that it is in our mutual best interests to continue a very close relationship.

And that Paul certainly understands that and I think he feels as though his objectives to make VMWare number one in their segment.

He's facing some significant competition coming up on the horizon and he's not about to jeopardize any close relationships they have.

A very pragmatic situation.

We've seen things perceived really positively in that regard.

The vertical breakdown, I give you real quick.

Tech and Internet was about 19%.

Financial services is back.

That was about 11.

Remarkably similar to Q4, I should point out.

Government was about 11% and followed by Telco, manufacturing and energy in

And can you sort of expand on the fact that you made some comments about the pipeline with respect to VMWare, how many of your--?

We've got a long queue waiting behind you.

We'll move on and you can come back.

We've already answered two.

Thank you.

You're welcome.

Our next question comes from the line of Richard Sherman with MKM Partners.

Question about discounting, was there greater pressure for discounting in the quarter especially at the high end of the business?

No, not particularly.

Your customers always want lower price.

No, our discounts, we've maintained significant discipline and I'm quite pleased.

Thank you.

Our next question comes from the line of Chris Whitmore with Deutsche Bank.

Go ahead.

Thanks.

Steve, DSOs came down a bit, a bunch in the quarter, can you talk about linearity through the course of the quarter or linearity specifically and can you give any color on total bookings and backlog.

That would be helpful?

Thanks.

Yes, so linearity was pretty much what we've experienced over the past several quarters.

It wasn't a big change.

Slightly better.

Slightly better but not materially.

I think the -- I attribute the reduction in DSO to a super-collections effort.

We collected -- we did a lot of work in the collections there.

We were able to knock down the collections bar type of thing.

So that was the big driver.

Obviously we're not going to be able to do that again next quarter.

So but, anyway, it was a super, super performance this past quarter that yielded the results.

Any comment on total Company bookings in the quarter and did you see an acceleration in bookings following the announcement to the upgrade of the 3,000?

Thanks.

No, we didn't see any significant difference in linearity in this quarter than we would see in any Q1.

Q1 always gets off to a slow start because everything that was an active deal we got closed at the end of the fiscal year and then we run to the finish in July and had exactly the same profile as prior years.

We have no comment on total bookings.

Our next question comes from the line of Jayson Noland with Robert Baird.

Go ahead.

Thanks a lot.

Maybe an update on 10 Gig-E, are you seeing much demand in the manned for 10 Gig-E and server virtualization pushing demand for 10 Gig-E and how would that impact your business?

Well, first of all, our systems are 10 Gig-E ready and we have systems out there running it today.

The general question of VMWare creating opportunity for ethernet storage, whether it be NAS or iSCSI, that is one of the motivators in that area.

Architecture of the data centers moving towards ethernet based methodologies.

As far as 10 Gig-ethernet, clearly pricing behavior by some of the suppliers in the industry slowed down some of its adoption but we're seeing breakthrough pricing on some of the newer systems.

I expect to see that picking up.

It is a relatively small percentage of our install base.

But the general question of ethernet based storage is unmistakably on an up trend.

When the infrastructure economics warrant it I think we'll see 10 gigabit ethernet as well and we want to lead in that area.

My experience is exactly the same as Tom's.

Lot of customers see valuating 10 gig where prior they thought it was just too expensive.

One of the preproduction pilots going on, server virtualization and general ethernet storage, has a higher density of 10 gig and they're not in production yet.

Hopefully you expect to see the take-up in that late in calendar Q4 or something like that.

Those preproduction pilots roll into production.

Thanks, guys.

Our next question comes from the line of Clay Sumner, FBR.

You guys, Dan, you talked about executing your plan to gain share in a weak economy to the letter, and if the economy stays weak for an extended period, longer than you originally expected well into '09 or whatever, would you consider changing the plan to stay below the operating model for an extended period to keep investing for share gain or would you rather get back on plan for 16%.

I would keep investing for share gain.

It really depends what the macroeconomic picture looks like.

I actually think our very best opportunity to gain share is when the global GDP is about 1%.

Budgets aren't getting whacked and cut, but they're getting squeezed to the point where customers have to look at new alternatives.

That's the sense we have.

The budgets are just getting macheted like they did in 2001, then we are not going to be immune from that and we'll probably pull back.

If you see a general implosion of the major economies, we would move them to more conservative stance.

As long as it's kind of the status quo, right?

I think we are on exactly the right track to gain enormous amount of share right now.

Customers still have money to spend.

That still is the key.

But they can't get the job done in the traditional manner and looking for new approaches.

The storage efficiency argument we have is just really compelling.

Run dedupe on your primary.

Drive more ATA on your primary environment.

All of those other kinds of things.

Move to overprovisioning scheme.

You go through the list and you go that makes sense.

And get my job done and not blow my budget.

We're I think convicted to stay in that mode as long as the economy doesn't significantly deteriorate.

I would say that unless you believe the long term growth rate of this industry was permanently impaired, which we don't, then I think that accumulating share when you're in the best position to grab it would be the most healthy strategy.

The storage efficiency story is really, really huge.

My general observation is that customers are under enormous pressure whether it be budget pressures, you got green IT on top of that, you got energy costs that are escalating and we go in there and we talk about deduplication and FlexClones and we can talk about thin provisioning and all of that and what it means to the VM environment or exchange or Oracle, customers are not hearing that from their vendors.

And I get a sense just looking at our momentum around those technologies and even frankly some of the start ups gaining traction is that I think the traditional SAN architectures are being exposed as being dated and inflexible and really have no meaningful answer on the storage efficiency story.

I think that is a gigantic opportunity for us and we're going to press it as hard as we can.

Clay, just to get back to business model, I want to make sure I didn't mislead anybody.

We made kind of an investment surge, if you will, not to use analogy to Middle East, but we have a troop surge in the field and we expected that surge to yield a, and in some delayed manner by a couple quarters, a couple of revenues to get us back to our 16% operating model.

That was assuming no change in the macroeconomic conditions.

I don't expect to have 11% operating, in the second half of this year if that was your question.

Yes, my question was if the economy stays weak, do you do another search?

No, I don't think so.

We got enough in the capacity bubble right now, that that should work just fine.

Again, if it goes down, right, then we'll have a different discussion.

But as long as the economy stays kind of global GDP 1% growth I think we're fine.

Okay.

Thank you.

The next question comes from the line of Glenn Hanus with Needham & Company.

Just following up on the competitive questions, what impact, if any do you think the EMCCX4 might have on, I don't know, sales cycles or the, introducing the new mid-range product you have, any color around that?

Thanks.

No, I think, certainly from a product competitiveness situation, I think that the 3100 stacks up quite nicely.

In fact it is a major step forward for us.

So I'm not concerned from a competitive perspective.

It is something new for your competition to talk to their customers about but overall I don't think it will change the competitive landscape any.

We still don't see deduplication we don't see FlexClones we don't see a lot of this other type of technology there.

And that is what customers are asking us about.

Okay.

Thanks.

Our next question comes from the line of Scott Craig with Banc of America.

Go ahead.

Thanks, good afternoon.

Steve, can you talk a little bit about the cost structure.

You guys have added a lot of people here and going to be adding some more next quarter.

And you -- it appears as you work in the back part of the year you are going to be doing a good job of managing that from a percentage of sales basis.

Where are the areas you are really able to offset some of these costs that you're adding from all these employees that you're bringing on?

So basically we're at the high point of our operating expenses as a percent of revenue, and for the subsequent quarters going forward, you should expect to see a decline.

A lot of the decline comes from the fact that revenue starts growing faster than operating expense, now Tom told you why some of the operating expenses are not going to be growing as fast because we re not going to be incurring these one time hits that we did this past quarter.

I think that after the sales surge, that Dan referred to in the first half of the year, in the second half of the year I think we start to see a calming or a settling if you will of the sales to revenue ratio.

All the other ratios are basically -- being held steady or improving throughout the year.

So they're all going down, basically.

It is across the board.

Ladies and gentlemen, that does conclude the time that we have for Q&A today.

I would like to turn the call back over to Mr.

Dan Warmenhoven.

Please proceed.

This is Dan Warmenhoven.

I want to thank you all for joining us today.

Thank you for your continued support.

Look forward to seeing you in about 91 days.

Thank you a wonderful day.

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

That does conclude the presentation.

You may disconnect.

Have a wonderful day.