NetApp Inc (NTAP) 2009 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the NetApp, Inc.

third quarter 2009 earnings conference call.

At this time, all participants are in listen-only mode.

We will be facilitating a question-and-answer session toward the end of this call.

(Operator Instructions).

I would now like to turn the presentation over to your host for today's call, Ms.

Tara Dhillon, Senior Director of Investor Relations.

You may proceed, ma'am.

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 netapp.com along with the earnings release, the financial tables and the GAAP to non-GAAP reconciliation.

Today we're also presenting slides concurrently with our audio remarks.

They will be available for download on our Investor Relations site at the end of this call.

In the course of today's call, we will make forward-looking statements and projections that involve risks and uncertainties, including statements regarding our financial performance in future periods, including Q4 of FY '09, our expectations regarding future growth, market share and customer demand, our expectations with respect to our inventory management, the expected cost of settling a dispute with the federal government, the expected financial benefits from our restructuring actions and our expectations regarding our effective tax rate.

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, our ability to maintain or increase backlog and increase revenue, increased competition and the material and adverse global economic market conditions that currently exist.

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 on our website, all of which are incorporated by reference into today's discussion.

Please note that all numbers are GAAP unless stated otherwise.

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

We would also like to notify you that in accordance with SEC guidance published on August 22, 2008, NetApp will begin to disseminate material information about the Company through our corporate website within the next several fiscal quarters.

We intend to designate a separate portion ofo ur website for purposes of these disclosures and will include a prominent link on our site to allow visitors to locate this information which NetApp will routinely update.

The website will supplement rather than replace NetApp's current existing channels of information distribution.

Now, with me on today's call are Dan Warmenhoven, Chairman and CEO; our President and COO, Tom Georgens; and our CFO, Steve Gomo.

Steve will review the third quarter financials and discuss our outlook.

Tom will discuss our operations and our opportunities.

Dan will share his perspective on the business in the market and then we'll wrap up with Q&A.

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

Thanks, Tara.

Good afternoon, everyone.

The financial highlight of our quarter was strong expense management by the entire NetApp team.

Given that the macroeconomic environment continues to be challenging and uncertain, this discipline was crucial.

While our results in November/December were close to plan, close rates became even more unpredictable than we had expected in January.

And January's performance was lower than planned.

Fortunately, our expense reduction efforts were already well in motion and we were able to expand our non-GAAP operating margin in spite of the revenue decline.

Despite our Q3 expense reductions, the worsening global macro conditions in January and the ensuing level of uncertainty about IT spending in calendar 2009 influenced us to move forward with a restructuring plan which we implemented earlier this week for fiscal Q4.

This restructuring will further streamline our expense stack for the lean economic times ahead.

Our actions are designed to preserve our revenue-generating potential, increase our focus on community growth opportunities, and at the same improve our operating margins in FY '10.

Before discussing the future, I'll will walk through our third quarter results.

On a non-GAAP basis, Company revenue for the third quarter was $874 million, down 4% sequentially and down 1% from Q3 last year.

Foreign currency effects diminished our sequential results by about 1.7 percentage points and lowered the year-over-year growth by almost 2 percentage points.

Including the impact of $128 million accrual to value contingency related to a dispute with the federal government, on a GAAP basis, total revenue was $746 million.

As we previously disclosed, this dispute relates to a disagreement over our discount practices and compliance with the price reduction clause provisions of our GSA contracts for the time period of 1995 to 2005.

Since 2005, most of NetApp's government business has been conducted via a third party who bears all of the responsibility for complying with GSA requirements.

This charge represents an estimate of the final resolution cost and is accounted for as a reduction to the GAAP revenue.

For the remainder of this call, our references to revenue will exclude the impact of the GSA reserve and will, therefore, be non-GAAP unless stated otherwise.

Product revenue of $528 million, which represents 60% of total revenue, was down 7% sequentially and down 13% year-over-year.

In a few minutes, Tom will describe how the January effect contributed to this decline.

Add-on software, which is a subset of product revenue, was 19% of total revenue.

Revenue from software entitlements and maintenance was $157 million, or 18% of total revenue.

Software E&M was up 3% sequentially and 25% year-over-year.

Total software, the combination of add-on software and software E&M, was 37% of total revenue compared to 37% in Q2 and 40% in Q3 last year.

Revenue from services was $190 million and 22% of total revenue, up almost 1% sequentially and up 26% over Q3 of last year.

Services revenues are comprised primarily of hardware maintenance support and professional services.

Revenue from these maintenance contracts, the largest components of our services category, primarily comes off of the balance sheet.

In Q3, hardware maintenance increased 1% sequentially and 27% year-over-year.

Professional Services decreased 1% sequentially, but increased 23% over last year.

Non-GAAP gross margins were 60.7% of revenue this quarter, down 0.3 of a percentage point from last quarter and in line with our expectations.

Non-GAAP product gross margins were down 2.2 percentage points to 53.5%, due in part to a continued shift away from our larger software-rich systems which we believe has been driven by customer frugality.

Non-GAAP service margins increased to 49.6% as a result of continued improvement in the scale economies of our services business.

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

Turning to non-GAAP expenses, our operating expenses totaled $424 million, or 48.5% of revenue.

OpEx declined 7% sequentially, and increased just 6% year-over-year.

Every functional category of operating expenses declined and OpEx dropped to its lowest level in the past year.

All categories of discretionary spending will continue to be tightly controlled going forward.

In the third quarter, our GAAP operating expenses include a number of unusual charges in addition to the normal items associated with FAS 123R stock compensation and the amortization of intangibles from prior period acquisitions.

This quarter, we also recognized an incremental $19 million of restructuring to close our Haifa, Israel facility and place our open system SnapManager product on an end-of-life status.

In addition, we recognized the $9 million charge to write off a sales force automation tool.

Non-GAAP income from operations totaled $107 million, or 12.2% of revenue in Q3.

Non-GAAP other income, which consists primarily of interest income, was $4.3 million, down 55% from last quarter due to the drop in interest rates.

Non-GAAP net income before taxes was $111 million, or 12.7% of revenue.

Our non-GAAP effective tax rate declined to 16% as a result of a greater mix of profits from our overseas operations.

We expect our non-GAAP effective tax rate for FY '09 to be about 16.5%.

Non-GAAP net income totaled $93 million, or $0.28 per share.

Including the GSA accrual, our GAAP results turned to a net loss of approximately $75 million, or $0.23 per share.

Now moving to our cash flow performance, our cash from operations was $236 million, up 14% sequentially and down 18% from Q3 of last year.

Capital expenditures were $51 million this quarter, up from $27 million last quarter.

Free cash flow, which we define as cash from operations less capital expenditures, totaled $185 million, up 3% sequentially and down 21% from Q3 last year.

Expressed as a percent of non-GAAP revenue, Q3 free cash flow was 21%.

Turning to the balance sheet, our cash and investments totaled $2.6 billion.

This balance excludes approximately $69 million of auction rate securities, which are are classified as long-term investments.

Our overseas cash balance is about 48% of our cash, or roughly $1.2 billion.

The total deferred revenue balance increased $52 million this quarter to $1.6 billion, a 3% sequential increase and a 21% increase in the balance year-over-year.

Turning to DSO, accounts receivable day sales outstanding were 36 days again this quarter compared to 36 days last quarter and 48 days days in Q3 last year.

Our collection efforts were very strong again this quarter and the quality of our receivables as measured by their aging remains very high.

Inventory turns were 16.8 times compared to 18.3 times achieved in Q2 reflecting lower levels of business in the third month of this quarter.

Inventory levels ended up modestly due to the last large buy of a specific type of disk drive.

This will work itself out of the system in the fourth quarter.

Look for turns to improve going forward.

During the third quarter, head count increased by three people on a net basis, ending up with 8,383 employees.

I will discuss our future employment levels shortly when I review our Q4 restructuring plan.

NetApp did not buy back stock in the third quarter.

We felt it was important to continue to conserve our available U.S.

cash balances and keep our future options open, given the uncertainty in the economy.

Turning to our outlook for Q4, our forecast is based on current business expectations and current market conditions and reflects our non-GAAP presentation.

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

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

With the poor visibility related to the macroeconomic environment, and the resulting uncertainty around customers' budgets, we will not provide revenue guidance for the fourth quarter.

What we can tell you is that we expect non-GAAP gross margins to stay around 60%.

And while we clearly demonstrated our ability to control expenses this quarter, some of the reductions, like travel levels, savings from sales event cancellations, and the holiday shutdown are not sustainable.

The result of this will be that our non-GAAP Q4 OpEx is expected to increase by about $5 million to $10 million from Q3 levels.

In addition to the expense reduction actions that have already been taken, per today's press release, we have implemented a restructuring of our business to improve the economics of our business model and to reallocate resources to improve our operational efficiencies going forward.

In Q4, we expect to incur about $30 million to $35 million in GAAP severance and other charges associated with these actions.

This is a wide ranging restructuring that includes dramatic decreases in the number of contractors that we use, a reduction in the amount of outside services that we purchase, and optimization of our real estate lease portfolio, and, unfortunately, the elimination of approximately 540 permanent employee jobs.

I mentioned that the restructuring was intended to help us reallocate resources to improve operating efficiencies.

Over the next couple of quarters, we will use a portion of the expense savings generated by the restructuring to make targeted investments in new skill sets around the world.

We expect the effect of these actions to have a minimal impact on our gross margin structure, but to reduce our FY '10 operating expense levels to about $405 million to $410 million per quarter on average.

About two thirds of the reduction from Q3 levels is effectively due to the employment reduction and about one-third is due to the cost savings in the other areas I mentioned.

At this point, I'll turn the call over to Tom for his operational update.

Thanks, Steve.

Despite the dismal economic backdrop, there's still several very encouraging items to highlight about our business this quarter.

Our storage efficiency story is particularly timely in this environment and our 50% savings guarantee for virtualized environment is generating higher rates of new customer engagements.

Our on channel development and sales force expansion have yielded record numbers of new midsize enterprise and storage 5000 accounts.

Our SAN bookings are up dramatically and we closed the largest deal in our history this quarter.

As Steve outlined for you, we are also taking appropriate steps to tune the Company for the current environment.

As we mentioned in the last call, we took actions in Q3 to stop most hiring and discretionary spending with a goal of more rapidly returning to our historical operating model.

The team responded aggressively and operating expenses were reduced by $30 million in a single quarter allowing us to generate sequential operating leverage despite the revenue decline.

However, the economic outlook has only become more challenging and we had to make further reductions.

Despite the difficult decision to reduce head count, we have actually increased investment in a number of key areas by eliminating low-yield products and inefficient activities.

Similarly, our investment in quota-bearing reps leaves us with sufficient sales capacity to rapidly rebound when the worldwide economies eventually recover.

A key factor this quarter is the reported January effect, where most customers' budgets were being formally releveled to reflect the reduced 2009 expectations.

In many cases customers were were still finalizing budgets in January and many have still not completed the process.

With our quarter ending January 23, earlier than usual, this uncertainty clearly impacted our business after somewhat more predictable conditions in November and December.

The portion of our business most impacted by the downturn has been our 50 largest accounts.

With relatively high shares of customer storage spending already achieved, opportunity to grow is often constrained by incremental storage demand as large new projects are deferred.

In many cases, particularly in financial services, budgets are being lowered aggressively.

The net impact is that despite few losses to competitors, these accounts have seen year-over-year revenue declines of about 24% and some as much as 65%.

Our NAS business has been particularly impacted as a large percentage of those products are contained in these accounts.

Similarly, the decline in the top accounts has skewed our business towards indirect channels.

While the decline in our largest accounts is hard to overcome, the good news is that the customer diversification activities we began over a year ago are yielding positive results even in a challenging environment.

This quarter's bookings from new customers were at an all-time high and we have added over 700 net new accounts, the largest quarterly number since we started tracking it four years ago.

We also added the highest number of net storage 5000 accounts since we began the initiative.

The primary value propositions driving the new account penetration are storage efficiency and server virtualization, particularly in SAN environments.

These are very encouraging statistics and evidence that our branding, awareness and new customer development efforts are clearly making an impact.

While the new accounts cannot yet fully diminish the impact of the decline of the large accounts we are progressively building a broader, more diversified account base that should position us well in the future.

Business from our indirect channel was up 8% year-over-year generating 69% of revenue this quarter.

Our distributors, [Arrow] and [Avnet], contributed 20% of revenue each at roughly 10%.

IBM had an outstanding quarter producing a record high of about $50 million, or 6% of revenue.

From a geographic perspective, on a non-GAAP basis, EMEA with the exception of the UK which is heavily financial services weighted, was relatively strong contributing 36% of revenue up 2% over last year.

Asia/Pac was 12% of total revenue, down 11% year-over-year.

The Americas contributed 52% of revenue, down 1% year-over-year.

Within the Americas, the federal team contributed 9% of total revenue, up 11% year-over-year.

On the product side, total store systems units shipped were up 14% year-over-year as we continue to install more footprints and acquire more customers.

Our FAS2000 entry level units drove much of the increase, up 42%.

Our midrange FAS3000 series was higher in the revenue mix this quarter, contributing about 57% of storage systems revenue.

The high end FAS6000 systems declined again this quarter, another reflection of customer preference towards fulfilling incremental demand and lowered appetite for large expenditures.

A NAS protocol was included in 60% of our bookings this quarter compared to 67% in Q3 of last year due to the concentration of our NAS business in our top accounts.

Orders with a fiber channel SAN, or an iSCSI component, totaled 45% of our bookings this quarter with 33% including fiber channel and 17% including iSCSI.

5% of those orders had an overlap which included both protocols.

The SAN numbers are particularly noteworthy as bookings grew more than 22% over Q3 of last year with even greater strength in fiber channel.

In fact, fiber channel SAN is the most commonly deployed protocol in first-time sales to new accounts.

The key data center trend driving these numbers is the proliferation of server virtualization where NetApp provides unique functionality.

More broadly, the storage efficiency story is especially relevant in this economic environment.

NetApp has compelling success stories about customers who have deployed thin provisioning, thin cloning and deduplication across all application types and has cut the cost of their storage in half.

In certain application environments we actually guarantee it.

Momentum here is particularly strong as products from the traditional SAN vendors have demonstrated little recent innovation and are very susceptible to the storage efficiency message.

In addition, our SAN screen product, acquired about a year ago, has exceeded our expectation, allowing us to close multi-million dollar transactions in high-end environments.

As a result, our SAN momentum continues unabated despite a difficult backdrop.

Deduplication continues to be the most rapidly adopted technology ever shipped with over 28,000 deduplication licenses downloaded at nearly 6,000 customers.

It is not uncommon for customers to see 70% reductions in their storage, and we've yet to be asked to pay on our 50% savings guarantee.

NetApp remains the only vendor to deploy deduplication for primary storage and we have recently introduced it on our virtual tape library product to provide an optimized solution for backup environments.

Our V series platform has third record quarter in a row as customers are deploying the solution in front of their existing EMC,HP and Hitachi infrastructures to achieve greater utilization and functionality.

The V series is a great vehicle to introduce the value proposition our software without requiring the customer to replace their current hardware.

It's a smaller sale for us initially, but helps customers require first-hand solutions with the NetApp solutions and they'll return for more business in the future.

Despite the drop in our revenue, we feel confident about our competitive position.

Our win rates remain essentially unchanged from previous quarters.

As I outlined earlier, our analysis shows that the decline in business this quarter is coming from our most highly penetrated accounts.

We believe their spending will rebound at some point and in the meantime we continue to win record numbers of new customers.

In the interim, we've taken serious steps to increase our efficiency, optimize our resource allocation for our strategic growth initiatives and protect our sales capacity for future growth.

With that, I'll turn the call over to Dan.

Thank you, Tom.

NetApp's fiscal third quarter was characterized by strong execution in the areas of new account acquisition and expense management in the face of demand headwinds resulting from the economic contraction.

The economic environment is impacting enterprises around the world, along with the vendors who do business with them.

Many companies are still trying to determine how severely their businesses will be impacted and, therefore, what their IT budget will be in 2009.

As a result, there's a high degree of uncertainty about what our business levels will be in the near term.

In terms of expense management, I would like to thank the NetApp team for their outstanding response when we asked them to do all they could to reduce expenses.

We took $30 million out of our expense structure in one quarter.

However, our expectation is that a challenging business environment will exist for at least the next several quarters.

We conclude that we must reduce our expense structure even further then the reductions we achieved in Q3.

Consequently, we made a very difficult decision to reduce our employment by (inaudible) more than 6% by approximately 540 positions.

It was especially disappointing that we had to take this action within three weeks of being named the best place to work in the U.S.

by Fortune Magazine.

The restructuring wasn't just about expense reduction.

The primary focus of the restructuring was to implement changes intended to improve our efficiency, while continuing to execute on our core strategy of delivering industry-leading products and support and focusing on new account acquisition.

These actions are designed to streamline our business and make sure we have the optimum resource allocation to maximize out ability to gain share during the downturn.

I believe that our team has now set the right foundation for effectiveness to best execute on our strategic goals.

Despite the current challenging economic environment, there are some fundmental aspects of our business that will allow us to do relatively well.

Our value proposition resonates with customers and prospects particularly when budgets are under pressure.

Our investments in branding, awareness and new customer acquisition have been very effective.

Our record levels of new customer acquisition will translate into share capture once the economy begins to recover and these accounts spend their additional budget dollars with NetApp.

Looking forward to Q4, there are a number of positive and negative factors which will affect our bookings and revenues in this upcoming quarter.

We expect customers' budgets to solidify at some point and we expect most to be at lower levels than last year.

We expect storage spending in aggregate to decline versus last year, but by a smaller amount than other areas of IT capital equipment.

On the positive side, I expect normal year-end behavior from our sales force to push very hard to close business.

I also expect our U.S.

public sector team should have a strong quarter with the passage of the federal stimulus package.

Overall, I do not expect the typical Q3 to Q4 sequential growth rate that we would normally experience.

Given the uncertainty in this economic environment, it is not possible to forecast our business levels in Q4.

Hence, our decision not to give formal revenue guidance for the quarter.

Looking further out into our next fiscal year, the restructuring actions we are taking now will enable us to achieve our targeted 16% operating margin at revenue levels in the low $900 million range.

This sets our foundation for future growth.

Our goal in any economic environment will continue to be the expansion of our market share and the actions we've taken will help us achieve that.

In closing, I would like to thank the NetApp team for their passion and commitment in helping NetApp achieve our strategic goals.

At this point, I will open the floor up to questions.

Please do keep it one question given the limited time we have and the number of people in the queue.

Thank you.

Operator?

Hello?

Operator, are are you there?

Tom, where did the call go?

(Operator Instructions).

Our first question comes from the line of [Wanzi Mohat].

You may proceed,sir.

Thank you.

Dan, you alluded to the opportunity to gain share when market conditions are tough.

Your results from the quarter sort of suggest otherwise, at least from product revenue standpoint that you lost some share.

Can you comment on whether your expectations of share gain of two to three times of market growth rate have changed, and if, yes, do you expect to run the business with a different operating margin target?

No.

Let me first challenge the assumption that we lost share.

Certainly, we were very weak in January, but I don't think there's anybody else to compare us to for the November/December period.

My guess is when you see the other storage vendors report on the first calendar quarter, which includes January, you may come to a different conclusion.

That said, we were clearly down in, as Tom indicated, our top enterprise accounts.

I think on a year-over-year basis, they were down about 20% and that was the cause for the major shortfall.

It was very concentrated in those accounts as 16% of revenues came from new accounts, so it almost balanced it out.

Nonetheless, you couldn't overcome the 20% shortfall.

To answer your question and I don't think we lost share in those accounts, I should add.

They just basically stopped spending.

So if you put it altogether, I think we're still on track to continue to gain share.

It may not be fully realized until the existing large accounts resume spending and the new accounts increase spending.

I think we still have the opportunity to grow at rates that are multiples of the market growth rate in storage.

And, no, we're not really changing our model for the operating income on leverage.

If I could add one comment to that.

I think if you look at the business, our NAS business clearly had a difficult time with our test enterprise accounts.

However, on the other hand, I would say that our SAN business is remarkably robust in this business market and I think there's no share we gained share on the SAN side.

In fact, arguably we may have gained more share this quarter on the SAN side than we have in any quarter in recent memory.

Thank you.

And our next question comes from the line of Brian Marshall from Broadpoint AmTech.

You may proceed, sir.

Hi, good afternoon, guys, thank you.

Question with regards to pricing trends on your stand alone product file servers.

It looks as though the implied product gross margins there in April is going to be down about 1,000 basis points year-over-year.

Do you expect this trend to continue going forward or flatten out at these levels?

If you could just provide some color, that would be great, thanks.

Everybody's here is confused about the comment about 1,000 basis points.

If you are talking about product, I think you're referring to the consolidated Company gross margin where we guided to something around 60% compared to 60.7% this quarter is that correct?

Actually, no, when I look at April '08, the product gross margins were about 60% that quarter and implied guidance for April '09 based on my model assumes about 50%,51% for product gross margins.

I don't have your model in front of me.

That's not what my model shows, but remember also that in the fourth quarter of last year we treated our warranty costs differently than we treat them in FY '09.

So it's about 1.5 to 1.9 percentage points additional charge to the product costs of goods sold reduces the margin by a like amount and services goes just the opposite direction.

So it's not quite a like for like.

It's true that product margins are down, but it's it's nothing on the order of what you described.

A substantial portion of it, i.e., one-third, is due to the effect of the reporting change.

Okay.

Thank you.

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

You may proceed.

Yes, thank you.

Just given the weakness in the month of January, could you just give us any color on your backlog heading into your fiscal Q4?

It's not materially different than you would expect for any other Q4.

It's in line with what it was in entry to this past quarter, Q3, and it's very consistent with prior levels.

Okay, thank you.

And our next question comes from the line of Brian Freed from Morgan Keegan.

You may proceed, sir.

Last conference call you gave us a little color in terms of booking trends, I think I think you told us what bookings were in October time frame.

Could you give us more color into what you guys have seen in January or year-to-date?

Yes, we were tracking pretty good through November and December, I think the focus was on the first three weeks in January.

That's where kind of things really stalled out.

You remember our quarter ended the Friday of the week that Obama was inaugurated on the 23rd.

It was very early end mostly because of the phenomena having our fiscal quarters walk, if you will, through the calendar every year.

The first three weeks were particularly weak in terms of bookings performance.

In round numbers, if you look at this as a normal pattern, you would have seen about $50 million more booked in those three weeks than we experienced and that's a gross number.

I'm not going to try to fend that memory.

You can come at it from three or four different directions, but that's kind of the sense of how the slowdown occurred, and --

[30 million] more .

It would have probably been $30 million to $35 million in revenue if we would have seen the normal bookings pattern those last three weeks.

Okay, and have you seen any improvement in the last two weeks?

I'm not going to comment on that.

Thanks.

And our next question comes from the line of Keith Bachman from Bank of Montreal.

Proceed, sir.

Hi.

This one's for you, Steve.

On the free cash flow generation, you mentioned it was about 20%, 21% of revenues, and that was fairly consistent with the October quarter.

Last year you're about 24% to 26% depending on the quarter.

Does that free cash flow yield so to speak continue up in this environment, and in particularly your DSO performance was pretty good.

Is that sustainable within the context of free cash flow?

It's a difficult question to answer since we're not forecasting the fourth quarter revenue levels or next year's revenue levels.

Let's just put it this way, if business stays in this range, free cash flow is going to be within a relevant range plus or minus $15 million to $20 million with where it is now.

I think our DSO is probably going to be better than our historical performance, primarily because of just the waiting of the deferred elements in our revenue base.

And remember those items have already been invoiced in a prior period, right.

So they don't have to collect those, et cetera.

The DSO is a little bit of an artifact of a shift in revenue mix towards a more deferred element.

That said, I think this Company's ability to generate cash is pretty substantial and I would think we should be be able to keep the free cash flow in a range of 18% to 24% depending on the quarter.

Okay.

Thanks, guys.

I'll jump back in the queue.

And your next question comes from the line of Mark Moskowitz from JPMorgan.

You may proceed, sir.

Yes, thank you, good afternoon.

Regarding the velocity or weakness within hardware, I want to get a sense if you guys can give us some context of how we should think about the rollout effect, if you will, in terms of software and services from this weakness of hardware over the next couple of quarters.

How does that impact both the revenue velocity as well as margins?

I guess I don't really expect anything to change in our mix if that's what you're getting at.

I don't see any fundmental changes going on in the market, so I would expect that the relative bookings profile of hardware/software services to be relatively the same.

Maybe, clearly, if revenue deteriorates further, certainly, that's not our hope or our forecast, the impact of the deferred components would be a greater percentage of our overall revenue and that would be a factor.

But I think for now I don't expect the dynamics to change very much.

Probably the only one detail in that is customers that are not necessarily buying as much new equipment as certainly keeping their existing equipment on maintenance, so certainly seeing maintenance renewal activity on equipment that's been out there for some time, and that will continue.

If this is consistent with what we saw in 2001, we would also expect to see add-on storage to increase in the mix going forward, as customers try to forestall upgrading systems and just kind of expand them in place as a temporary stop gap measure.

We did not see this that quarter which I was a little surprised at, but I still expect to see it going forward.

Thank you.

And our next question is coming from the line of Bill Choi from Jefferies.

You may proceed, sir.

Okay, thanks.

I would like to get some more color on January perhaps in a slightly different way.

Are you able to provide some kind of a year-over-year comparison on a monthly basis that would give us a sense of how rapidly things dropped in January and whether given the push into fiscal year-end that is the level you would expect heading into this Q4?

Thanks.

No, I can't.

Here's the problem.

The calendar year and our fiscal year don't line up very well.

And you find end of the year effects on the calendar year, such as IBM, for instance, which had a really big finish in the calendar year don't line up week-by-week in our fiscal calendar.

Right, but compared to the same time period for you a year ago are you able to give a year-over-year comparison of how November, December, then January?

The best I can do is what I've already done and tell you that I think our bookings on a normal progression would have been about $50 million higher in that last three weeks than what we actually experienced.

Could I ask another question in regards --

I would like to follow-up on that one too if I could.

The one thing that I want to be clear about with our quarter ending on the 23rd what typically happens is it isn't only about January activity levels.

It's also about customer behavior.

So usually the first couple weeks in January, customers are coming back from the holiday, they're resetting their budgets and usually those are difficult weeks to get business closed.

In our particular case, we typically have two or three weeks after that to actually close the quarter.

In this particular case we only had one such week.

So our commentary about the January effect is just as much about our corporate calendar as it is about business levels.

I think at this point it's hard to speculate what relevant impact of those two were.

Next question?

Our next question will come from the line of Bill Fearnley from FTN Equity Capital.

You may proceed, sir.

Yes, thanks, guys.

Wanted to ask if I could, how you are looking at near term and long-term changes in the sales of support staff deployments?

I mean certainly you saw weakness in your biggest accounts, but that strength in the channels, and how do you look at deployments going forward and how do the upcoming staff cutbacks affect some of that as well?

Well, first all of on the staff cutbacks, substantially complete and that process actually began this week, and your point is a fair one.

The staff cutbacks was not just about a financial exercise of beating cost targets.

We actually used this exercise to restructure in a number of ways and I would say every aspect of the Company has taken substantial steps to not only find a way to reduce cost, but also find a way to invest in our key investment areas and our key priorities going forward.

So we did not cut all aspects of the Company equally.

We clearly kept the focus on those things that were going to keep generating business in the near term as well as generate business for us in the long run in terms of product development and the like.

But clearly we have restructured our activities around moving support personnel closer to the customer in some cases, redeploying our people away from some of our slow moving, low-growth accounts towards new account activity.

So all those things are underway.

That was a big part of our process.

The whole activity was not only about meeting new cost targets.

The reengineering component, as I say, had equal emphasis and was probably equally as dramatic.

Is there any overhang with any negotiations you have to do with work councils or whatever in Europe?

I know you've taken the actions, but is there any delay in terms of when the people actually leave the Company?

Yes, the answer to that is, yes.

Obviously, there's a lot of complexity associated.

That's why I said the process is substantially complete.

There's certainly going to be some overhang in Europe and some other GOs, and there will also be some people in transitionary roles for a while as we make some of these reengineering changes.

Thanks.

And our next question comes from the line of Chris Whitmore from Deutsche Bank.

You may proceed, sir.

Thanks, can you quantify the impact of exiting product lines on your annual revenue?

How large are those products and what's the impact going forward?

I suspect you're referring to two in particular.

One would be StoreVault and I think at peak I don't think that one reached $5 million per quarter in revenue.

And the other would be the SnapManager for open systems and that one really struggled to be very honest with you.

I'm not sure if it ever reached a million.

Yes, I think in summary, a big part of our thinking here is that in a cost-constrained or investment-constrained environment we need to make sure that we're spending our money on the things that will be making the greatest return.

So clearly those products didn't measure up to that particular metric and as a result, we basically skewed those resources to other, more productive, activities.

So, I think that is visible, but that's emblematic of a lot of the changes we've made internally in terms of making these around activities that are not yielding what we want them to.

And effectively, the message is that the opportunity to invest in new initiative is going to have come from reducing investments in those things that are not nearly as lucrative.

Okay, and if I could just ask a question about expectations around OpEx and salespeople making their year-end targets.

Presumably you've made some assumption there, can you share with us in terms of is in that OpEx guidance for sales force bonuses?

Well, we have -- we have a normal seasonality, a normal commission structure that occurs in the fourth quarter when all of the -- a lot of accelerators in place as many people are beating their numbers and indeed many of our sales reps are beating there numbers this year.

I don't know that it's going to be a whole lot different than it has been in past years.

The aggregate level will probably be down -- in aggregate on a per average, per person basis, but not that much.

Yet you're getting less than normal seasonality on the top line, I'm just trying to understand that?

It's not a one-for-one relationship because the question is it's account-to-account.

Is a certain account in accelerated situation?

Are the people serving that account being paid on an accelerated basis?

You can have an account that's 200% of their goal and the rest of them are 80%, and if you do the math the way the multipliers work, you can get a year that looks normal even though on average the Company is down a little bit.

Thank you.

And our next question comes from the line of Ben Reitzes from Barclays Capital.

You may proceed, sir.

Yes, thank you very much.

Good afternoon.

With regard to just another way to think about going forward.

You're indirect sales great %, that's down, I believe, from 24% the previous quarter, but your direct sales down 17%, I mean, just common sense and I was wondering if you could refute this.

Wouldn't direct sales go next?

We just heard from Arrow, and, obviously, things are pretty weak, but wouldn't indirect go next and go pretty negative here and that's something you have to factor into your views for the upcoming quarter and make revenue go down sequentially?

You would think indirect keep this trend on the big accounts.

You said the top 50 accounts.

So I'm just thinking isn't this indirect figure on a lag and we get that hit next quarter and how do you not know that?

I would not make that assumption.

I'm not sure that logically follows.

The fact that we're gaining so many new customers and we're actually acquiring customers at record rates tells me that the dynamic that we're seeing are account specific and not fundmental to the entire industry at large or our competitive position.

If we were not adding new customers at the same rate I would say this industry is mostly locked in and we would expect to see these slowdowns across the board.

When we see the new midsize enterprise account growth, when we see the new storage 5000 account growth I still think there's an opportunity for those channels to still be successful.

A lot of that business is coming through our indirect channels and if anything, if I look at when my competition is winning and losing that proposition looks similar to ours and that is the high ends are weak and there's lot of new customer activity in the midsize enterprise area.

And I think our challenge is actually reaching it, not running out of demand.

Thanks a lot, Tom.

And our next question comes from the line of Keith Bachman from Bank of Montreal.

You may proceed, sir.

Hey, Dan, I just want it on record that I went back in the queue to ask my second question.

I do appreciate it, really.

(laughter)

I wanted to ask you guys about product plans and that is to say big ticket generally isn't selling well no matter what company, IBM, Sun, I imagine we'll hear it from HP, and you guys, the 6000 didn't do as well as the 2000 series.

How does that make you think differently or not about your product road maps for the balance of the year in particularly any color on the GX and how you think about the operating system unification plans going forward?

Thanks.

Okay.

Engineering is a long lead time activity.

So I think responding from the road map to events that might be a quarter or two quarters to duration is difficult.

So we haven't done anything to change our road maps in terms of, certainly our hardware platforms which are the longest lead time items in response to this in any way.

As far as the high end is concerned you basically intertwine two things, which I think are interesting, and that is with the advent of the convergence of our operating systems and bringing clustering to our mainstream customer base, the trade-off of how many big high-end platforms do we need to continue to develop in the future, as opposed to basically building large complexes at a more cost effective building blocks using clustering, that's a fundamental architectural question.

I don't think that anybody in this industry is ready to say we are not going to build another high-end platform but the question is beyond that will there be another one and another one after that, I think time will tell.

But for us I think our road map is intact.

We still have another high-end platform on the road map.

We totally intend to deliver that as we previously said we would.

But I think beyond that as we see clustering become more pervasive, then I think there's more of an option for debate.

Okay.

I will cede the floor.

Thank you

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

Baird.

You may proceed, sir.

Question on verticals.

I think government was down off of a tough FQ2 comp, was the difference made up on the financial services side?

Let's see, I'm trying to look at year-over-year comparisons.

First of all, it's hard to believe that financial services would make up for anything.

(laughter) But, frankly, our government business was up 11% year-over-year.

It was probably our most successful growth geo in terms of of our major geos.

So I don't feel like our government business has seen any weathering overall.

In the aggregate our breakdown is, tech was still 15%.

Financial services and government were 11% and then the other verticals were all single digits.

Thanks, Tom.

Just to underscore the federal government.

Remember, they had really two strong quarters which are our fiscals 2 and 4.

Fiscal Q2, which ends in October, contains the end of the U.S.

government fiscal year which is the end of September.

So on a sequential basis you would expect to see it fall quite dramatically which it did.

And our next question comes from the line of Alex Kurtz from Merriman Curhan Ford.

You may proceed, sir.

Yes, thanks for taking the question.

Just on the competitive front as you guys concentrate more on the midsize enterprise, are you seeing more CTOs and CIOs bring additional vendors in for the RFP process?

Are you seeing more people in the deal or is it still the same group across the board?

Thanks.

The competitive mix didn't change that much, I mean we looked at frequency of engagement versus various competitors.

Win-loss rates both on deals and dollar value of the deals and it was remarkably consistent from Q2 to Q3.

So it's really the same players.

I know we don't see much difference.

I think you might see a difference when you got to the next layer down.

We call the small enterprise.

They have a tendency to buy more from the server vendor with the storage bundled in, but the medium-sized enterprise is still a pretty good size.

They're not small businesses in general.

If you were to look at the 700 accounts that you were talking about that you added this quarter was there a specific geo or vertical that really stood out from those customer acquisitions?

Thanks.

No, actually not.

I would say what is more interesting is the technologies that stood out.

Server virtualization and the other line technology of SAN, and probably just for a point is is that the new customer account information actually does not include IBM which is a whole other tranche of new accounts both in storage 5000 and midsize enterprise.

However, if I was going to make one observation about the industry and vendors is, and this is particularly around the SAN industry, is we are certainly seeing some of the newer companies showing some momentum.

Our SAN business is particularly robust in this climate, and I actually think that there actually is a shift in SAN share underway.

In fact, if you look at the five-year charts of San share NetApp has clearly gained the most share of the major players.

But the only other category gaining share is "other," and I tried to highlight this a little bit in my comments, but what I believe is you're starting to see new innovative technologies enter the SAN market that are not being offered by the traditional vendors.

And as a result, I think, particularly in this environment because most of those new technologies whether thin provisioning or deduplication or the like are particularly relevant in an investment-constrained environment.

And as a result I think some of the new innovation is getting a look it didn't get two years ago.

And I think what you're starting to see is some of the traditional SAN vendors, particularly in the midrange, particularly vulnerable to it and you're starting to see companies like ourselves and other companies offering new innovation gaining share.

Okay.

Thank you.

And our next question comes from the line of Kaushik Roy from Pacific Growth Equities.

You may proceed, sir.

Thank you.

Congratulations on the nice expense management.

On operating margins, I understand the long-term target is still 16%.

Can you comment on your expectations on your expectations on operating margins for the next couple of quarters?

I guess at what revenue run rate are you inclined to reduce head count more?

Kaushik, you were breaking up a little bit, so I'm not the sure I heard the question, but we're not giving revenue guidance, I can't really give you operating margin guidance.

I think his question was, it was a little hard to hear, but I think the question was at what level do we achieve the 16%?

Right.

So, when we get to a steady state, let's say in the FY '10 we should be able to hit 16% at $920 million.

And even at $900 million we're within, we're very close, within 1 percentage point of that.

So by restructuring we have positioned our ourselves to be able to achieve our objective of 16% at very low levels of $900 million plus in revenue and even if we dipped into the 800s, which we're not projecting, but if that were to happen we're still within reach of our goal.

You don't have cut more heads if it falls slightly below $900 million?

My answer today would be no.

Okay, thanks.

And our next question comes from the line of Bill Shope from Credit Suisse.

You may proceed, sir.

Okay, thanks.

Dan, I wanted to ask a question on the competitive landscape as well.

There was some chatter that some of your competitors may have been offering fairly aggressive bundle deals in December to pull in business into the quarter.

Did you see any impacts from these types of actions and is there a risk that the environment could get incrementally aggressive as we progress through the next several quarters potentially impacting your margins beyond just (inaudible)?

Yes, there's nothing really unusual.

I should point out that a lot of our competitors do have quarters which end at the end of the calendar year, and in particular the market leader has one that ends that way.

So they have a tendency to get more aggressive every December, but this is nothing unusual from that prospective.

And, again, as you looked at the competitive frequency of engagement, resolution of the deal, win-loss loss dollar value of the deal, reason for win or loss, et cetera, it really was very, very consistent with prior periods, both the year ago period and the quarter earlier period, both.

So, no, I really didn't see the change much -- I think what you probably saw is normal behavior.

But everyone is more tuned into it now because they are looking for it because the economic conditions are bad.

But I've got to tell you salespeople have a tendency to try to drive into the accelerators and so on are willing to provide some financial incentives to their customers to close business.

That's a normal pattern of behavior.

Okay.

Thank you.

And our next question comes from the line of Brent Bracelin from Pacific Crest Securities.

You may proceed, sir.

Thank you.

I guess this specific question for Tom.

Tom, as you look at NetApp, clearly as a long history of seeing increasing storage efficiency through software, clearly, talked about strong adoption of deduplication, reducing storage footprints by up to 70%.

As you think about the product business, how do you know a portion of the 13% kind of decline here in product sales is not partially attributed to the success you're having on deduplication that's at least partially exacerbating the macro concerns you see out there?

Well, I guess kind of my first response is so what if it is.

(laughter) If we had 90% market share, then I would say let's be careful with this technology because we don't know what's going to happen.

But it's a mixed bag -- so a fair number of our big customers are using or accelerating the deployment of this technology in order to defer storage purchases because they're under enormous budget pressure, I have no doubt that's going on.

In fact, I do see it.

On the other hand, once they've done that I think it makes them pretty sticky NetApp customers when it comes to actually buy some things.

On the other hand, not all of our platforms, not a lot of our older platforms actually are capable of running this and in that case it's an opportunity to upgrade.

And the other thing, the connect rate of this technology into new environments is extremely high, so I'm sure it's helping business.

So in the aggregate I have no doubt, no doubt that some of the storage efficiency stuff is slowing our momentum in some of our big large installed bases.

However, if that drives customer loyalty in the long run, I think that's a risk worth taking.

But in the end, I think if you've got new innovation, the best thing to do is to make it available to your customers.

I think only good things happen to you in the long run.

We would, under no circumstances I could imagine, unless we had massive market share would we contemplate holding this technology back.

We will aggressively promote it and if it has a short-term impact on demand from our existing customer base then so be it.

When you look at the 16% of revenue that came from new accounts in the quarter, and you go through the detail as to reasons why we won, it was predominantly storage efficiency.

And so I think that more than offsets any decline we might have seen from even our installed base customers.

It sounds like deduplication certainly could be a potential headwind here in the short run, but as you start to anniversary the installation of the technology you should go back to a normalized kind of share gain environment, is that the right way to look at it?

Yes, I think so.

They're going to free up some space by doing things like deduplication and as soon as that's full they're going to have expand.

There may be a short-term effect, and like Tom said many of those have to be upgraded from a systems viewpoint before they can turn it on.

Great, very helpful.

Thank you.

Yes, I also believe in the long run certainly this environment is extraordinary, but in the long run, storage tends not to be capacity limited or demand limited.

It tends to be budgeted limited.

So I think in normal environments where people get the efficiency to do deduplication and the thin provisioning and all of the other technologies, typically what they do is find ways to put even more stuff online or make more copies of data and do things along those lines.

In this environment I think they're probably curtailing the second part of that, but in the long run I feel since this is demand limited if you can compress it, they'll find other things to put online and more than make up for it.

I'm a firm believer, and I have never been proved wrong, that in the long run anything that lowers cost per bit stimulates demand.

Thank you.

Our next question comes from the line of Bill Fearnley from FTN Equity Capital.

You may proceed, sir.

Yes, Steve, I apologize, but a housekeeping question here.

How should we be thinking about the tax rate and any potential tax benefits from R&D tax credits and also how should we be thinking about share count and buybacks here in the near term?

Okay, so from a tax rate standpoint, if you're looking on a go-forward basis, I would be using a 16% effective tax rate.

That's what we're using here.

That's what we expect.

As far as the share count's concerned, I think there's a number of puts and takes there.

The bottom line is I would look for it to be very flat.

Thanks.

And at this time we have no additional questions.

I'll turn the call back over to Tara Dhillon for closing remarks.

Thank you for joining us today, everyone.

We'll look forward to talking to you again again on May 2.

Thank you all.

Have a great day.