NetApp Inc (NTAP) 2010 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the NetApp first quarter 2010 earnings conference call.

I will be your operator for today.

(Operator Instructions).

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

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

I would now like to turn the call over to Ms.

Tara Dhillon, Senior Director of Investor Relations.

Please proceed.

Good afternoon, everyone.

Thank you for joining us today.

Our call is being Webcast live and will be available for replay on our Website at NetApp.com, along with the earning release, the financial tables and the GAAP to non-GAAP reconciliation.

As a reminder, we are 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 risk and uncertainties, including statements regarding our financial performance for the second quarter of fiscal 2010, the timing of our new product introductions, our expectations regarding our professional services business and our expectations regarding future customer demand and our growth 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 increase revenue, increased competition, and the challenging 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 reconciling items between non-GAAP and GAAP, refer to the table in our press release and on our Website.

I would also like to point out that prior year GAAP financial statements are adjusted retrospectively for the adoption of FSP APB 14-1, related to our convertible debt.

For example, last year's Q1 FY '09 GAAP P&L now reflects approximately $5 million more interest expense and $0.01 less EPS related to the change.

Our balance sheet and cash flow statements have also been adjusted.

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

Steve will review the first fiscal quarter financials.

And then, Tom will discuss the trends we're seeing in our business and initiatives we have underway.

But first, I'll turn the call over to Dan for some brief remarks.

Dan?

Thank you, Tara.

I'd like to invite everyone on the call to join me in congratulating Tom Georgens on being appointed CEO of NetApp.

Over the past four years, Tom has demonstrated tremendous leadership and strategic thinking and operational ability, especially during the challenging environment this past year.

He has earned the respect of our employees, our customers, our shareholders and the Board of Directors.

And I'm confident Tom is the right person to lead NetApp into the future.

My 15-year tenure as NetApp's CEO has been an incredibly rewarding journey but nothing lasts forever.

I've had a long time personal goal to transition out of the CEO role by the time I turned 60, which is only about five quarters from now.

And this felt like an appropriate time to make the transition.

The economy appears to have stabilized and it feels like we're sailing on somewhat calmer seas.

It's always better to implement a transition during a time of relative tranquility.

NetApp is also in the cusp of a new era.

An era characterized by cloud computing and infrastructure service providers, which will change the nature of our business.

Plus a change in the character of our products as we start shipping the scale-out technology in ONTAP Release 8 in a few weeks.

It seems wise to make the CEO change at the beginning of an era, rather than the middle, to maximize continuity and minimize disruption.

And Tom is absolutely the right person to succeed me and he's ready to step into the CEO role to lead NetApp into this new era.

Tom has demonstrated outstanding strategic leadership regarding the best ways for NetApp to capitalize on the cloud opportunity.

And he'll talk with you more about this opportunity at NetApp's October 8 analyst day.

As you probably saw in the press release, while I'm stepping down from the CEO position, I will continue with NetApp in two distinct roles.

First, I will continue as Chairman of the Board of Directors.

In addition, I'll also take on an executive role in the Company to help build and expand relationships with certain key strategic partners.

In this newly created position, I will report to Tom as a member of the executive management team.

I'd like to thank everyone for their support and loyalty over the years.

I'm looking forward to do next stage of NetApp's evolution under the direction of our new leader.

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

Steve?

Thanks, Dan.

Good afternoon, everyone.

Given the economic backdrop, NetApp performed reasonably well in the first quarter.

The overall business environment also appeared to stabilize somewhat.

As I walk through our results, please keep in mind that Q1 was a 14-week quarter.

Revenue for the first quarter was $838 million, down 5% sequentially and down 4% from Q1 last year.

We estimate that about $20 million of revenue was added by the extra week in Q1.

Foreign currency effects improved our sequential results by about 0.9 percentage point and reduced our year over year growth by almost 4 percentage points.

Product revenue was down 6% sequentially and down 13% year over year to $478 million.

Add-on software, which is a subset of product revenue, was 16% of total revenue.

Revenue from software entitlements and maintenance, which is a deferred revenue element, was $165 million or 20% of total revenue.

Software E&M was up slightly sequentially and up 14% year over year.

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

Revenue from services was $194 million and 23% of total revenue, down 7% sequentially and up 10% over Q1 of last year.

Service revenues are comprised mainly of hardware maintenance support and professional services.

Revenue from maintenance support contracts is also a deferred element and was about 2/3 of our service revenue category this quarter.

In Q1, it increased 2% sequentially and 19% year over year.

During the first quarter, we proactively began the process of moving some of our professional service business to partners.

A trend will you continue to see going forward.

Our partners appreciate the additional business and we are able to focus our investments on higher leverage areas of our business.

As a result of this effort, professional services declined 21% sequentially and decreased 3% from last year.

On a non-GAAP basis, consolidated gross margin was 63.6% of revenue this quarter.

This was an increase of 1.8 percentage points over last quarter, primarily due to an increase in software entitlements and maintenance in the revenue mix, as well as better than expected margins on products this quarter.

Compared to Q4, non-GAAP product gross margins were up 4.1 percentage points to 56.8%.

This was due in part to improvements in the product cost and variance performance.

Product discounts were also down slightly compared to Q4 of FY '09.

Non-GAAP service margins decreased to 51%, returning to more typical levels.

Non-GAAP software E&M gross margins declined slightly to 98.1%.

Turning to our non-GAAP expenses.

Our operating expenses totaled $444 million or 53% of revenue.

OpEx increased 4% sequentially and was virtually flat year over year.

The $18 million increase in operating expense from Q4 was a little larger than we had planned.

The effect of the 14th week was about $16 million or approximately $2 million higher than we had estimated.

In addition, currency effects and the pull up of a planned outsourcing project added about $3 million more in expenses than anticipated.

In addition to the non-GAAP operating expenses, Q1 GAAP operating expenses include FAS 123-R stock compensation expense, amortization of intangible assets associated with prior acquisitions, and the current period impact of prior restructuring actions.

Also, included in our GAAP operating expenses this quarter are the impact of the Data Domain merger termination fee and the professional advisor expenses incurred in conducting the transaction.

Finally, the GAAP operating expenses included $13 million of non-cash interest expense associated with the adoption of APB 14-1 for our accounting treatment of convertible debt.

All of these items may be found in their appropriate expense category in our GAAP to non-GAAP reconciliation.

Our headcount at the end of the quarter was 8,042, an increase of 66 people.

Compared to Q4 of FY '09, non-GAAP income from operations decreased to $89 million or 10.6% of revenue in Q1.

However, non-GAAP operating income increased by 7% year over year and our non-GAAP operating margin finished 1 percentage point higher than in Q1 of last year.

Non-GAAP other income, which consists primarily of interest income, was $1.5 million, down from Q4 almost entirely because of lower interest rates earned on our investments.

Non-GAAP net income before taxes was $90 million or 10.8% of revenue.

Our non-GAAP effective tax rate remained at 16%.

Non-GAAP net income totaled $75.9 million or $0.22 per share.

Diluted share count increased 5.4 million shares from Q4, primarily due to the effect of our option exchange program.

In April, our shareholders approved an option exchange, which resulted in 24.5 million options being surrendered in exchange for 3.2 million restricted shares on June 21.

Going forward, share count is expected to increase by about 1 million shares per quarter.

Now, moving to our cash flow performance.

Our cash from operations was $38 million, down 79% sequentially and down 85% from Q1 of last year.

As we previously disclosed, in Q4, we settled the dispute with the General Services Administration.

The cash payment of $129 million, including interest associated with the settlement, was paid at the beginning of the first quarter of FY '10.

Also, in Q1, we recorded the termination fee and external advisor expenses associated with the Data Domain transaction.

The net effect of the Data Domain item added about $41 million to our cash flow.

Capital expenditures were $25 million this quarter, down from $135 million last quarter.

Free cash flow, which we define as cash from operations, less capital expenditures, totaled $13.5 million, a decrease of 70% sequentially and down 92% from last year.

Expressed as a percent of non-GAAP revenue, Q1 free cash flow was 2%.

Now, excluding the GSA payment and the effect of the Data Domain transaction, free cash flow would have been roughly $100 million or 12% of revenue.

Turning to our balance sheet.

Our Q1 cash and short term investments totaled just under $2.7 billion, for a net increase in cash and short term investments of $59 million over Q4.

At the end of Q1, our US cash balance was 44% of our cash or roughly $1.2 billion.

The total deferred revenue balance decreased sequentially by approximately $600,000 this quarter to $1.7 billion, which reflects a 10% increase in the balance year over year.

Turning to DSO, accounts receivable days sales outstanding were 39 days this quarter, compared to 44 days last quarter and 45 days in Q1 last year.

Inventory turns were solid at almost 20 turns, compared to 22.1 turns achieved in Q4 and 21.7 turns achieved in Q1 of last year.

Turning to our outlook for the second quarter of FY 2010.

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 risk and uncertainties.

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

While we believe the economy has begun to stabilize, predictability of close rates is improving but still remains somewhat limited.

Therefore, we will not provide specific revenue guidance for the second quarter.

In terms of color, we can tell you that we do not expect normal sequential seasonality, since we're coming off a 14-week quarter and we certainly haven't returned to a normal spending environment.

Moving down the P&L, we expect non-GAAP consolidated gross margins to remain strong, likely holding between 62.5% and 63%.

We expect our second quarter non-GAAP OpEx to decrease by about $20 million from Q1 levels, reflecting the return to a 13-week quarter.

Given this updated forecast for expenses, we do not expect to reach the $405 million to $410 million OpEx level that we had previously planned for Q2 and Q3.

Compared to our plan, currency effects, a transfer of some employees from services COGS to sales and some minor administrative charges, account for most of the difference.

In Q2, our operating expenses are likely to be in a range of around $425 million, subject to an adjustment, based upon what we see happening in the economy and our pipeline.

The transfer of employees between service COGS and sales is neutral to the operating margin.

Finally, in Q2, other income is expected to remain at similar levels to Q1 and then expand into the second half of the year.

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

Thanks, Steve.

And thank you, Dan, for the support and confidence.

I'm looking forward to leading the team towards a new period of growth for NetApp.

With the turn of the fiscal year and sensing some stabilization in the economy, we took the opportunity to vigorously drive some new initiatives into the organization.

We put a particular focus on a more disciplined pricing behavior and increasing market share by driving product revenue.

The first indication of our progress is the highest gross margin quarter in many years.

Further evidence of the strength of our storage efficiency message to both end users and IT infrastructure provides.

It is my expectation that the gross margin will not likely stay that high and we will use this as an opportunity to drive growth and market share.

Turning now to specific operating results.

This quarter, the Americas showed signs of stabilization.

Despite Q4 to Q1 seasonality and difficult year over year compares, the Americas was up 1% both sequentially and from Q1 of last year, contributing 58% of total revenue.

Within this, federal had a strong quarter, up 8% sequentially and up 17% year over year, producing 13% of total revenue.

Europe had its typical seasonally softest summer performance, down 16% sequentially and down 7% year over year to 32% of total revenue.

Incidentally, Europe contributed the exact same 32% of total revenue in Q1 of last year.

Although Asia-Pac was down 14% year over year, they were up 2% sequentially, for a total of 11% of revenue.

Overall, on a constant currency basis, we were nearly flat year over year.

Despite a traditional Q4 to Q1 seasonal decline, two of our three major geographies were actually up sequentially.

Direct revenue was 31% of total revenue this quarter, down 23% year over year.

Our indirect channel contributed 69% of total revenue, up 9% year over year.

Arrow and Avnet each contributed about 11% of total revenue.

Our IBM OEM bookings were down 7% year over year and IBM contributed almost 5% of revenue in Q1.

The top 100 accounts increased as a percentage of total bookings compared to last quarter, accounting for about 35%.

The rest of the storage 5,000 contributed about 1/3 and mid-sized enterprise accounts contributed a little over 30% of total bookings this quarter.

We are pleased with this healthier balance of contribution from these three major segments, compared to two years ago when just our top 50 were over 1/3 of our business.

This is a major improvement in the diversification of our revenue base and an outcome of the awareness and new customer acquisition activities of the last 18 months.

With respect to protocol trends, this quarter, 51% of our configured system revenue was sold with only NAS protocols.

15% was sold with only SAN protocols.

And 35% was included both block and file protocols, which we call unified storage.

These numbers are based upon the new methodology we outlined for you a few weeks ago, the details of which can be found on our Investor Relations Website.

For the sake of comparison as we transition, this quarter, you will find data from the previous methodology in our accompanying slides.

From a platform perspective, almost 60% of our revenue continues to come from the mid-range.

With the low end and the high-end each contributing about the same percentage of configured systems revenue.

Units shipped were down about 7% year over year.

With the largest percentage decline coming from high-end systems, typical of the other storage vendors as well.

Renewals continue to be heavily skewed towards one year terms for both service maintenance contracts and for software entitlements and maintenance, indicating a continued aging of the installed base and a potential refresh opportunity when economic conditions are more favorable.

Once again, we had another strong quarter from our V-Series platform, which is our controller and software functionality without any discs.

Originally designed as a NAS gateway for SAN systems, the incremental growth drive is to deliver NetApp data management and storage efficiency to the large footprints of legacy SAN products offered by our largest competitors.

It is a great way for them to experience NetApp functionality without a big investment or an immediate replacement of their existing traditional infrastructure.

In fact, our V-Series often pays for itself almost immediately with the space reclaimed when our de-duplication technology is run on a competitors' storage.

Our V-Series units shipped were up 135% year over year and is one of the drivers of our new account growth.

This quarter, over 20% of our V-Series were installed in front of EMC storage, which is one of our highest V-Series growth areas.

I'd like to take a moment to share our perspective on the implications of not completing the Data Domain transaction.

As we said on last quarter's earnings call, Data Domain would have brought a complementary product line with high synergy to our portfolio and selling motion.

We also said that the market segment we were targeting was heterogeneous disk-based back up.

Where NetApp has the primary storage footprint for the initial copy of the data, we have a high attach rate of our disk-based back up solutions behind it.

The unified primary and secondary offerings are tightly integrated and space efficient, so we do not see deep penetration of other disk-based back up products into our installed base.

However, other primary storage vendors represent 80% of the market and do not share our high attach rates of disk-based back up.

That has been the target market of Data Domain.

We also participate in that market but our entry has been relatively recent and Data Domain would have accelerated our presence in this segment.

While having Data Domain in our portfolio would have added another growth vector for the Company, the absence of Data Domain will not diminish or otherwise make vulnerable the growth prospects of our core business.

The two biggest drivers of new business continue to be server virtualization and Windows consolidation.

We have been very successful selling into virtual server environments with bookings sold into VMware environments up over 500% year over year.

A recent InfoStore survey ranked NetApp number two when IT professionals were asked who they considered to be the market leader in storage for virtualized servers.

And number one, when asked who they consider to be the innovation leader in storage for virtualized servers.

Another highlight this quarter was being named Microsoft's storage solution partner of the year.

Demonstrating the tremendous progress we've made with this key alliance partner, both in optimizing the performance of their applications, as well as in their server virtualization initiatives.

We are involved in various joint market activities with Microsoft and Microsoft apps remain the most common installation environment for NetApp.

Looking forward, the cloud computing opportunity Dan mention is one we believe will have dramatic impact on our business in the future and NetApp is uniquely poised to capitalize on it.

Customers are looking everywhere for budget relief and ways to preserve capital.

As a result, they are more urgently exploring the outsourcing of part or all of their IT function to a service provider or systems integrator, rather than developing and running it in-house.

These service providers and SI's, whom we call aggregators since they are aggregating customer demands, are in turn looking for best of breed solutions to help them offer enterprise class IT at extremely competitive prices.

This new breed of vendor has a strong affinity for our compelling economics and simplified data management, which in turn allows them to compete more effectively in this new business paradigm.

With our unified architecture and virtualization technologies, combined with our seamless scale app solutions, which will be available in ONTAP 8, we make it difficult for other storage vendors with traditional architectures or siloed disparate systems to vie for this new business.

We have had many early successes with large scale aggregators who provide mission critical, yet cost effective solutions for their customers.

We expect this customer shift towards IT as a service or cloud computing to accelerate over the next few years.

And as these new aggregators of demand grow in influence and scope, we believe NetApp will grow commensurately.

We will go into greater detail about our positioning and enabling technologies related to cloud computing at our analysts day on October 8 in New York.

I'll close by commending the entire NetApp team for their continued frugality and to the sales organization for such a prompt response to our call to action.

We've managed to increase operating income and operating margin year over year and produce the highest gross margin percentage in my four years with the Company.

While timing is uncertain, true year over year growth and a return to our operating model are more easily envisioned today than they were six months ago.

We will talk more about our prospects at analysts day.

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

As always, please limit yourself to one question.

That rule does not change.

And return to the queue for follow-ups, so that we may address everyone at least once during our allotted time.

Thank you.

Operator?

(Operator Instructions).

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

Please proceed.

Thank you.

Dan, first thing, I want to thank you for your insights over the last 10 years and that I've been working here with NetApp and hope you take some time off.

Tom, congratulations on the promotion.

My primary question is for Steve here.

On the services business, 10% growth year over year, 10% decline sequentially, that's actually the slowest in more than five years.

Clearly, dragged down by professional services.

How should we think about this transition of professional services shifting to your partners?

Is this a one quarter kind of drag on the services business?

Should we model a drag for the next two or three quarters?

How should we think about this transition and how long will it last?

Okay, Brent.

I think that this is not going to have a big effect on the service revenue line.

It will have some minor impact.

We're not getting rid of all our professional services activities by any means.

And in fact, some of the ones that we're retaining will still continue to grow and we'll be providing fairly significant amount of professional services to support our product.

That said, if you look at the low end of the market, some of the basics that need to be required, our partners are in much better position to provide those services.

And the margins are much more in tune with their business model than they are with ours.

So we're just -- that's the portion of the services that we're moving out.

I would think that it would have a de minimus impact over the next two to three quarters.

It may knock 1 point or 2 off service growth but that's probably the biggest impact you'll see.

And from a sequential standpoint, there still could be a sequential impact over the next couple of quarters?

Yes, for the next couple, three quarters, I think you'll see, again, maybe 1 point of growth knocked off.

I don't think it's more than that.

Okay.

Great.

Thank you.

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

Please proceed.

Hi, can you hear me?

Yes.

Thanks.

Sorry.

Wanted to ask a little bit more about your expenses and margins.

It looks like, if I do the calculations, the higher run rate expenses per quarter of about $15 million to $20 million versus your goal are completely offset by the higher gross margin, roughly each about $0.04 to $0.05 a quarter offsetting each other.

And I was just wondering if that math is about right?

And if that's the way it works out and whether there was an opportunity to actually hit your goal though, eventually, later in the year on the OpEx side, while keeping gross margins higher?

So, if you can comment on that math and then, whether you can actually still hit that goal eventually on the OpEx and still keep gross margins up?

Thanks.

Ben, Steve here.

The math is roughly right.

I'm looking at some worksheets here that say the benefit from gross margin is slightly better than the impact on expenses.

And in fact, I think our revenue level required to hit our targeted margins has probably been lowered as a result of this but we're talking $10 million type of thing.

As we go forward, just so you know, the reason why expenses are up, it's not like we are adding a lot of resources here but if you look at a $15 million Delta between the $410 million that we were hoping to hit and the $425 million, over 50% of it is due to currency.

We've also reclassified some people.

We just talked about freeing up some professional services resources.

So we're taking those effective resources, if you will, and we've moved them down to the sales line.

So, there's about $3 million associated with that.

And finally, there's some miscellaneous commissions and one-time transformation projects, et cetera, that are $2 million.

But the big effect is currency.

So, it's not like we're pouring a lot of new money here, hiring a lot of new people.

That's not the point behind the increase in OpEx.

Yes, if I could just file onto that.

Effectively, the goal in the organization and the annual plan that people are spending to has not changed.

So, all these differentials or the special items that Steve indicated, we've not actually loosened the spending spigot, either in terms of hiring or in terms of other spending at the Company.

So, I think in terms of what the individual budgets and individual managers are seeing, they're actually performing according to our original plan, is they had a couple of these line items that added on top of the number.

Okay.

Thank you very much.

Our next question comes from the line of Mark Kelleher of Brigantine Advisors.

Please proceed.

Thanks for taking the question.

Appreciate it.

Could you just clarify your commentary regarding not expecting normal seasonality into the October quarter?

Perhaps what effect did that 14th week have on revenue in the July quarter, so we can maybe calibrate that effect on the seasonal sequential growth?

Thanks.

I think the seasonal sequential growth question, I think has two elements.

One of them is; What is the overall economic climate going to allow?

And I think the other one is; How much of it was absorbed into the 14th week in this current quarter.

And I think that there's been a lot of discussion internally about what the 14th week actually meant in terms of the revenue impact.

I think the expense impact is a lot easier to predict because its related to fixed costs.

And our estimate is around $20 million.

The contribution, the deferred revenue, deferred waterfall is pretty low and easy to understand and that's actually under $1 million.

And the rest of it is business that was taken in the quarter that was turned and turned into revenue.

And given that not all the weeks are equal and we're back-end loaded and the end of the fiscal months tend to be big weeks, booking-wise, I think we all generally believe that the impact is well less than a full week and $20 million is a good a number as any.

So, I think that's the number that we're asking you to think about and you can factor into your own macroeconomic assessment as to what seasonality may look like.

I don't think this is the normal seasonality, in the sense that I went back and looked at seven out of the past eight years, I threw the year out where we missed the first quarter, so we had a 14% or 15% increase in 2Q over 1Q a couple of years ago.

But if you look at those six out of those seven years, we averaged about a 5.5% sequential increase when our growth rates were much higher, obviously, than they are today and the market was a lot healthier.

So, you guys can take it from there.

Okay.

Thanks.

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

Please proceed.

Hi, guys, thanks for taking my call.

Real quick, when you guys looked at your free cash flow in the quarter relative to what it's been historically, your previous low was about 19.8% of revenue.

And this quarter, even normalized, it's more like 13% of revenue.

Can you talk a little bit about your free cash flow goals going forward and what impaired cash flow generation for the quarter?

Okay.

First of all, please check your phone, I think we got about every other word but did you get enough of that, Steve?

I think I did.

You were breaking up pretty badly there, Brian.

But if the question is, given the fact that you were roughly 12% of revenue this quarter with free cash flow and traditionally, you guys have been north of 20% and do you see yourself getting back there can et cetera, how do you get back there?

Well, if you think about it, we just finished a quarter where the operating margin was 10.6 percentage points.

So we got another 5.5 or 6 points right there when we get back to the operating model, that we're going to take up in our cash flow, roughly because of our very efficient tax rate.

The other thing to keep in mind is that our other income is extremely low right now.

It's down to the lowest levels we've seen, certainly, since I've been here, seven years now.

And the reason for that is that our cash is kept in such short term investments.

So, the yield on those investments is very, very small.

Over time, we'll be layering those out again as we feel comfortable with the kind of investment opportunities available to us and the securities, that we have confidence in and we'll be able to increase that.

So when you add back both the margin improvement we're going to get, you add back the other income improvement I think we're going to get, we don't have to get a big one but just a reasonable one.

And finally, you return to some nominal level of growth, it doesn't have to start with a two or a three type of thing.

I think that -- I feel very comfortable about getting back up to the kind of levels in free cash flow that we've seen in the past.

Okay.

Thanks.

Our next question comes from the line of David Bailey of Goldman Sachs.

Please proceed.

Great.

Thank you.

I just had some questions on sort of the tone of business.

Have you seen the sales conversion rate increase and did you see the current period purchases also start to reaccelerate this period and what were the drivers?

Well, I think there's a couple of factors.

I think if you compare to where we were six and nine months ago, particularly towards the last part of last calendar year, kind of the big trend out there or probably the biggest source of frustration was the fact that people had budgets in place but still could not get deals approved.

So, we saw a substantial amount of transactions where we had technical recommendations and even departmental recommendations but we couldn't get sign off.

And I think that, to that extent, the world is a bit different today.

I think the budgets are a bit more predictable, although there's still some of that.

And I'd say that the range of outcomes, in terms of predictability of pipeline closing, is better than it was six or nine months ago but I would say it's not quite back to normal.

So clearly, we're still seeing a lot of "no decision made" being a criteria in our ability to close the pipeline.

So, the win/loss ratio I think will remain substantially unchanged and I think that the deferred decisions are going down but not quite where they once were.

So, I'm not going to declare that we've got a normal buying behavior at this point but certainly, an improvement over where we were at the end of last year.

If I can add to that, Tom, I think one additional point to keep in mind is we're still seeing a lot of one year renewals in service and support.

And that's an indication that people are trying to stretch their capital as far as they can before they renew.

And I do think that that will drop.

And as -- that will be an indicator that things are returning to normal and people are starting their normal buying pattern.

But did you see the one year renewals come down this quarter or were they the same level as last quarter?

They came down slightly from last quarter but you're always expecting a very high fourth quarter, right, because we were paying commissions on it and the sales guys would do everything they can to get everything in the door.

Compared to what I would have expected for the first quarter, we're still a little bit on the high side.

Great.

Thank you.

Our next question comes from the line of Amit Daryanani of RBC Capital Markets.

Please proceed.

Thanks.

I just had a question on the margin, guys.

Just given all the puts and takes in the OpEx and gross margins, could you just talk about if you're still comfortable with the ability to achieve 16% operating margins on I think [920 to 925] moving sales target?

And maybe just address the concern that NetApp may end up spending the margin upside from revenues on more hiring or sales discounts going forward.

So I'll let Steve answer part of that but from my perspective, the gross margins are high.

I think part of it is discipline.

It's a discussion that we had with our sales organization going in, it's having a bit more stabilization, so we can put more pressure on them.

So, I think we're quite pleased with the margin and I think that clearly indicates the strength of the product line, particularly the storage efficiency.

I don't think the market has gotten any less competitive in the last quarter.

I think that we've been a bit firmer and a bit more diligent and I think we've done that without sacrificing revenue growth.

I think all around, I think that feels good.

As far as get back to 16-points, I'll let Steve put a number on it if he wants but the way I look at it is last year in a deteriorating market, we had three consecutive quarters, Q2, Q3, Q4 of increasing operating margins, despite a deteriorating environment.

We start this year 1 point better than where we started last year and hopefully, with a better environment ahead of us.

So, to my point about envisioning 16-points, I'm not quite sure I'm quite in a position to talk about when we can get there.

But certainly, the mathematics are favorable and even with modest growth, it's certainly -- no matter how you look at it, those numbers are achievable again.

As far as our spending plan, I think we want to remain disciplined around our spending and I don't think we have any real anticipation of releasing our spending constraints until we get back to our operating model.

So right now we are very, very focused on achieving year over year growth.

And once we do that, I think we'll be pretty close to our operating model.

And when that happens, I think only then will we think about spending more.

So right now, I don't anticipate us opening up the flood gates on spending in the near term, until such time as we get closer to our historical model.

I'd just add a couple of minor thoughts.

I think that if you look at our product margins if you think about it, as things bounce back, the thing we're going to see first on the P&L is the revenue that we record in the period.

And that's the product margin.

And that's why it's important to get those back towards 60%.

So this big jump this quarter was very important.

And you'll note or I'll note for you right now, that the guidance we just gave you with respect to our gross margins going forward, the reason that it's probably a little higher than I think was anticipated is because we expect those product margins, maybe not to hold at the current level, but they're going to be up from where they certainly have been running.

And indeed, I think the trend is in the right direction and I expect to see those continue to decline over the next few quarters.

Great.

Thanks a lot.

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

Please proceed.

Hi, Steve, for you, also.

On the gross margin, you've mentioned a few times that you thought gross margins could trend down in aggregate overtime.

And it doesn't sound like it's coming from the product side, based on what you just said.

But the two-fold question is, if you anticipate that those gross margins move down from the current 62%, 63% level, what does that mean?

Is that 61%, is it 62%?

Any kind of color on what the driver -- or what the end game is?

And then, what are the drivers if it's not product?

Keith, so first this is the eternal struggle.

Right?

The natural tendency is for gross margins to decline.

The natural tendency for the management team to fight that every step of the way.

We're just trying to give you a prediction of where we think it's going to fall.

I think in the relatively short term here, I'm looking for relative stability, a slight decline from the 63.7%.

So, a relative stability in product gross margins.

Look at the mix of SEM.

SEM mix is at the highest level it's ever been at.

SEM mix is at 98%, the revenue on SEM has a 98% conversion rate to gross margin.

So, that's going to help, our service profitability is good and products are coming up.

So right now, I think we're in a relatively stable situation, give me a couple percentage points, but a relatively stable situation with respect to gross margin.

If I were -- so, when Steve talked about backing away from the number, I don't think he was backing away from 61%.

He was backing away from where we just came came in of nearly 64%.

Now, going forward, I think the gross margin number was impressive and I think a sign of the field's response to our requests.

But I think in general, that's probably a higher number than our historical pattern and not what it's going to take for to us get back to 16-points.

And I think we'd like to use a little bit of that to go a bit more competitively and use that to try and gain some share or motivate some partners or whatever.

So, I think the dynamics that are leading to that number, I think, are largely intact.

We may choose to use some of that strategically to the generate some more demand.

Okay.

Thank you.

Our next question comes from the line of Brian Marshall of Broadpoint Amtech.

Please proceed.

Hi, thanks, guys.

A question on the product gross margin side.

I think, Steve, you mentioned you expect it to continue to climb over the next couple of quarters off the, call it, 56.8% that we saw in July.

Is that largely dependent upon increasing volumes here in the back half of the year or what's that comment based off of?

Yes, I think it's just based on the performance we've seen.

If we can just hold our discounts levels where we are, that will help us.

I do expect it to come down a little bit next quarter.

I don't think we're going to see the kind of performance in manufacturing with respect to purchased part price variance and manufacturing rebates we did but nonetheless, are going to be positive.

So as I look forward, if we get any shift in mix back towards the mid-range, if we have any favorable volume effects, again, we saw decline in volume this past quarter but if we see any favorable volume effects, that's only going to be good news for product margins.

And the target is 60%, to clarify?

I'm sorry.

Your target on the product gross margins side over time is 60% gross margin?

I think that's a reasonable long-term objective for product margins.

Great.

Thank you.

Our next question comes from the line of Eric Martinuzzi of Craig-Hallum.

Please proceed.

Thanks.

What are the macro criteria we need to -- you guys need to see to get back to giving revenue guidance?

Given this current quarter we've seen sequential growth here in the Americas and sequential growth in APAC, what's the checklist for you guys to get comfortable there again?

I think there's a couple.

I think one of the first ones is just confidence in the conversion rate of the pipeline.

Again, if you look at our pipeline, you'd say, "Gosh, this is a real good looking pipeline, what's wrong with it?" Well, it's a question of how confident we are that all those points on there convert when they say they're going to convert.

And while things are improving there, they're not where they were a year ago type of thing when we were -- when we have -- that gave us the confidence level to be able to predict.

So, we're getting there.

I'd just say that we're just not quite there yet.

Is this something you believe you could see in the current fiscal year?

I think we'll know it when we see it.

It's probably the best way I'd describe it.

And I think at this point, I think we're pleased with how this quarter came out.

If you look at the storage industry, we're seeing our competitors all talking about high teens and down 20% year over year.

In fact, most of the competition in this industry has given up on year on year compares and we just put up a quarter that was flat year over year.

So, I wouldn't read into that not giving guidance means that we've got drastic concerns about the business.

It's just that the business is unpredictable and there's a pretty high error VAR around it.

But overall, I think that just in the recently reported quarters, I think our numbers are pretty substantial compared to those of our competition.

Thanks.

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

Please proceed.

Great, thanks.

First of all, a clarification off the spending question that was asked previously.

It sounds like you were saying head count wouldn't increase until operating margins hit the target range.

Did I hear that right?

And then an extension off of that, given the current head counts numbers, what do you think your current revenue capacity is, so we can understand when we do need to see the hiring spigot turn on again?

Okay.

So, a couple questions.

One of them is, headcount did go up this quarter.

And if you remember when we talked about the restructuring that we did two quarters ago, we indicated that virtually every group cut 50% their targets, in order to free up investment for new strategic initiatives.

So, the expectation is that they would backfill according to -- in accordance with that.

So that's more or less what happened.

Plus some functions move around, there's some displacement.

So the hiring that we put in place and the incremental hiring that we have is absolutely consistent with those activities and don't represent a change in our stance relative to our overall spending strategy.

I think going forward, sales force capacity is a fascinating question.

And I think we've tried to put numbers on it in the past.

I'd say, overall sales force productivity today is still substantially below where it was in more steady state times.

And would lead me to believe that we've got substantial sales capacity built into our existing infrastructure.

And I think we can grow the business when the opportunity returns without having to hire a bunch of people first.

Okay, fair enough.

Thanks.

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

Please proceed.

Thanks very much.

I wanted to ask Steve a question about deferreds and the future waterfall as a the deferreds come onto the income statement.

Deferreds were actually down a little bit sequentially.

The first time I've seen that in quite awhile and a bit below my expectations.

What's going on with deferreds and what should we expect in terms of software subscriptions going forward in terms of growth rate?

Thanks.

Yes, so it's not surprising that deferreds are slowing.

After a year plus of seeing kind of a deteriorating economic situation and a slowing of our business, we have not been putting deferreds on the balance sheet at the rate we've been pulling them off.

So obviously, at some point you start to cross over.

We saw sequentially this quarter.

I think that as you look forward, I don't think deferreds rise in the mix.

If you'll notice both the SEM revenues and services have been rising in the mix over the past year or so as the slowing has been going on.

I don't think you're going to see that.

I think what's going to happen if I were to predict going forward is, as business starts to pick up, first stabilizes and then starts to tilt up towards growth, the first thing that's going to hit the P&L is the non-deferred stuff because that was stuff we recognized in the period.

So, that's going to A, tend to drive the other two -- the non-deferred elements down.

Plus non-deferred elements are still going to suffer from the lag effect of the slow growth period that we incurred over the past 15, 18 months.

Over time though, as we start to grow, deferreds start to pile up on the balance sheet again.

So, it's predictable.

It's a complex equation, Chris.

But I think that the way to model this going forward is I'd hold my deferred element pretty flattish at the first quarter levels, as I move into the second quarter and maybe into the third.

That's very helpful.

Do you think they continue to grow on a year on year basis?

I think they do but at a diminishing rate.

And then, I think that as our growth starts to kick in, slowly they'll start to turn the other way.

Remember, everything attaches to products.

Products drive everything and products are the leading indicator.

And if I could invoke the question as we get closer to the end of the call.

Our next question comes from the line of Walter Pritchard of Cohen and Company.

Please proceed.

Hi, thanks.

I'm wondering if you could just talk about M&A, post the Data Domain attempt there?

And whether or not you see any other, not expecting you to name specifics but just talking in general, about whether or not you see another large area that you might look to move into to drive -- to leverage your channel?

Or if you think you'll return to more the historical NetApp of smaller acquisitions?

Well, I think we're always open to ideas.

I think the first part of your question about -- we'll always be open to technology tuck-ins and I think we'll continue to do that.

We did an RO roughly a year ago and that clearly, had a very, very successful year for us, way over plan.

And I think we'll continue to look for those, particularly in the software space, particularly in the management space.

As far as Data Domain is concerned, I went through the rationale for that.

I think it gave us an opportunity to enter an adjacent market.

And it allowed to us enter an adjacent market in a way, with a scale that was actually going to impact our overall growth rate of the Company.

And I think that we would be open to that.

I don't think that that represents any diminishment of our confidence in our core business but absent -- given the opportunity to pick up a property like Data Domain, I think we'd be glad to do it.

Eventually, those things have a price and this one I thought was beyond reasonable, at least in terms of our analysis.

But I don't think that it opens up a void that we feel any compelling nature to fill with something else.

I think it was an adjacent market.

We have products in that market.

We can up our investment or not and we can grow organically in that environment or not.

So I think for us, I think the core business is still healthy and if there's an opportunistic way to add an adjacent market, whether it be heterogeneous back up or something else, I think we'll pursue it.

Certainly, I don't think we're gun shy.

Thanks.

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

Please proceed.

Yes, thanks for taking the question.

Tom, when you look out on the current quarter, what are your thoughts about the different customer segments in mid-sized enterprise and then, larger enterprise as far as expectation of pipeline and close rate?

Do you see one improving over the other or are they both sort of bottoming and last quarter improving both sequentially?

Well, I think in the mid-size enterprise, you've just got far more accounts in there.

So, the statistical relief works in your favor.

In the large accounts, what we see is -- we can see an average performance across them all.

But it's not that they're all within a few percentage of each other.

Some are way up.

Some are way down, some were up last quarter and then they take a stall.

So, I think when you've got smaller accounts, you've got a lot more volatility from quarter to quarter and therefore, it makes that business harder to predict.

So, when you try to track top enterprise accounts and you talk about 30 to 40 accounts, they're up, they're down.

And one way up can move the number in one quarter and one way down can move the number.

So that business, I think by nature, simply because it's a smaller set with big numbers that are very volatile, I think have a bigger impact on our business.

The MSE, is it's just big, long, deep pipeline and I think just statistically, they tend to be a little bit easier to predict, maybe not individually but in the aggregate.

So, I think of the two, the MSE is probably a little bit easier to predict for us.

And I think if you look at our performance over the last year, talking about new customer acquisitions, I think we've clearly diversified our revenue stream and I think that's been an important objective.

Because when you've got a relatively high concentration and volatility of a small number of accounts have a big impact on our business.

And I think that the diversification, as well as the overall economic climate, have given us a bit more predictability.

As another way of asking --?

Only one question, I'm sorry.

Okay.

Thank you.

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

Please proceed.

Yes, thank you and good afternoon.

I want to talk a little bit about the unified bookings of the composition, did it decrease here sequentially?

What was the impact on margins, if any?

And could there be any sort of improvement in the unified platform as ONTAP 8 rolls out here going forward?

No, we went with the new methodology.

I think we need to get some quarters under our belt in terms of identifying the trend.

Certainly, we've been higher than we've been at this point, we've been lower than this point before.

So, it's not a point off the curves just yet.

I think overall from a margin perspective, I don't think it really has any margin impact at all.

If they're going to buy a product that's going to be SAN only on are or NAS only, as opposed to both of them, they aren't going to buy both protocols but I think that's going to have a small impact overall.

So, I wouldn't read anything into the margin story.

Certainly, I wouldn't draw on the fact that our margins were up because unified was down.

I think that would be incorrect.

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

Please proceed.

Yes, thanks.

I had a question if I could on the customer side.

You've been doing more new account acquisition and development.

What's the latest there?

How many added new customers?

And then, is there any additional color you can give in the change in the sales of support staff development?

Is that designed to get more pitches to hit here in terms of new client and new customer development?

I missed a word there.

I didn't quite catch the question, if you could repeat it please?

Okay.

You're doing more new account acquisition and development and how many new customers did you add during the quarter?

And then, any additional colors on the change in the sales of support staff deployments?

Is this designed to get more pitches to hit here for new customer development and new customer acquisition?

Is that what it's designed to do?

Yes, well, I think we've done a few things.

I don't have the new customer acquisition number off the top of my head but that clearly remains a priority for us.

I think overall, as a Company, the leverage of our partners as a way to reach both the mid-size enterprise and the fact even a fair amount of the storage 5,000 has been an important objective.

So, our indirect business this year -- or this quarter was up year over year.

While our direct business was down.

So I think we're going to a more aggressive leveraged model, whether it be through reseller or systems integrators or bigger our partners like Fujitsu and IBM, that's clearly an emphasis for us, both in terms of gaining more market coverage and also getting more sales leverage from a SG&A perspective.

Our next question comes from the line of Paul Mansky of Canaccord Adams.

Please proceed.

Great, thanks.

First, Dan and Tom, let me echo the prior sentiments.

Congratulations on your respective transitions.

Shifting gears just a touch over to V-Series, obviously, unit volumes have been, certainly, impressive for a number of quarters now.

How are you thinking about that internally as relates to kind of transitioning that footprint into larger revenue opportunities vis-a-vis systems sales?

Is there specific product rev coming?

Is it tied up in Data ONTAP 8.0 or the subsequent spin of the kernel?

How do you think about turning that into a bigger revenue opportunities?

Well, one of the things that actually drags on V-Series revenue is the fact that V-Series is often our entry point into new accounts.

It's one thing to go into a customer base and tell them, "Look, we have this technology that can dramatically reduce the amount of storage you need.

We could reduce it by 20%, 30%, 40%, 50%." In a lot of those cases, we actually guarantee it.

And the customer says, "Well, that's great but I've already bought all this stuff." And we go in with a V-series today as an entry point.

But over time, as that back end equipment ages and comes to the end of its life and that will get replaced, it's not uncommon, in fact for years our very, very largest

V-Series account has recently converted over to actually selling full systems.

So, as these systems -- as our relationship grows with those, a lot of the V-Series business goes away and converts to traditional FAS systems.

So, the FAS -- the V-Series volume has actually had to overcome that offset of customers who buy the V-Series as an initial entry point and then it converts them so full systems.

So, that dynamic clearly exists and the V-Series growth has overcome that.

So, in the early days of the V-Series, the sales force was somewhat reluctant to sell it, simply because it didn't have the dollar ASP of a full system.

And some point back, we actually made it so we could actually add our own disk drives, so you could sell a V-Series today then add disk drives.

And then, ultimately, sell sell full system when the customer is ready to do that.

So, I'm not quite sure what -- where you were going with the question but overall, I think we have been expanding our V-Series footprint and the V-Series represents a new account penetration.

And it also has this negative drag on it, a fact that the next-generation customer might actually buy.

After buying V-Series in the past, might buy full systems from us, yet it's still growing any way.

So, I think all in all, the V-Series is an enormously powerful tool to new customer acquisitions.

Any rough estimate of what percentage --?

Sorry, I have to go with one question.

Got you.

I'll save it for the follow up.

Our next question comes from the line of Wamsi Mohan of Bank of America - Merrill Lynch.

Please proceed.

Yes, thanks a lot.

Your software license as a percent of sales, the 16% is the lowest we've seen in years and moving towards sort of the 35% for total software mix.

At the same time, you've seen in your new classificational system the SAN, NAS and unified, your unified system has sort of increased as a part of the mix.

So, is there some correlation in terms of the does software attach for those deploying your systems in unified systems, is it lower or is it just a mix of high-end versus low end?

Thanks.

Well, I think it's a list -- it's a range of mix.

Another factor is when we talk about "systems and hardware," those thing are not devoid of software.

And as a result, it's also a function of what type of software we include in the base unit.

So, things like de-duplication, our file systems and those type of things, all come with the base system.

The other thing we've been doing in order to simplify our software purchases, we've been doing more and more bundling.

Certainly, feedback we've gotten from customers is that our software menu leads for a very, very complex generation of PO's and upgrades of that nature.

So, we're restructuring how our software is put together, both in terms of bundles, both in terms of what we call a package and also, what we include with the base system.

So, I think that the numbers may move around but they might not necessarily be apples and apples comparisons.

I think probably the more compelling component of that is actually the combined product gross margin.

That's probably more an indication of how successful we are in selling our value.

I also think that as the economy comes back, I think we're going to see a shift in mix just slightly.

I think our mix has stabilized over the past several quarters now.

It hasn't -- we have haven't talked about a significant change but as the economy starts to grow and customers feel more comfortable spending in IT and specifically storage, I think we're going to see a mix shift back towards more of the mid-range and towards more highly configured systems, which included more software up front.

And I think there's going to be less service renewal also to go along with that.

but the net-net of that would be to probably kick up the amount of configured software in the mix over time.

It's not going to knock it off the charts.

It's not going to move it 4 percentage points or something like that but it will move it up from where it is.

Just to clarify on your bundling comment.

I'm already going to have to cut the call off probably after two more callers.

This is already a record length call.

So, I'm probably going to move on to the next one, I'm sorry.

As we only do have five more minutes in the allotted time, we will take two more questions.

And the next one comes from Glenn Hanus of Needham.

Please proceed.

Good afternoon.

Data ONTAP 8.0, can you give us any thoughts there on how many beta sites you have?

What types of accounts you're targeting?

And how that might be sort of think about impacting the business model over the next few quarters?

Okay.

So Data ONTAP is in the hands of some customers.

I'm not going to take about how many beta sites or how long they've had it.

In the prepared talk, Dan mentioned in the next few weeks and I think that's where we're at with that.

Overall, I don't anticipate that it's going to be a sudden boost in revenue.

Certainly, it's going to open up some other account activity for us but there shouldn't be this sense that customers are waiting for that in order to buy from us.

Data ONTAP is a free upgrade for those people who have got Data ONTAP 7.

It runs on the safe hardware as Data ONTAP 7.

So, I think that the continuity of customer demand is probably not being disrupted or enhanced by Data ONTAP 8.

It's a foundational technology for us.

It brings a lot of base functionality but also, enables a ton of future innovation and that's really where we're going with it.

So, I wouldn't look for DATA ONTAP to be an immediate stimulus of new demand nor would I conclude that Data ONTAP is somehow deferring purchases until it comes out.

Yes, I was just going to add that I think that one of the new operating system is out there and once it gets adopted into our installed base, I think it's going to be a major leverage point for R&D efforts.

It's going to be the platform of development and now, we'll be able to concentrate on one OS and hit it really hard with innovation.

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

Please proceed.

Yes, thanks.

A number of storage companies talked about more robust orders in the month of June.

Did that strength carry into or even accelerate as you went into the month of July?

Well, I'm not going to do month by month.

I think -- and I'm not going to comment on what other people have got or talked about robust demand.

Virtually every single other storage company is actually seeing year over year declines increase in Q2 and not Q1 and that's not true of NetApp.

So although, we don't want to prognosticate about the future, I think that we feel pretty darn good about the quarter we just put out there.

And I think we feel pretty darn good about our prospects.

And I think we're doing a lot better than those other companies.

So, was June better than July and where is August?

It's kind of hard.

We have a back end loaded quarter.

Typically, the only month that matters is the last one.

But overall, I think that we feel really good about the quarter that was out there.

And I think flat year over year, the cliche is flat to new up.

Our aspirations are better than that but we're still talking about year over year comparison and everybody else has given up on them.

That concludes our question-and-answer portion.

I would now like to turn the call over to Tom Georgens for closing remarks.

Please proceed, sir.

Great.

Well, we look forward to seeing you all on October 8 at our analysts day in New York and updating you on our Q2 results on November 18.

Registration for analysts day is open on September 1.

And thank you for your time.

Thanks for the kind words and goodbye.

Thank you for your participation in today's conference.

This concludes the presentation.

You may now disconnect and have a great day.