NetApp Inc (NTAP) 2010 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the NetApp second quarter fiscal year 2010 earnings conference call. I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of the conference. (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. 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 earnings 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 risks and uncertainties including statements regarding our financial performance for the third quarter of fiscal 2010, our expectations regarding future customer demand and mix of customers, our belief regarding our market share and our growth rate, and our expectations regarding our future relationship with Fujitsu and our expectations regarding Data ONTAP 8 and other new product offerings. Actual results may differ materially from our statements or projections.

Factors that could cause actual results to differ from our projection include but are not limited to customer demand for products and services, our ability to increase revenue, and increase competition. Our 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.

Now with me on today's call are our CEO, Tom Georgens, and our CFO, Steve Gomo. Steve will review the second fiscal quarter financials as well as our targets for Q3 and then Tom will discuss additional operational results along with the trends we're seeing in our business. I will now turn the call over to Steve for his update. Steve?

Thanks, Tara, good afternoon, everyone. The NetApp team delivered a quarter that exceeded our expectations in almost every geography and business segment. Our value proposition is clearly resonating with customers helping drive the highest gross margin level in our history, and thus our out performance on the operating income line. While the overall business environment appears to have stabilized, NetApp significantly out paced both the market and the competition.

Now let's walk through our results. Revenue for the second quarter was $910 million, up 9% sequentially and nearly flat compared to Q2 of last year. Foreign currency effects increased our sequential results by just under 1 percentage point and decreased our year-over-year growth by just over 1 percentage point. Were it not for currency effects we would be one of the few companies in our industry actually generating year-over-year growth. Product revenue was up 10% sequentially and down 8% year-over-year to $525 million. Products represented 58% of total revenue. Included in product revenue is add-on software, which was 15% of total revenue. As I indicated at our analyst day in October, after this quarter we will no longer break out add-on software due to the increase in our bundled product offerings which masked the distinction between software and solutions. It is no longer a useful indicator given that this metric is the lowest is it has been in several years yet our product margins are at an all time high. Going forward the best proxy for the impact of software on our business is our product gross margins. Revenue from software, entitlements and maintenance which is a deferred revenue element was $170 million or 19% of total revenue. Software ENM was up 3% sequentially and up 11% year-over-year. Revenue from services was $215 million and 24% of total revenue, up 11% sequentially and up 14% over Q2 of last year. Service revenues are comprised mainly of hardware maintenance support and professional services. Revenue from maintenance support contracts is a deferred revenue element and comprised about 63% of our services revenue this quarter. In Q2 it increased 7% sequentially and 20% year-over-year. The professional services component increased 16% sequentially and was up 3% year-over-year.

On a non-GAAP basis consolidated gross margin was a record 67.5% of revenue this quarter. This was nearly 4 percentage points higher than in Q1 primarily due to significantly higher than expected product margins as well as a healthy contribution from the deferred elements coming off the balance sheet. Revenue from deferred elements comprised about 40% of our total revenue compared to about 33% in Q2 last year. These deferred revenue elements carry a very high margin. Non-GAAP product gross margins were up 6.2 percentage points sequentially to 63%. The competitive strength of our product offering was the primary driver of this performance. The beneficial confluence of improved material costs, favorable product and configuration mix, stronger volumes, and well controlled manufacturing costs all contributed to this outstanding performance. Non-GAAP service margins increased to 54.4% also exceeding expected levels because of a jump in professional services utilization rates. Non-GAAP software ENM gross margins were up just slightly to 98.2%. Compared to non-GAAP expenses our OpEx increased 3% sequentially and up 1% year-over-year totaling $459 million or 50.5% of revenue. These expense levels are roughly 5% above the $439 million forecast we laid out for you at analyst day. This overage was caused by appreciably higher than planned accruals for commissions and incentive compensation related to this quarter's out performance on both our revenue and operating income lines. However, true to the commitment that we made to you at the time, there were no additional projects funded and no greater than planned hiring in this quarter's expense [stack].

In addition to the non-GAAP operating expenses Q2 GAAP operating expenses include $33 million of stock compensation expense compared to $52 million in Q1. Also included in the GAAP expenses are amortization of intangible assets associated with prior acquisitions and the current period impact of prior restructuring actions. GAAP other income expense also includes $12.2 million of noncash interest expense associated with our convertible debt and a gain of $2.8 million on our [Casion] investment. You will find a detailed list of these items in the GAAP to non-GAAP reconciliation on our website and in our press release. Our head count at the end of the quarter was 8,105, an increase of 63 people.

Non-GAAP income from operations was up 74% sequentially and 53% year-over-year to $155 million or 17% of revenue in Q2. Non-GAAP other income and expense which typically consists mainly of interest income was only $4,000 this quarter primarily because of the low interest rate returns generated by our investment portfolio. Non-GAAP net income before taxes was $155 million or 17% of revenue. Our non-GAAP effective tax rate remains at 16%. With the increase in stock price during the quarter weighing heavily on the treasury method of accounting for shares, NetApp's diluted share count increased 10.9 million shares this quarter. Non-GAAP net income totaled $130 million or $0.37 per share.

Moving to our cash flow performance, our cash from operations was $267 million, up 29% from Q2 last year. Capital expenditures were about $23 million this quarter, down from $25 million last quarter. Free cash flow which we define as cash from operations less capital expenditures totaled a record $245 million up 36% from Q2 last year. Expressed as a percent of revenue Q2 free cash flow was 27% of revenue, well above our targeted range of 17% to 22%.

Turning to the balance sheet, our Q2 cash and short-term investments totaled nearly $3 billion for net increase in cash and short-term investments of $293 million over Q1. At the end of Q2 our cash and short-term investments held in the US were 49% of the balance. The total deferred revenue balance of $1.7 billion reflects a sequential increase of approximately $7.3 million this quarter and the 9% increase in the balance year-over-year. With respect to DSO, accounts receivable day sales outstanding, were 32 days this quarter compared to 39 days last quarter and 36 days in Q2 last year. Q2 collections were extremely strong resulting in accounts receivable balance that is 93% current which is also a record. Inventory turns were approximately 20 turns, the same as achieved in Q1 and up from the 18 turns in Q2 of last year.

Turning now to the outlook for our third 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 risks and uncertainties. Actual results may differ materially from our statements or projections for the reasons cited previously. The economy continues to show increased stabilization and the predictability of our close rates continues to improve. More importantly, our business is experiencing strong demand for our storage efficiency value proposition which resonates particularly well with customers during tight budget constrained times. That said our second quarter business benefited from a record contribution from the public sector business as well as from Europe, both of which are expected to fall off seasonally in the third quarter. This will be modestly offset by an expected increase in the business we do through IBM. Therefore we're expecting Q3 revenue in the range of $935 million to $955 million. To reiterate what I pointed out at analyst day, you should not expect to see quote, unquote normal historical sequential seasonality going into Q3. It is not logical to compare the sequential growth achieved when the Company was growing the top line at about 30% per year to the current slower Company growth rate in the more challenging economic environment.

Turning to non-GAAP consolidated gross margins we expect them to pull back to approximately 64% given that the windfall of beneficial effects that I described earlier are not all expected to continue. We plan to pass most of the material cost savings onto our customers and are not expecting to maintain configuration mix at such a favorable level. We also expect to have a higher mix of revenue from IBM in Q3 which is neutral to our operating income target but lower than our average corporate gross margin. Also, because product revenue is picking up momentum, the deferred revenue elements will be a smaller portion of revenue in Q3. We are forecasting third quarter non-GAAP OpEx to decline modestly to about $445 million to $455 million range subject to adjustment based upon what we see happening in the economy and in our pipeline. As a result, our non-GAAP operating profit should return to roughly 16% in Q3. Our share count is expected to increase by about 5 million shares. We expect non-GAAP earnings per share to be between $0.36 and $0.37 per share. Now, at this point I will turn the call over to Tom for his comments.

Thanks, Steve. I am very proud of the NetApp's team's performance this quarter. We achieved several records including record gross margin, record DSOs, record revenue from the public sector, record SAN contribution and record free cash flow. We also exceeded our operating income target and did so a quarter faster than planned. In addition, the midpoint of our target revenue range for Q3 would be a record revenue quarter.

Before I walk through our operating results, I will give you our view on what is happening in the current marketing environment. With the overall economy appearing to stabilize, we are seeing more and more customers begin to have forward-looking discussions again. Rather than just figuring out how little they need to buy in order to fulfill a near term demand, they announced during the talk about their next generation virtualized data center architectures. While not all of this is translating into spending just yet, our performance this quarter indicates we are better aligned to the direction our customers are heading than our competitors. We believe there is pent up need for tech refreshes across the industry, and we are not only capitalizing on those in our own install base but we are also intercepting many of our competitors systems as they come up for renewal. This upgrade cycle is just beginning and represents one of our largest near term opportunities to gain share.

Turning now to specific operating results, you will see early signs that spending by our large accounts has begun to thaw. Total revenue generated by the Americas was up 3% sequentially and down 4% from Q2 of last year contributing 55% of total revenue. Within this, our public sector team had a record quarter up 32% sequentially and up 1% year-over-year producing 16% of total revenue. We now believe we have achieved number one market share in the US public sector driven by strong growth in existing accounts as well as multi-million dollar wins in new accounts. Led by a stellar performance in Germany, where we also have number one market share, Europe had its second strongest quarter ever up 21% sequentially and up 10% year-over-year to 35% of total revenue. Asia Pac was up 3% sequentially and down 7% year-over-year for a total of 10% of revenue. All major geographies were up sequentially and on a constant currency basis we were up about 1% year-over-year in a quarter where most major competitors were down double digits. The rec revenue was 33% of total revenue this quarter, up 14% sequentially and flat year-over-year. Our indirect channel contributed 67%, up 6% sequentially and also flat year-over-year. Within the indirect channel, Arrow grew to 12% of total revenue and Avnet contributed 11% of revenue again this quarter. Our IBM OEM relationship contributed 4% of total revenue and we expect it to be around 6% for the upcoming quarter. The top 100 accounts increased in the mix this quarter accounting for about 44% of total revenue, a little higher than previous quarters. While this is an indication that large accounts have begun buying again, we remain committed to growing business with newer and smaller accounts to continue our efforts to diversify our revenue stream. This top 100 concentration should moderate next quarter as the public sector declines seasonally in the mix.

With respect to protocol trends, this quarter 48% of our configured system product revenue was sold with only NAS protocols. 19% was sold with only SAN protocols and 34% sold as unified storage which includes both block and file protocols. While it is our expectation that unified configurations will continue to grow in the mix, we're still seeing healthy growth in our NAS attach rates. Where they're configured as NAS only or unified, in Q2 our NAS strength was driven by rapid growth in VMware over NFS deployments which grew 220% year-over-year. According to our system reported data, almost 40% of NetApp machines in virtualized the environments are now running the NFS protocol, a departure from earlier days when virtualization deployments were largely SAN. Our success in virtualization on SAN has been well demonstrated, but the customer understanding of the additional benefits of running NFS plays to our strength in unified storage and NAS and should position us well in the future. Even though we see some movement of virtualization deployments to NFS our SAN revenue continues to grow faster than both NAS and Unified achieving its highest ever level of contribution to our business this quarter.

This quarter in a number of our largest NAS accounts we have succeeded in crossing over into the SAN infrastructure and won large new deployments. We had several multi-million dollar SAN only wins including a large US telco we spent $13 million to refresh their data center using NetApp. A $5 million SAN transaction at one of the largest proprietary web 2.0 companies in the US, and a $3 million deal with the largest bank in Italy who is expanding across Europe. We believe that the mid-range SAN products from the traditional SAN vendors who have demonstrated little recent innovation are going to be particularly vulnerable in the coming tech refresh.

From a platform perspective the sales of high-end units came back strongly this quarter growing 24% sequentially although still down 18% year-over-year. This was enabled by improved customer sentiments and spending in larger accounts as well as the strength in the public sector which has a higher concentration of high-end systems. Our mid-range units shipped grew both sequentially and year-over-year while low end units were up 4% sequentially and down 13% year-over-year. Overall units shipped were up 4% sequentially and down about 6% year-over-year with the decline driven by a movement towards fewer but larger systems.

Our V-Series platform, which is our controller and data management software without any disks, once again delivered tremendous performance. This product is designed to provide NetApp data management and storage efficiency in front of large footprints of legacy SAN products offered by our competitors. It allows customers to experience NetApp functionality without a big initial investment and can pay for itself almost immediately with the space reclaimed when our space efficiency technologies are enabled. Units shipped were up 68% year-over-year despite our largest V-Series customer switching to new NetApp fast systems and is no longer buying the SAN units from a competitor. One of the fastest growing segments of this business is deployments in front of EMC mid-range systems. In addition to large number of CLARiiON deployments, we now have more than two dozen V-Series units sitting in front of EMCDMX machines. The growth, in fact the mere presence of this business, is evidence that we offer a set of features that cannot be matched by the traditional SAN offerings. Further, the increased presence in front of large frame arrays proves we can deliver this value even in the most demanding environments from an availability and performance perspective.

The final indication of improving customer sentiment I will point out is that short-term renewals are both contract maintenance and software entitlements have moderate rated. One year contract renewals declined as a percentage of business while initial purchases of three-year contracts increased providing initial indications that the tech refresh cycle may be under way.

Looking forward, one of the key components of our strategy to broaden our market reach is to deepen our partner relationships. An important step in this process is the announcement this morning of an expanded partnership with Fujitsu. As you saw in our press release, we are looking to enhance our global relationship with joint product development, joint go to market efforts, and providing integrated solutions to our customers and partners specifically in the areas of virtualization and data management. In addition to expanding our partnerships, we are feeling positive about our technology portfolio as well. NetApp is uniquely positioned to capitalize on the virtualization and cloud computing trends that will be essential to the future of data center architectures. In addition, this quarter saw the announcement of Data ONTAP 8, the first combined release of our 7G and GX operating systems. While not an immediate revenue generator, it enables even greater development leverage going forward by having a single code base and provides a robust platform for another decade of data management innovation. For those of who you are not at our October 8th analyst day, to get more information about our technology and our go to market strategies, you can find video replays of our presentations on our IR website.

To summarize my perspective on the quarter, we beat our plan, we beat Wall Street's expectations, we out performed our largest competitors, but that's not the same as growing. We are committed to delivering year-over-year growth in the second half of our fiscal year 2010 when most of the industry has retreated from that goal and talks mainly of sequential growth. Despite the achievement of our target operating model and impending return to true growth, we intend to remain cautious regarding operating expenses. We do not expect the record gross margins to remain at this level partially by design as we become more aggressive in driving growth and partially due to uncertainty about the economic environment. Even if gross margins moderate being prudent about expense growth will allow to us maintain the 16% operating margin model the team has worked so hard all year to achieve. Overall, it was a solid quarter and we definitely feel we have momentum heading into the second half of our fiscal year. At this point, I will open up the floor to questions. As usual we will ask you to limit yourself to one question so that we may address everybody during our allotted time. Thank you. Operator?

(Operator Instructions). Your first question is from the line of Mark Kelleher of Brigantine Advisors. Please proceed.

Thanks. With the quarter results coming in meaningfully over the guidance provided in early October, I was just wondering if you could talk about linearity in the quarter. Was there a late surge of demand that surprised you? Thanks.

This is Steve. It was a little stronger than we had anticipated in those last three weeks. We were doing really well right up to the analyst day, and to be fair we didn't know if it was going to continue at the rate it had particularly given that the Feds business ended the month ended September, but the commercial business really finished very, very strong. We actually I think ended up revenuing about $220 million during the last three weeks. Yes, we were a little surprised at how strong it was.

Thanks.

Your next question comes from the line of David Bailey of Goldman Sachs. Please proceed.

Great. Thank you. You have commented in the past that you had priced maybe a little bit more aggressively than you needed to and seems like better pricing helped gross margin this quarter. Does that pricing strategy still hold? You made some comments about maybe pricing a little bit more aggressively to drive growth. Can you talk about that a little bit?

Yes. I would say I think at 67 points of gross margin I think that the discipline that we put in the system around discounting we had very frank conversations with the sales organization and communicated to them the impact of more discipline I think is clearly paid off. In the last call we were high in gross margin also, higher than we thought, and we indicated that we would do some more aggressive pricing in certain situations. I don't think we want to price more broadly unless that discipline dissipates. I think that we were committed to aggressively pursuing some deals and did that, but nonetheless the numbers remain strong.

I think Steve talked about the components, the product mix and the like, obviously the roll of the defers, but all in all I think we did in fact pursue aggressively a number of deals, but the overall price margin gross margin remained strong, so all in all I think the value proposition is clearly resonating. It all starts with that is defending the price and supporting the price in the face of the customer. I think we have done a really good job there. Even though we have indeed pursued some very aggressive deals, the aggregate gross margin remained strong.

And I mentioned in the guidance we gave you for the third quarter, David, we expect the margin to recede a little bit from the high water mark we just hit and part of the reason for that is we're going to be giving some of those cost savings that we think are fundamental or long-term if you will, we're going to be passing those through to our customers.

The other thing is what we don't want to do is broadly drop price if that's what you're getting at. We're clearly not going to do that. On the other hand there are incentive programs we can run with our partners to generate demand and those are come at the cost of contra revenue which will impact gross margin. So I think those are the things we have in mind to stimulate demand at this point as opposed to a broad pricing change.

Great. Thank you.

Your next question comes from the line of Mark Moskowitz of JPMorgan. Please proceed.

Thank you. Can you talk a little more about the OpEx, just given the substantial increase in your SAN exposure? Should we think about R&D potentially going up as the complexity of some of those solutions with some of your customers maybe requires more R&D in terms of new products products down the road?

I wouldn't go there. I think -- I don't think that the growth of our SAN business is going to impact our R&D investment. Clearly we have been investing a lot of R&D in our SAN business to drive the functionality, so I think we feel good about our competitive position, but I think over all the mix of SAN versus NAS, we have an integrated architecture so the vast majority of features, or I should say unified architecture, so the vast majority of features are common to both. As a result, I think the strength of SAN I think has to do with the previous investments we made to drive the competitors to the product, and I think just as important the sales force competent. I think the sales force is very confident leading with a product now, so I think if anything the R&D investment will stabilize in that dimension as we made the progress that we have.

Next question.

Your next question comes from the line of Keith Bachman of Bank of Montreal. Please proceed.

Thanks. I wanted to go back to gross margin if I could. On products in particular, you had about a 10% sequential increase in revenues for products, and yet I think your cost could sold even on a dollar base was down sequentially, and I just want to try to understand more what was the key drivers there and then what changes as we look at the next couple quarters? Was there any one time events in there either on a materials basis or otherwise just want to try to get more color on the product gross margins specifically.

Okay. I will try to quantify some of the commentary that I had in the script there, Keith. Starting with the big items, probably material costs themselves were the biggest issue. This has to do with the timing of when we receive a cost increase versus when we can pass it onto our customers. That was about a 2 percentage point favorable benefit going from Q1 to Q2. The configuration we saw this quarter were very rich. Really across the board across all segments and up and down the line for the product line for that matter and remember V-Series had one of its strongest quarters ever with very large in the mix and the V-Series has a very, very favorable gross margin structure.

Right.

Warranty was favor favorable by about a point compared to the prior quarter. Our quality is getting better and we recognize that based on our analysis of the expected warranty charges we're going to take in the future. Volume was favorable along with our manufacturing variances that was about 7/10 of a point. IBM was down in the mix this past quarter. That was about a half a point, and discounts were slightly favorable to last quarter. They were about 4/10 of a point favorable. All of that adds up to just over 6 percentage points and pretty much I think captures the quantitative aspect of what I said in the script.

Okay.

As we look forward, a lot of these events are going to continue or they may manifest themselves a different way, but I don't think we're going to continue to see this extremely rich configuration mix we saw across all products, all segments, and certainly the level of V-Series that we saw, so we're expecting that to come down. We expect IBM to rise in our shipment mix next quarter because IBM is going to have its strongest quarter with us coming up, and IBM has a much lower gross margin than the corporate average.

Some of the materials benefit I talked about were actually going be passed back to customers through pricing adjustments we made. Our volume and manufacturing variances, we will probably keep the volume where it is, but some of the manufacturing variances aren't going to be sustainable, so we're going to give about 4/10 of a point back there, and finally as Tom pointed out, there will be some selective discounting we do at targeted customer accounts or targeted sales situations, and that's going to be just under a percentage point that will probably come out because of that.

Okay. Thanks for the color, Steve.

You bet.

Your next question comes from the line of Aaron Rakers of Stifel Nicolaus. Please proceed.

Thanks for taking the questions. I guess one of the questions I have is on the services side of the business, and it might segway into the gross margin there as well. I think last quarter you had mentioned that you were proactively moving some of your professional services business to your partners, and if I look at it, I think you had stated that trend was expected to continue. With professional services up 16%, did you pull back on that plan? Have you changed your approach there? Was that the predominant driver of your gross margin in the services segment?

I think on the professional services side, we are clearly our focus remains and in fact we continue to move in the direction focusing our professional services teams towards very specialized high-end very specific customer engagements, and we're moving some of the other professional services business whether it be in the mid-sized enterprise, or what we call general territories, and likewise our installation business, we want move that to partners, and in a lot of cases it is important profit opportunity for them, historically found ourselves competing with them for professional services business, and we intend to continue that.

There has been no reversal, it is not we have moved further on that dimension. The overall services line that you talk about includes the support contracts as well, I believe, and so those are all merged in. The professional services business that we're trying to exit just to put it in context is really around installation and consulting in the general territory, and those are only a few percentage points of our business.

Okay. Thank you.

Your next question comes from the line of Kaushik Roy of Wedbush Securities.

Congratulations on good quarter and higher guidance. Tom, your biggest competitor, EMC, just announced a joint venture with two of our strongest partners, Cisco and VMware. Can you comment how it impacts your product development and partnership especially with VMware?

You broke up a little there. I think you asked me about the EMC, Cisco and VMware thing.

Right.

We can spend a whole call on that subject. Kind of simplify, I think you need to look at the motivations of each of the individual players. I think from VMware's perspective, I think that if anything they want to remain neutral, and I don't think they're an advocate or supporter of anything that's going to favor EMC and Cisco. Cisco is a great company, and has a great track record and are a formidable competitor but doesn't change the fact they don't have market share and servers yet, and I don't think that VMware would like to see HP and IBM, who do have share, partner more closely with Microsoft, so I think VMware will remain independent and they have actually put that in writing that they certainly intend to maintain the relationship they have had with NetApp and continue to cooperate both from a technology perspective and a go to market perspective. I expect no change there.

I think Cisco's role in this is clearly they want to ride the VMware momentum and likewise EMC has a big base they want to leverage, so I think the go to market appeal and partnering with EMC makes a lot of sense to them. On the other hand, I think that EMC from a storage perspective brings the least to this relationship, and the primary motivation of being engaged by Cisco is around the go to market side. At the end of the day this relationship doesn't produce anything for the customer. To be perfectly honest I think what Cisco is going to find is once they move away from EMC's strong hold accounts, they're going to find their transformation is hindered by EMC, in fact EMC is the antithesis of transformation, and the goal that I have given our team is that I want to form the same relationship with Cisco that we have with VMware. In other words a very neutral status from corporate, but I want to be engaged with the sales teams in front of customers every day demonstrating our value and I want to be in a position that outside of the EMC stronghold accounts we do more business with Cisco than EMC does.

Okay.

Your next question comes from the line of he Kevin Hunt of Hapoalim Securities. Please proceed.

Thank you. Just wanted to clarify again on the gross margin versus OpEx question. So you're saying you're basically going to get back down to that 16% operating margin and just the question really is if you do see a gross margin trending above kind of expectations would you then ratchet up those OpEx expenses or kind of let that flow through or maybe if you can help us understand what your kind of spending patterns would be and different scenarios going forward.

Okay. First of all, I want to enjoy the statement of moving back down to our 16% operating margin. Actually we've got to the operating margin target through basically very, very high gross margins, and while I think that's attributed to a lot of hard work we have done over the last year, I think it is attributed to our product success and the value proposition that we have out there, I don't expect the gross margins are going to remain at that level indefinitely. What we don't want to do as a company is bake in a permanent operating expense that necessitates us to have very, very high gross margins at that level to meet our operating margin targets.

On the same token, we don't want to pass up an opportunity to invest in our business. The focus that we have right now going forward is what can we do for short-term activities, perhaps activities that are rebate in nature or things that would stimulate demand above the line and likewise short-term OpEx things we could do to stimulate growth. What we to want do is maintain the 16% target and preserve the flexibility that we could still maintain that target even at a lower gross margin. I do expect that we're going to do things, leverage the fact that we have this option available to us of high gross margin, and use that to stimulate sales but I don't think we're in a position to think about adding permanently to our long-term run rate until such time as we believe we can achieve that at more normal gross margin levels.

Your next question comes from the line of Brian Marshall of Broadpoint AmTech. Please proceed.

Thanks. My question with regard to IBM and the gross margin degradation we're going to see in the January quarter, I guess by my calculation IBM probably represents a little less than half of that, 350 basis points decline, so I guess I wanted to clarify that, and, two, if that's the case, I guess trying to figure out if the 64% gross margin is actually maybe conservative, or sustainable if not conservative looking out into the future past January. Thanks.

I think that our gross margin performance on bookings on the accounts other than IBM are probably going to have a bigger impact on where we ultimately end up at IBM. IBM will still be 6% of our business, and it is neutral from an operating margin perspective although lower on a gross margin, so I think the gross margin story is going to be written on the rest of our business, not just IBM.

I don't see a model in front of me so I don't know what your assumptions are, but revenue is going to virtually double from IBM quarter to quarter, and if you look at the delta in the gross margin percentages between the average that we achieve and IBM, you get about a half a percentage point, so that's what I am expecting to see. If all things being equal if that was the only transaction to implement things I expect things to fall by about half a point.

Thank you.

Your next question comes from the line of Troy Jensen of Piper Jaffray. Please proceed.

Congrats on the nice quarter. Quick question for Steve here. Steve, over the past two or three quarters outside of the October quarter you talked about an abnormal amount of one-year service and maintenance extensions. Curious to know if you think you can get a nice tailwind, maybe better than typical seasonality over the next few quarters as those service and maintenance extensions come back for renewals?

I think that is somewhat a function of the economy and somewhat a function of customers mindsets with respect to where they are in terms of their own budgets, et cetera, and I think that as the economy stabilizes that we think we're starting to see today, we're not seeing quite as many of those one-year extensions as we were. In fact, this quarter they actually declined slightly, and we're seeing more than normal three-year contracts at the point-of-sale, so we're not back to where we were two years ago type of thing before the economy tanked, but we're clearly, clearly off the low point that we have seen with respect to the mix of one-year contracts.

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

Thanks. Steve, the accrued compensation on the balance sheet jumped more than typical this quarter. Is that just a function of the upside you saw in the top line and wouldn't that have been an offsetting headwind on gross margins that potentially alleviates going forward?

Well, you're right about the increase of the accrued compensation on the balance sheet. Actually, that is a result of what we call our incentive compensation plan which is actually based on our operating profit dollar performance, and the fact that we exceeded our internal expectation, our internal target by so much, means that we accrued a lot more intentive compensation for the vast majority of our noncommissioned employees.

Also included on that line, the causes to an increase, was an increase in commissions as well due to the share volume of our business. In the second half we're actually resetting our target for operating profit commensurate with what we have just done with our guidance and so it is going to be more difficult or let's put it this way, we set a higher bar for over achievement, so we're not as expecting nearly as much over achievement in the second half of the year. We'll have to see how things play out.

Got it. Thank you.

Your next question comes from the line of Ittai Kidron of Oppenheimer. Please proceed.

Thank you. Congrats on good numbers and guidance. Steve, I wanted to hopefully get more color from you on the V-Series. Is there any way for you to give us some color on how much of the revenue this quarter and the previous quarter was generated from sales into prior V-Series installments, so just that we get a better sense of how much is that V-Series really contributing to current performance on your product line?

I think there is a couple of factors there. It depends on why the customer buys the V-Series, and in many cases the V-Series is an entry point into new accounts that allows people to use our data management technology and our storage efficiency technology without whipping out all the stuff they already have which may have usable life left in it.

One of the things that mitigates V-Series growth and V-Series overall is probably less than 5% of our revenue, so I don't know if that's enough to answer your question, a little more than that but less than 10% of our revenue. What mitigates against the V-Series growth is for the customer that is use that as an entry point, when the time comes for them to come to the usable end of the life of the infrastructure behind it we seek to replace that with NetApp gear so the V-Series business converts into conventional system sales.

So what's interesting about V-Series is it is basically a new account generator for us, and the mature accounts actually move into other categories simply because they move along, and in fact one of those big SAN opportunities that we talked about was in fact the largest V-Series customer that actually converted to NetApp and buy full systems from us and no longer buy the SAN back from other players, and so I say the V-Series is one of the key vehicles for opening up new accounts, and I think we think about it more on those terms rather than ongoing contributor to our revenue stream.

Just to comment also, just keep in mind why the V-Series is so structurally favorable. Remember the V-Series is sold without disks, so it is basically just the computer head and the software which gives it the rich configuration mix I was talking about earlier.

Your next question comes from the line of Ben Reitzes of Barclays Capital. Please proceed.

Thank you very much. Can you talk a little bit more about your guidance for the January quarter in particular what is going on with public sequentially? You mentioned that you didn't expect the surge to continue so can you talk about how much that declined sequentially as well as the Europe phenomenon if you could describe that sequentially in a little bit more detail and what needs to fill the void sequentially to hit your guidance that would be great. Thanks a lot.

There is a number of moving parts in there. One of them clearly is the federal season reaches its peak of euphoria in September, at the end of the government fiscal year, so clearly this is the biggest federal quarter of the year or the biggest public sector quarter of the year, and as we go forward we lose some of that. I don't really want to quantify that to any detail. We basically lose some of that.

What we will see in the fourth quarter is we will see IBM's very, very fourth quarter centricity and we'll see IBM December which will take them up in the mix and Q3 also traditionally is a very, very strong quarter for us in Europe. Now, they just had a very, very strong quarter, so as I would see it, that we should see a significant Q3 decline in federal just like we see every year. We should see strength in Europe because that's usually the strongest quarter and we should see some strength in IBM. Those are kind of the key moving parts for us.

Thanks a lot.

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

Thank you very much. In the past you commented on the number of deals above a million dollars in the quarter, is there any additional color on the number of larger deals, which verticals, and if you see a sustainable improvement in larger deal flow here for the next couple of quarters as you see improvement in the overall market?

No doubt that we actually had a -- we had a number of larger deals this quarter, so certainly deal size, whether it be over $10 million we had some this quarter, we haven't had any of those in over a year, $5 million to $10 million was up, $2 million to $6 million is up, pretty much every single category of deals over a million dollars have been up. Clearly deal size is improving. I think that would be an indicator that customers are moving away from just satisfying incremental demand for short-term covering of their needs and I think they're moving more towards tech refreshes and broader buildouts of new infrastructures particularly as they look towards their internal cloud.

As you can well imagine large deal sizes tend to be lumpy, they tend to be hard to predict, they tend to be the one that is are going to get pushed out in time because they get a a lot of scrutiny up and down the approval chain. There is no doubt a lot more came to fruition. When we think about implicit measures of the health of the overall industry the fact that more and more of those deals are coming out the other end tells me two things. One is while budgets are certainly not what they once were, budgets are more firm than they once were and also tells me people are thinking and starting to implement new data center architectures and new tech refreshes as opposed to just satisfying incremental demand with bare bone systems.

Your next question comes from the line of Paul Mansky of Canaccord Adams. Please proceed.

Thank you for taking the questions, and I would like to echo congratulations on that quarter and outlook. Maybe trying to bundle a couple of questions into one. Building on some of the gross margins in revenue expectations, and you provided a lot of explanation, but didn't really hear much about components of availability and we have been hearing quite a bit about it on our end. Maybe could you address how you feel about availability of components, particularly those higher capacity disk drives?

There is no doubt that availability is becoming something that we will be spending more time on. It is no doubt tighter now than it has been. The first statement is I think within the range of guidance that we gave, I don't believe that component availability is going to be a threat to that, so I will just start with that. What is interesting about the supply chain is we have actually seen a lot of capacity come off line in the last couple of years, and a lot of subsuppliers to our suppliers, cables, sheet metal, connectors, a lot of suppliers have gone out of business.

As a result as demand starts to pick up, we're seeing a fair amount of reluctance in the supply chain of companies that are doubting whether this is going to be a broad based recovery or not. I think your observation about the supply chain is definitely true. I don't believe it is going to be an issue for us in terms of any of the guidance that we have given. It is something that we are watching more closely that we did six to nine months ago. I think one thing that does help, companies like NetApp on offset quarters is that we are competing for capacity for contract manufacturers or for parts at the same time some of the larger companies are on traditional quarterly boundaries. I think that helps us a little bit.

Bottom line answer to your question, is supply line is definitely tightening not just disk drives but a lot of areas, bankruptcy of major suppliers is has been a factor, and I don't believe it is going to be a threat to the guidance we gave.

Great. Thank you for that.

You have a question from the line of Bill Shope of Credit Suisse. Please proceed.

Great. Thanks. Can you comment on backlog trends exiting this quarter versus historical averages? I understand you don't usually give quantitative measures here but qualitatively was it above or below normal?

Bill, we really don't talk about backlog here. We really don't think it is material so much of backlog could be canceled at any time type of thing. Let's suffice to say we're very pleased with our backlog position right now and it has all been factored into the guidance we gave.

Could I I guess change that to pipeline? How do you see the pipeline right now? I am assuming it is improved substantially from the prior quarter.

The pipeline, our pipeline looked very good and the good news is the close rates have improved, so we feel that the predictability of the pipeline is much better than it was, certainly six months ago. Again, all we know about the pipeline and all we know about our backlog has been factored into the guidance we gave you.

Great. Thank you.

You have a question from the line of Brent Bracelin of Pacific Crest Securities. Please proceed.

Thank you for taking my question. I guess a question for you, Tom, the SAN only kind of step up here this quarter, a little surprising. My question is what's changed? How sustainable is the success in SAN only? Are you seeing increasing win rates there? Is it driven by the new hardware upgrades or OS upgrades or really just by more of the economy picking up and large enterprise picking up? Any more color on the momentum there and how sustainable that is would be helpful.

I think it is obviously modulated by the overall market size, but I think in terms of win rates and market share, I not only think it is sustainable, I also think it is one of our key objectives. If you look at the overall storage industry, and you look specifically at the SAN space, I think that's been the area particularly in mid-range SAN, where the pace of innovation by the major vendors has been the slowest. So when I look at products from the major players, and you know who they are, I actually think those are the weakest offerings in the storage industry and the ones we need to be attacking most aggressively.

When I look at the tech refresh cycle, I presume my competitors have also have old equipment sitting out there as well, and when you look at it, that equipment is three, four, five years old. The architecture people have in mind going forward, particularly around the virtualized data centers and internal clouds, but basically server virtualization intensive environments. Those are very different than the environments that they had in mind when they bought that equipment three, four, five years ago.

When that comes up for tech refresh and most has seen little innovation particularly in terms of relevance in virtualized server environments, I think that's NetApp strength, so I think intercepting that tech refresh, particularly around mid-range SAN, is a a very core focus of ours, so I am not going to predict what the market is going to do, but in terms of our continued success, I am actually very bullish on our opportunity and I expect to see similar deals like this in the future.

Your next question comes from the line Rajesh Ghai of ThinkEquity.

You mentioned that you were seeing growing traction for (inaudible) in virtual server deployments. A couple of questions there. Of your customers how many have moved from SANs to NAS based deployment and what percent of these first time adopters are customers are first time adopters of server virtualization?

I don't have any numbers how many have transitioned. There was a time when the VMware business was 90% SAN, and now based on our system reported stuff which is basically the systems you have in the field which is our entire assault base, says the entire assault base moved to about whatever the number I quoted, roughly 50/50, a little less I think 40%. That would tell me that a fair number of them have moved from SAN to NAS or are running both at the same time. Maybe SAN for their original deployment and NAS for their new deployments. Where we really see the pay off is in the very, very large accounts. Many of the accounts that VMware promotes as their success stories are actually running NetApp on NFS.

The other thing is NFS was not available in the initial releases of VMware and it is now, and I think the education process both with our customer base, with our sales force, and with VMware sales force has moved in that direction. I think the data management flexibility, the reconfiguration, the data mobility, all of those things are just fundamentally enabled by NFS and fundamentally made more difficult with SANs. I want to be real clear. If a customer wants SAN we can win there. The value proposition we offer in terms of integration and storage efficiency are just as viable in SAN as they are in NAS. I just think the NAS architecture generates a degree of flexibility independent of NetApp that customers should definitely consider.

Thanks.

You have a question from the line of Chris Whitmore of Deutsche Bank. Please proceed.

Thanks very much. Question for Steve around deferred revenue and cash flow margins. Can you provide any color as to, number one, when you expect deferred revenue to grow on the cash flow statement and secondly what's the outlook for cash flow margins going forward maybe in the quarter for the year? Any change to your view there? Thanks a lot.

Okay, Chris. What do I expect to see grow on the cash flow statement? The deferred -- what you're referring to then is an increase in the deferred liability on the balance sheet. Well we just saw in this past quarter, about $7 million, it was -- I am not expecting to see large increases in the balance sheet deferred liability until we get our bookings growing probably north of 10% year-over-year and revenues would be growing roughly 10% year-over-year also, and as you know, we're roughly just under zero right now, still slightly negative in products.

I think it is going to be several quarters before you start to see a appreciable growth in deferred revenues on the balance sheet. As far as the impact on cash flow, that said, I think that we're going to be in the range that I gave you at the analyst day certainly my anticipation for next quarter and I am not going out beyond that right now.

I think the 32 day DSO is pretty remarkable achievement by the Company and a tribute to our collections team. I also believe DSO starts with customer satisfaction, but nonetheless that's a very, very low number, and a day of DSO is $10 million of cash.

That's right.

You have a question from the line of Jayson Noland of Robert Baird. Please proceed.

Thank you. Tom, just a question follow-up with Cisco. What kind of attach have you seen to Cisco's UCS platform so far and is it fair to think that going forward your expectations there are just moderated I guess given VCE?

No. They're not moderate rated at all. I said it before, is that I think that in EMC's firmly entrenched accounts, that is really the target of this relationship. By definition, those are not NetApp accounts. Once you get out of those, I consider Cisco a fair game partner just like everybody else, and we tend to partner with them aggressively and compete against EMC, and time will tell in terms of stories that is are out there, but I can personally speak of or aware of a number of very, very significant UCS deals that are Cisco partnering directly with NetApp with no EMC involvement at all and there will come a time when we can talk about them. But I think in the short run Cisco's goal is leverage EMC's market presence, but where EMC doesn't have a market presence the whole world knows who EMC is, those customers have consciously chosen not to buy EMC, and I don't think the VCE is going to change their mind.

Thank you.

You have a question from the line of Richard Gardner of Citigroup. Please proceed.

Okay. Great. Thank you for taking the question. Tom, I was just hoping that you could summarize some of the key metrics on new account penetration during the quarter and the progress that you're making against your storage 5,000 goals?

Okay. So I don't have any -- I don't have those data points. I do know that new account acquisition was up this quarter over last quarter as you would expect with our sequential growth, so I think we're on track. I don't have anything to report positively or negatively on that dimension but still it remains a focus, something that we're clearly trying to do and not only in our own channels but also IBM doubled our new account acquisition last year through our activities with them so expect that to continue and expect to have a good quarter with them as they close their fiscal year.

Your final question comes from the line of Glenn Hanus of Needham & Company. Please proceed.

Thanks. Maybe talk a little bit more about the Fujitsu relationship, what have they really been reselling to date and where and how significant is this new announcement in expanding that relationship and any specifics you can provide?

Yes. Okay. So the Fujitsu announcement is something we have been working on for quite some time, and if you follow the Fujitsu story, it was Fujitsu, Siemens and recapitalized the Company and it slowed things down a bit and renewed in earnest with a new leadership and basically what we're trying to do is now that Fujitsu own that is entity, they're looking to drive a unified storage strategy across Japan and all of Fujitsu, so they have got some internally developed products, they have got partnerships with NetApp which is quite significant.

I think we talked about them in the past. We haven't quantified them but I think we said they're bigger than the IBM relationship which is a fact and, so it is an important partner for us and also have other partner that is our competitors to ours that they also do business on a significant scale.

I think going forward, what we have agreed to do is that we want to jointly build a storage portfolio that unifies a number of their technologies, storage management and some of the other core technologies we have and basically build a single product portfolio for Fujitsu that's based on a combination of their technologies and our technologies. So Fujitsu is a multi-hundred million dollar partner of ours, and I think that this represents a very, very interesting relationship for us going forward, and it gives them an opportunity to streamline their storage story and allows them to have a single story worldwide around storage as opposed to some of the reseller relationships they have today.

Thank you.

This concludes the Q&A portion of today's call. I would now like to turn the call back over to management for closing remarks.

Thank you for joining us today, everyone. I would like to close by letting you know that our targeted third quarter earnings release date is February 17th 2010. We look forward to updating you then and thanks for your time today. Goodbye.

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