NetApp Inc (NTAP) 2010 Q4 法說會逐字稿

Good day, ladies and gentlemen.

Welcome to the NetApp Q4 and fiscal year 2010 earnings conference call.

My name is Shamika, and I'll be your coordinator.

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

We will conduct a question and answer session towards the end of today's conference.

(Operator Instructions).

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

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

Tara Calhoun, Vice President of Investor Relations.

Please proceed.

Good afternoon, everyone.

Thank you for joining us.

With me on today's call are our CEO, Tom Georgens, and our CFO, Steve Gomo.

This call is being webcast live and will be available for replay on our website at NetApp.com along with the Earnings Release, the supplemental commentary, the financial tables and the non-GAAP to GAAP reconciliation.

Last quarter we implemented a new format for our quarterly results announcements.

Concurrent with the press release we are now publishing and distributing a supplemental commentary which contains metrics and some of the analysis we have previously provided in our live call.

Our goal is to provide the investment community with additional time to review and analyze all our results, allowing for a more thoughtful interactive dialogue during the Q&A.

This live call will focus on strategic commentary and outlook from our CEO and CFO and allow for a slightly longer Q&A period.

We received very positive feedback on this new approach so we will be using it going forward.

As a reminder, during today's call we will make forward-looking statements and projections including our financial outlook, which involves risks and uncertainties.

Actual results may differ materially from our statements and projections.

Factors that could cause actual results to differ from our projections are detailed in our accompanying press release which we have filed on an 8-K with the SEC, as well as our 10-K and 10-Q reports also on file with the SEC and available on our website, all of which are Incorporated by reference in today's discussion.

These factors include among others that our quarterly operating results may fluctuate for a number of reasons, some of which are beyond our control.

All numbers mentioned are GAAP unless otherwise stated.

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

I'll now turn the call over to Steve for his thoughts.

Steve?

Thanks, Tara.

Good afternoon, everyone.

NetApp further separated itself from the pack this quarter.

We again achieved records across most areas of our business from revenue to cash generation.

Record levels of net income, deferred revenue and impressive accounts receivable collection efforts drove both cash from operations and free cash flow to new heights.

Free cash flow expressed as a percentage of revenue was 37%, well above our targeted range; however, I believe the best indicator of our business strength is our 50% growth in product revenue.

That's 5-0.

50% organic growth in product revenue demonstrates unquestionable share gains in the network storage market, and we accomplished this while maintaining very strong non-GAAP product gross margins.

The main reason I'm so excited about this particular metric is that everything attaches to product.

Sustained product growth eventually drives the growth of the deferred revenue element on our P & L.

It is no coincidence that the large increase in product revenues was accompanied by a significant increase in the deferred revenue levels on our balance sheet.

The growth in demand for our product has also put additional strain on our supply chain, which was already experiencing challenges due to unpredictable spot shortages of some parts and the disruptive effect of the volcanic eruption in Europe.

To deal with this environment of Supply Chain variability, we have taken steps to protect the sustainability of our revenue growth by forward provisioning a lot more material around the world.

As a result, you should expect all categories of inventory levels, raw material, work in process, and finished goods, to run higher than normal for the next few quarters.

Our non-GAAP operating expenses were also above plan in Q4, although it was again due primarily to greater than expected variable and incentive compensation related to our business volume and our operating income performance.

We will continue to invest in both sales and engineering to further strengthen both our near term and longer term growth opportunities.

At the same time, we will maintain control over the level of investments we make to ensure we are spending our resources wisely.

We will not spend beyond levels which we believe we can manage effectively to achieve our growth objective.

Looking forward, Q1 revenue is expected to decline from Q4 levels by about 3% to 6%.

It is worth noting that the mid point of our targets for Q1 revenues implies a year-over-year growth rate of almost 34%.

Granted, this is over an easy compare, but at the mid point of our revenue guidance, we expect product revenue growth to be about 45%.

A 45% organic product revenue growth is a remarkable number for a Company of our size in any environment, giving you a strong indication of the momentum we have in our business.

We expect our Q1 operating expenses to fall from Q4 levels now that the variables and incentive compensation bar gets reset at the beginning of our fiscal year.

As a result, our forecast non-GAAP operating margin is now expected to be in a range around 17.5% of revenue, plus or minus half a point or so.

I'd also like to point out that free cash flow we received from Q4 levels as the accrued compensation for commission and incentive compensation is paid out to employees in Q1.

As a result, expect free cash flow to be lower than our targeted range of 17% to 22% in the first quarter.

To summarize, we are forecasting continued momentum in our business.

Once again driven by strong demand for our products, and while we continue to invest assertively in sales and R & D, the combination of strong revenue growth and solid gross margins will drive our operating margins higher than our long term targets.

Now I'd like to turn the call over to Tom.

Tom?

Thank you, Steve.

What a difference a year makes.

At the beginning of the last calendar year, economic conditions forced some difficult choices.

In response, we created a more focused articulation of our product and go to market strategies.

We eliminated products and programs that were not aligned with our strategic direction, and we moved substantial resources from low yield activities to be able to fund key initiatives in an investment constrained environment.

While there is still much to do, and opportunities for further improvement abound, I am proud to report the results created by the dedication and hard work of the NetApp team.

Despite a slow start and a challenging environment, for the full year, we still managed double digit revenue growth and achieved our target operating margin level of 16%.

In addition, we produced the highest full year gross margin levels in over a decade, while generating a record number of deals over $1 million.

Our growth accelerated over the course of the year, and we closed with tremendous momentum and record revenues, profits, and free cash flow.

Last year, we spoke at our Analyst day about the impending tech refresh cycle.

The premise was that a protracted downturn had stole storage spending, resulting in an aging infrastructure that would need replacing; however, there was also a transformation under way, as customers have begun moving from the application silo model to a shared application infrastructure, to underlying architecture for the internal and the external cloud.

This evolution was enabled by server virtualization, and our competitive advantage in that area would position us well as the cloud infrastructure implementations began.

This is clearly playing out as we expected.

The tech refresh has been the rising tide that has produced recent growth for most of our major competitors, with NetApp growing significantly faster.

The sudden vitality of the storage industry has raised the inevitable question of sustainability, so I would like to point out that the dynamics of NetApp's growth are different than that of the market at large.

To get a clearer picture of relative performance, it is instructive to look back at the same quarter two years ago to eliminate the distortion of weak compares.

If you look at the storage businesses of the largest vendors on this two year quarterly compare, you will find that one is down double digits, two are down high single digits, and while the fourth is up single digits, almost all of that is inorganic, with its legacy businesses roughly flat.

Over the same period, NetApp revenue is up 25%, demonstrating a clear and sustained separation of our relative growth rates.

What is different about NetApp is that two years ago, we acquired more new customers than in any year in our history, and we believe our slowdown was cushioned by this new revenue stream.

This past year has seen repeat purchases from these customers, as well as a new set of first time buys in another strong customer acquisition year.

While the tech refresh is a tail wind for NetApp as well, our story is also about share gains, opening new accounts, and being chosen for significantly larger data center projects, which combined produce growth sooner than any major competitor, creating greater momentum today, and leaves us well positioned for continued outperformance even if the current environment moderates.

Our traditional business areas are providing primary and secondary storage offerings in file services, Microsoft, Oracle and SAP environments continue to be robust.

In the last few years, virtualization, both server and now desktop, has become a rapidly accelerating part of the business.

Roughly one-third of our current installed base is supporting virtualized environments.

It was not that long ago when people were questioning whether server virtualization was a potential threat to NetApp, when we were in fact the first to recognize the impact of this trend on storage and are now the acknowledged innovation leader in storage for virtualized infrastructures.

In the emerging space of desktop virtualization, we have been selected by nine of the 10 largest banks in New York, further evidence that we have earned our place in the data center is that we had a record number of $1 million deals and a record number of new customers whose first purchases were over $500,000.

Partnerships have been important to our momentum and our penetration into large accounts.

We remain actively engaged in joint innovation and go to market activities with our alliance partners, Microsoft, Cisco and VMware.

We were named Microsoft Storage Partner of the Year last year and we launched with Cisco and VMware for joint collaboration and support for secure multi-tenancy, which is an absolutely essential component in providing data privacy in shared infrastructure cloud environments, both external and internal.

Our distribution partners, Arrow and Avnet achieved a combined $1 billion in annual revenue for the first time ever, and our relationships with IBM and Fujitsu continue to generate growth.

As we mentioned at Analyst day, systems integrator partners are a big emphasis this year with a large number of practices being developed or in progress.

Not surprisingly, many of them are around virtual servers, virtual desktop, and cloud computing.

The strong performance of our go to market team was enabled by a compelling set of product offerings.

In our target market, to be the platform of choice for the shared infrastructure, our portfolio of products is second to no one.

Despite considerable noise in the industry, NetApp has quietly demonstrated the most efficient and effective way to deploy flash technology in storage systems and we believe our nearly 20% attach rate is the highest of our major competitors.

Our storage efficiency, as evidenced by our 50% guarantee, enables customers to meet their business objectives with dramatically less storage, which has opened up new customers and new projects within existing customers, especially in difficult economic conditions.

Our solutions around virtualization remain leading edge as we move beyond simple server virtualization to virtual desktop, hyper V and the internal and external clouds.

A key component here is our secure multi-tenancy capability, an end-to-end solution which allows multiple Apps or multiple customers to securely share hardware at every level of the stack.

We have yet to see any meaningful competitive response to this offering.

In storage, 2009 might have been the year of Flash, with NetApp emerging as the leader, but this year will be the year of unified storage.

The ability to do both block and file access will become even more important in the future.

If people were to realize the full potential of a shared homogeneous infrastructure running multiple applications, multi-protocol capability will be a requirement.

In fact about 80% of our systems deployed in virtualized environments today run multiple protocols, and products without this capability will eventually be relegated to legacy and niche applications.

NetApp has had unified storage since 2002, and with over 150,000 such units installed, we are the unquestioned market leader in this space.

Cloud computing will surely be a hot topic for the foreseeable future, and a shared infrastructure will be a key component of any cloud architecture.

This is our focus where we are winning today, and where our biggest go forward opportunity lies.

The confluence of an aging infrastructure and a rearchitecting of the data center represent one of the largest share shift opportunities in a decade.

NetApp has innovated beyond the conventional approaches, and offers compelling functionality, attractive economics, and dramatically reduced complexity, enabling customers to realize the business objectives of cloud computing with reduced risk.

We have customers in production and at scale in the areas of internal clouds, virtual desktops, and external clouds, using technology we introduced years ahead of the rest of the industry.

While we finished the year with momentum, we have elected not to give annual guidance.

We believe that any 12 month projection will be dominated by a number of external moving parts that we are in no position to predict.

However, do not let the lack of guidance reflect any lack of confidence in the sustainability of our competitive position.

Good market or bad, we expect to gain share.

Evidence of this confidence is our continued aggressive investment in the business.

With our current momentum, and the compelling amount of market share and play in the intermediate term, executing on this opportunity is still our highest priority.

That said, due to the better than expected revenue growth in gross margins, we exceeded our long term model of 16% for three quarters in a row, and guided above it again next quarter.

As long as business remains strong, I see our operating margin staying around our projected Q1 level, give or take half a point for the rest of fiscal year 2011.

For the economic conditions to deteriorate to the extent we can, we will adjust our spending accordingly and work to protect a 16% long term target.

I will close by offering my sincere thanks to the entire NetApp team for tremendous execution this quarter, and for a remarkable year.

The difficult decisions made early last year and the transformation projects they generated, many of which are still under way, enable the rapid turnaround in the business and the record results we announced today.

I would also like to take a moment to honor Mr.

Don Valentine.

After 16 years of tremendous service, Don has decided to retire from the NetApp Board of Directors.

I'm sure many of you know that Don is a founding partner of Sequoia Capital, which lead the Series C round of venture financing of NetApp back in September of 1994.

Don has been on the Board ever since, serving as Chairman until 2008.

On behalf of the Company and the Board, I would like to thank him for his immeasurable contribution and wish him all the best for the future.

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

Given the number of people in the queue, we ask you limit yourself to one question, so that we have a chance to address everyone during our allotted time.

Thank you.

Operator?

(Operator Instructions).

Your first question comes from the line of Ittai Kidron of Oppenheimer.

Please proceed.

Thank you and congratulations gentlemen on a great quarter.

Tom, three times during your prepared remarks, you've mentioned something to the extent of should things turn around, turn back down South from an economic standpoint, could you give us a little bit more clarity?

I would assume over the last two weeks you've made a lot of phone calls to your people on the ground in Europe.

What is it that you're seeing over there and is there any indication that the recovery that we've seen up until now is to stall?

Well first of all thank you very much for the kind words.

I think that we don't see anything in the horizon that you don't read about in the papers every day.

I think clearly the concerns about Europe, we had Wall Street Journal this week talk about the potential of the double dip, and I think all of those are out there and I'm not going to handicap the likelihood of them, but I think we need to be aware of them.

As far as what we're hearing from Europe, there's two components of the story.

Number one is, I don't see anybody backing away from the number even in dollar terms.

On the other hand, it's still early in the quarter and we'll see how that plays out but I think the big thing about Europe is while we have some strong presence in a number of countries, we also have very very small presence in a bunch of others that represent significant growth and share opportunities for us.

In economies where you have very little market share the macro doesn't matter that much and that's my message to them, independent of their message to me but right now, I think everybody is reading the headlines but people are still bullish about the business, and our ability to gain share, and the customers that we talk to that are going to drive the number are still relatively positive.

So I think Europe is really two components.

One is the local currency conversion and where are we going to go from $1.22 or $1.23 I don't think anybody knows and that's clearly estimates that factor into our guidance and the other is a reduction of demand and in the latter category at this point in time we're not seeing that yet.

Very good.

Good luck.

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

Please proceed.

Great.

Thanks guys.

Nice execution.

A question with regards to the operating margin, pro forma operating margin guidance for July, at about 17.5%.

Typically, the Q1 time frame for your fiscal year is the low point of the margin structure for you guys throughout the fiscal year, so was wondering how you could talk about that kind of being flattish relative to Steve's prior comments in the call saying that we're going to invest wisely and not jeopardize kind of margins going forward, so thank you.

Hi, Brian.

Steve here.

So a couple of things.

First you'll notice that the guidance in revenue, revenues are not rolling off probably as much as had been anticipated they would.

Probably more importantly is gross margins are going to remain fairly strong.

In fact they aren't going to change a whole lot from the fourth quarter, they will be down slightly but not much.

Operating expenses will fall, primarily because we had so much acceleration of our incentive compensation program and our commissions in the fourth quarter, so when you add those three things up, revenues that are at a relatively stable level, at least compared with past years, gross margins that are going to stay firm, and a reduction in expenses, that's how you're able to protect that operating margin.

And so that rolls through the fiscal year you would expect pro forma operating expenses to be relatively constant as a percent of sales?

I think that's what Tom said in his prepared remarks.

Yes, I think that's the only way you get there.

I don't believe that gross margins are going to be particularly volatile over the course of the year so I think we'll do that.

And sales remain robust, certainly we've had accelerating sales growth as the year has gone on.

And I think even if they stay around this level, we're not holding back on the spending side.

We're investing heavily in engineering, we're investing heavily in sales as obviously other parts of the business we need to invest in the scale, so but there's a limit to how much we can do that and as long as revenue remains at this kind of growth rate that's what's enabling us to stay at our operating margin now for three quarters going on four above our historical level, so I think that's not been a fundamental change in philosophy here.

I just think the sales and gross margins have been particularly robust over a sustained period of time.

Excellent.

Thanks.

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

Please proceed.

Thank you, good afternoon.

The question is around the mid range market.

Clearly you talked about in your prepared remarks about the opportunity and deployments taking place competitively.

On behalf of NetApp, I want to get a sense is this a function of a market shift where we're seeing the low end and high end come to the mid range so plenty of revenue opportunities to go around or are you just coming to market with a much better technology that even with your peers, trying to come out with new refreshes, you're still a couple steps ahead.

I kind of Mark, bristle a little bit at the mid range and high end.

I think there is a storage market and there are different kinds of products for different needs within that market, and I think that we're winning in storage in general.

I just don't think that the "mid range" has substantially different dynamics than what you would call the high end and in fact if you look at the numbers we had a remarkably strong quarter at the very very high end in terms of units shipped so I think all in all the business is robust.

Customers buy different types of products for different things.

Certainly we saw a year ago when customers were not that focused on building in excess capacity or future head room.

They were trying to get by with the minimum they could and clearly that was skewing the demand toward the smallest machines they could possibly buy to keep the business running and now people have a little bit more view towards the future but when I think about our 3,000 sales and our 6,000 sales, I really don't think there are separate dynamics driving both of those.

I think there maybe individual customer dynamics time to time but overall I consider those two markets homogeneous.

Thank you.

Your next question comes from the line of Amit Daryanani of RBC.

Please proceed.

Thanks, good afternoon guys.

I think you talked about unified storage being a fairly big focus in 2010.

Could you just talk about how do you see EMC's launch of their own unified offering down the road playing up to you guys and could you share any of the feedback you've gotten from your customers on that product and if you do see a source of it being revenue down the road.

Well I think first and foremost think unified storage is a big deal and I would expect to hear a lot more from the competition this year going forward about that.

If you think about what customers are trying to do with their server infrastructure, they are trying to build a broad homogeneous shared infrastructure capable of running multiple apps.

From the storage side they are trying to do the same thing and if they are going to try and build a shared infrastructure that has different solutions for the low end and high end, for SAN and for NAS, it defeats the entire purpose and the economic model of the share infrastructure so I think that multi-protocol is absolutely an essential component and if you look at what we sell in virtualization, the amount of unified products we have is very high, it's 80% of the products with multiple protocols but point number one is that I think any product that does not have multiple protocol capability is eventually approaching obsolescence and is going to be at best a niche or legacy product and it applies to the other products from the vendor you mentioned.

As far as EMC's entry into the space, we've been doing this since 2002, certainly we've learned a few things along the way and I'm sure they've learned a few things from us and when this product ultimately emerges I think we'll know more about it how well unified it really is or just two things in one box.

Time will tell and I don't want to speculate about what they're going to offer but at the end of the day I expect them to have a product and we'll meet them in the mark the and see how it shakes out but the big question, unified storage should be a requirement for every customer buying storage and a single protocol box would be hard to defend in terms of future price protection and future architecture protection.

Thanks.

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

Please proceed.

Thank you.

Tom, NetApp's growth was really impressive over the quarter despot the lower level of IBM contribution in almost three years now.

A few years ago this was supposed to be about 10% of your revenue.

It seems to be moving the other way.

Is there a mutual deemphasis especially giving IBM is shipping its own scale of mass product and you view the relationship of less strategic or is it mostly seasonal weakness which we should expect will reverse next quarter.

Thanks.

Okay, as far as IBM is concerned a couple of interesting things at play is the growth numbers to the business measured in their quarterly boundaries are something we would have liked to have highlighted so some of it is timing and we'll see where it goes.

The other thing is we're coming off the quarter that wrapped around their Q4 which is the traditional quarter where they are the highest percentage of our revenue.

So they still generate growth year-over-year but clearly not at the rate of the broader NetApp.

So as far as IBM is concerned they are still very very important to us.

There's no doubt that they've got a set of products that are internally developed and I think all else being equal they would prefer to sell those.

I think there's economic reasons and customer account control reasons why they would want to do that and we certainly see that going on.

On the other hand, with our growth this tremendous demand for our products in the market and we collaborate them around selling the big accounts or we've got common partners, what is customer specific demand for our product I think they move ahead with it.

The big picture the way we see IBM is there's going to be a class of customers that are going to value the integration of all of the technologies together and in that particular case for the customers that value integration over individual functionality of every level of the stack, in order for us to reach that set of customers partners like IBM will matter and they remain strategic for us.

On the other hand I think when customers gain an integration they lose in best of breed and in that regard, clearly that's going to be a key part of our selling motion as well so I think IBM for the customers looking for integrated solutions is very very important.

Our observation more generally around IBM is clearly they would like to position their own products where they can, however the customer facing component of IBM, the people that deal with customers every day and have to offer up solutions for virtualization, that's probably where the support for NetApp is coming.

Clearly, the percentage of our revenue is real money as a real part of their business and I think they would sell their own product if they could but there's a lot of customer demand for our product and that continues to exist and continues to grow so all in all I think obviously there is complexity.

I'm not going to deny it.

I think we will never be satisfied with the positioning of the product.

On the other hand I think we add value in the core strategic areas that are a point of emphasis for IBM around cloud computing and in those areas we continue to engage very productively.

Thanks for the color.

You have a question from the line of Paul Mansky of Canaccord.

Please proceed.

On the V-series specifically, you've been growing that product line both sequentially and year on year at a pretty good clip for basically as long as I can remember.

I'm paraphrasing here, but I know in the past you've characterized that as customer acquisition versus immediate revenue needle moving business.

Can you maybe update give us an update vis-a-vis where we are on that kind of toe-hold business maturing into larger system sales, particularly as it relates to some of the commentary around the high end that you put up this past quarter?

Yes.

The V-series remains very very robust, and one little idiosyncrasy about the V-series business which is the essence of your question, is over time, a lot of the V-series business converts into conventional system sales, so in some cases, their business ages off, so in order to maintain this growth rate they need to continue to get new customers, because if two, three four years down the pipe they actually convert to standard customers, they aren't V-series accounts anymore, and in fact they had one account I remember when I joined the Company it was 20% of the V-series business, in that time it was the largest SAN installation in the world and it was V-series and about a year ago they converted over to buying our standard products, so your point is well taken.

When we move into accounts and we tell the NetApp story around storage efficiency and integration with apps and unified data protection and all the things we can do, customers could be intrigued by that, but they aren't in a position to rip out everything they've got and replace it.

It's just not economically viable, probably the accounting won't handle it so this is a way to introduce our technology into a customer that could standardize on our software base, which is where our truly value add is, and we can bring value to the infrastructure they already have but make no mistake our long term goal is to replace that infrastructure and that's what's going on, so I think that's playing out exactly as we said, so the growth of that business is despite the fact that a lot of the biggest most successful accounts are in fact converting to our standard product so I'm extremely pleased with V-series, it's a key component of us entering new accounts, particularly in the storage 5,000 and it remains so and it's exciting to see the product so robust so when we look at the V-series it's not only about revenue but about new accounts open with V-series because clearly if it's a very very compelling and easy entry point for our customers.

Great.

Thanks for the color.

I appreciate it.

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

Please proceed.

Great.

Thank you very much.

Indirect revenue continues to increase as a percentage of your mix and this quarter it was up to 71%.

Do you have a target for your direct/indirect mix or is there a natural cap for indirect as a percentage of revenue?

I don't think we have a target per se.

I think what's driving that is a recognition that as we think about the storage 5,000 and we think about the mid size enterprise business, it's how much of that opportunity is still uncovered.

A couple years ago we started doing the Storage 5,000 we realized how concentrated we were and we have uncovered or we've executed on a bunch of plans both in terms of refreshing the product offerings, incentives for the channel, training for the channel, turning over professional services for the channel, bundling, things to drive velocity and it's really expanded our channel business at the low end.

I think in the rest of the business, worked with the systems integrators and our OEMs is very successful so I don't think we're staring at a number saying some day we want to get to 85.

I think a more accurate characterization would be NetApp is trying to grow this business at a high rate.

We need to expand our coverage model and the most cost effective way of doing that is through the channel and we're making those investments and it's a big part of our growth.

Great.

Thank you.

Your next question comes from the line of Maynard Um of UBS.

Please proceed.

Hi.

Just a question on the inventories.

Was there a significant amount of business you left on the table this quarter because of the component and does any of that flow over into the July quarter and embedded into your guidance, and I'm curious because if you're doing strategic buys this quarter and next it seems to imply we're going to see a big ramp coming maybe in the October quarter, so if you could help me understand the inventory versus the product revenue, thanks.

Hi, it's Steve here.

So yes, we have inventory designated for shipment left over every quarter.

Revenue recognition rules are very complex and if we can't recognize the revenue, basically we reverse the shipment transaction and things appear to be back in inventory.

We had a large amount at the end of last quarter, the third quarter.

We have a similar amount this quarter relative to the revenue level, and we expect to have some at the end of the first quarter at about the same level relative to the revenue level so there's nothing other than that going on.

With respect to the inventory purchases we're making, we have experienced these spot shortages of parts and they create havoc for us because a single part can hold up an entire shipment sale so basically what we've done here is forward provision if you will by advance a whole bunch of critical product parts that come in at various levels of inventory whether it's raw material or whip or FGI, and basically we pull those forward, we put them in inventory now so the inventory levels step up but it basically protects us and gives us more confidence in our revenue levels going forward and all that's been factored into the guidance.

The one thing I'd add to that is I never imagined in 100 years I'd be talking about volcanos on this call but the volcano eruption was not exactly at a favorable time in our quarter.

It wasn't in the last week but it was close and our supply chain into our European manufacturing primarily emanates in the Far East so from our perspective is the situation is probably not going to go away overnight and I think we want to be a little bit more careful about forward provisioning some materials so that we could tolerate if there's some type of disruption in the supply chain in that regard, so at the very least I don't want to use volcanos, the worst thing I could do or the only thing worse than blaming inventory on volcanos is blaming a revenue miss on volcanos but I think the operations team did a great job of overcoming not only spot shortages but disruptions in the transportation and I think that we ultimately fulfilled what we're going to fulfill this quarter and I don't believe there was any arbitrary hold up of revenue as a result of these disruptions.

Perfect, thank you.

We have a question from the line of Keith Bachman of Bank of Montreal.

Please proceed.

Hi, guys.

Thanks very much.

Steve, I wanted to see if I could target this one to you.

Your sequential growth on products was fantastic and how should we be thinking about the mix of revenues not only in the July quarter but thereafter, I assume there would be some catch up so to speak on software entitlement and services and then the margin implications on that if I could please.

You bet, Keith.

So the bottom line is that you're not going to see a great deal of growth in the services and SEM line sequentially into the first quarter.

We're going through a transition.

We're in the process of building deferred revenues.

The revenues that are coming off the balance sheet are coming off and mostly represent a period when the Company was growing much slower, so you're going to see a relatively flat sequential growth on those items.

Products, however, are doing as you mention, are doing very very well sequentially and even as we move into the first quarter, they're the ones causing the decline, right?

Right.

But nonetheless, compared to any other first quarter, it's extremely robust and right now the story of NetApp is the story of our product sales.

Yes, I think the historical seasonality discussion in this environment I think might be, I think it might be hard to draw historical comparisons.

I think that the market is not on a straight line so I don't think this is a normal year.

We could argue where the second half is going to go but I think right now, some of the traditional seasonality components I think are not going to be what they were historically both positive and negative and that's the reason why we haven't done the full year guidance and I think we have some visibility into Q1, we gave that the best we could, but I think simple seasonality makes an assumption that the overall environment is stable and I think certainly we've seen a run up recently and we'll see how long that sustains.

And I would add to that Keith you have to be careful of historical seasonality.

In history the deferred level in our revenues were roughly 20%.

Today it's only 5.

Okay, thanks, guys, nice job.

Thank you.

We have a question from the line of Chris Whitmore of Deutsche Bank.

Please proceed.

Thanks very much.

Beyond this year, I wanted to get some color in terms of longer term operating expectations.

Are you resetting the bar on a longer term basis towards that 17.5% level?

Can you maintain and make the investments you need to make to continue to grow, or is this a one year bump up?

I think long term I don't think that our fundamental position has changed.

I think we're in a situation now where the revenue and gross margin has been sufficiently robust to support a higher number.

Probably more generally though is, we went through a period whereas the product revenue dropped down the components coming off the Balance Sheet which are higher margin were higher and holding up the gross margin.

I think that the longer term question is, as products become more stabilized and a bigger percentage of our revenue going forward, that's going to put downward pressure over time on the gross margin and so our options were that we choose to invest today to basically stay at 16% today and invest at a much much higher rate, and as the margins come down lower, and our feeling was at this particular time we're investing as fast as we can prudently invest and that's producing with the high gross margin umbrella, actually producing high operating margin but in the long run we do expect, in the long run I don't know how long the long run is.

I gave guidance for this year.

I would think some time beyond that, we'll start to see probably movement back towards 16% but for the foreseeable future as long as the business holds up, I think we'll stay in the range we're at now.

Thank you very much.

You have a question from the line of Aaron Rakers of Stifel Nicolaus.

Please proceed.

Yes, thanks guys and good quarter.

My question is on the cash generation that you guys have seen here.

And in the context of share repurchases and use of cash going forward.

Can you update us on your thoughts around share repurchase with continually seeing a little bit of a creep up in the fully diluted share count and in that discussion also maybe it would be helpful to update us on kind of where your thoughts are in terms of the cash sitting overseas relative to domestic and thoughts on acquisitions?

Okay, well I'll handle the first part of that.

So where to start here.

Right now we have no, we're not planning any action with respect to a stock repurchase.

That said, we haven't changed our policy in terms of trying to make sure that we offset the effects of our own stock option grants.

We're actually ahead of our game right now.

We're actually ahead of our objectives, so we don't see any compelling need to do a stock repurchase.

We also prefer at this point to let the stock or excuse me to let the cash accumulate.

It gives us just a ton more flexibility with all of the other risks in the world type of thing, makes you feel very very good to have that cash and gives us a lot of flexibility from a strategic initiative standpoint so that's been our strategy and I think that's going to be our strategy going forward for the foreseeable future.

With respect to the location geographically of the cash, we had about 56% of the cash this quarter was domestic and the rest of it is overseas.

We have no plans to bring that back.

There's no way we can bring that back without a significant tax unless we use it as part of a M & A initiative, so I don't see that changing very much.

I think these ratios are going to stay in place for a while.

On the question of M & A we just closed one just a couple weeks ago and I think the M & A will fall into two categories.

One of them is technology that we would like to integrate as part of our portfolio and that's clearly where the acquisition we just did with Bicast, we're quite excited about that in terms of the emerging space of content repositories and particularly the vertical that they staked out in healthcare so I think we'll continue to do that.

The long term objective of that technology is to embed it in our core offering, unifying storage around content repositories with everything else we do.

Beyond the tuck ins, I think we also are open to other types of transactions.

I think the key criteria that we look to evaluate them is something that's not too far afield.

Something that is going to have leverage of our own salesforce, something our own salesforce can sell, or something to have in our portfolio that by virtue of having it will actually accelerate the sales of our existing products.

So from an acquisition perspective, I think that last Summer there was a lot of speculation could NetApp grow without acquiring and I think we've proven that one, but I think as we go forward there's still adjacent markets we think we can exploit but the adjacency and the cross-leverage is a key component of any choice we make and that's how we're looking at it, so tuck ins, I expect to do more of them.

Larger transactions, we may or may not do them but really the leverage is the key criteria.

Very helpful, thank you.

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

Thanks a lot.

Appreciate it.

With regard to Europe, could you just talk about how it went in the quarter because you really exceeded my expectations there by the most of any deal and what your guidance implies for Europe in the first quarter.

Obviously you said before you haven't seen any economic effects there but just a little more detail if you can talk about what you saw that made it so strong in the quarter and what's baked in your guidance including currency.

Thanks so much.

What we're doing over there is really about gaining share, so the macro environment, we've got pipeline, we're executing against the pipeline, we're closing deals and until such time is we actually see the pipeline disappear or the deals be unable to close, then I don't think we're particularly alarmed about where we are in Europe so, so far we haven't seen that.

We had really strong momentum there last quarter.

Q1, or the quarter we're going into is traditionally a soft quarter for them.

They historically are strong in our Q3.

Usually that's the biggest quarter of the year, although they did quite well in Q4 as well which is a bit of an anomaly, so I think they have momentum.

The headlines are not great, and I think they are going to come down somewhere between those two extremes, but so far, I don't see them talking about weakness in the pipeline or inability to close deals and we'll see how that plays out over time.

And currency impact you guys are using?

The currency impact, you probably saw the currency impact this quarter.

If rates stay roughly where they are, we're going to see about a three percentage point headwind for the Company in the first quarter.

It would be larger than that in Europe obviously.

Thanks so much.

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

Baird.

Please proceed.

Yes, thank you.

Just a follow-up to the question on direct versus indirect.

Direct has fared roughly flat over the last couple years and channel has been very strong.

I guess, are you seeing pent-up demand at all on the direct side, or have you shifted business from direct to indirect?

I don't know if I'd buy the flat argument.

Even this quarter it was up 19% or so year-over-year, I need to recheck my number, but there's no doubt the indirect is growing faster than direct.

There's no doubt about that, and the other thing that we are to bear in mind is a lot of our people are very very actively engaged with a lot of the indirect accounts.

Our federal business which is one of the strongest businesses we have in the Company is almost all indirect yet we're involved with a lot of those transactions directly with the end-user, directly with the integrators, directly with the resellers so I wouldn't make indirect synonymous with no touch.

Clearly the work we're doing with Avnet, less of that business is touched by NetApp but as you go upstream, into larger deals even with those guys with our major resellers or systems integrators there's still a fair amount of touch associated with it.

A lot of reasons customers buy indirect because they have purchasing agreements and contracts in place and things of the like, so I think that frankly our challenge is to get more no touch business into the Company and we're trying to make more and more of our partners self-sufficient, so I think that's a big part of it as well but the simple fact of the matter is there are a lot of customers we're just not going to get to with our own direct salesforce and we need the leverage and coverage of the indirect players.

As far as our big direct accounts clearly we saw a bounce back over the last six months there, certainly from where they were a year prior, so I think we've seen bounce back there as well and the number actually in this past quarter was that our direct business was up 19% year-over-year, up 33% overall so our indirect business you can do the math was the majority was higher so had to be in the 40 plus percent range.

It actually was 40%.

Thanks, Tom.

Congrats on the quarter.

Thank you.

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

Please proceed.

Thanks and nice quarter.

In the conversation with Keith, you talked about the impressive sequential growth in the product revenue business and product gross margins are very healthy but they didn't come up with the higher volume so can you just talk through the impact from component costs and mix and anything you saw on pricing during the quarter?

Well, I think all of those are factors.

I think pricing is probably the most benign.

I'll admit it's not as easy to negotiate price reductions when you're begging people for parts, but for the most part I don't think that component pricing was a serious factor in the overall margin picture.

As far as scale, we also did a record number of big accounts as well, and in those particular scenarios discounting becomes a bit more competitive, so I think all in all, we have a portfolio of business that we're trying to manage the portfolio to a guidepoint, but I think overall the component pricing is probably the least impactful in terms of our margin picture and more of it is just individual business dynamics, and the other thing is the luxury of scale and the margin tail wind that that gives us allows us to be more aggressive elsewhere to win deals very aggressively we need to.

Yes, I think for what it's worth, Katie, the volume effects were actually positive during the quarter and offset by other minor things, a lot of little things but the volume effects were fairly substantial, about half a point during the quarter favorable but eaten away by a number of other things.

Makes sense, thank you.

You have a question from the line of Rob Cihra of Caris & Company.

Hi.

Thanks very much.

Your mix between systems mid range and high end was obviously quite strong sequentially but your year-over-year trends have been a little funky just given year ago comps where we were.

Can you give any kind of insight into what areas feel strongest for you now, looking forward by other customer segment or competitive positioning, that sort of thing, thanks.

In terms of the use cases, virtual desktop is clearly hot and probably one of the areas where we have the highest win rate.

I think the integration of our technology in terms of dramatically reducing the cost per seat is really impact full and it's a difference between customers making the choice to move ahead or not move ahead.

I think we're also seeing in our larger accounts, I think we've earned the right to compete more broadly for businesses and other projects or opportunities and other projects and I think particularly now as I think about the internal cloud or the private cloud or the shared infrastructure, whatever you want to call it, maybe four or five years ago, we probably aren't considered for those, and we're clearly being considered for those now.

So in the big accounts, I think we're competing more broadly beyond our historical where we had previously been relegated, I think a lot more of the opportunity in those accounts is open to us.

In terms of new account acquisition, one of the things that was particularly notable this quarter is the amount of first time transactions over $0.5 million and that's a sign I always tell people of the history of a NetApp sales call is we tell people our value proposition, customers say I don't hear that from the competition, I'm not so sure you could do it and we ask them to give us a project to prove it and we prove it and we don't prove it, more often we do and then we grow.

I think in a lot of cases we moved to a point where we're being recognized as an innovation leader around these new technologies and people make bigger bets with us in their first engagement with NetApp.

Great.

Thank you very much.

Your next question comes from the line of Richard Gardner of Citigroup.

Please proceed.

Hi, this is John Slack on for Rich.

A quick question, a couple quarters back you guys were talking about using the Service Provider as a channel and bolstering the service provider indirect salesforce as we move to cloud orientation.

I'd love to hear an update on how those efforts are going.

Yes, so I think I heard the question wrong.

I think you said Service Provider and I heard systems integrator?

I'll take them both actually.

Okay.

So I was preparing one answer when I realized I heard the question wrong so I'm sorry about that.

First of all as far as systems integrators go, yes that is a big part of our approach.

The key to the systems integrators is at this point in the evolution of those relationships is more about getting design into the practices and the product offerings they are in turn delivering so if they build a practice delivery around SAP deployments or virtual desktop or Oracle, we want to be an integral part of that, so while we're clearly working together on deals and we actually measure revenue we do through our systems integrators and that's working out fine, at this point, what's more keen interest is the practice development so they've got more components in their arsenal where they are bidding NetApp every day at a high solution level and much more strategic so I'm quite pleased with the rollout there.

In the service providers, in some way it's somewhat similar because a lot of them are making important infrastructure choices about how they structure their competitive offerings to their market so I say the market is somewhat uneven.

In Europe I'd say the progress of the Service Providers as a significant provider in the market is far more mature than in the United States, so if I look at British Telecom they've built a cloud offering around NetApp.

I look at some of the other players but probably the biggest one we talk about is T-systems.

The T-systems is proven to be a very very successful Service Provider in Europe.

They've built their own platform they migrate applications to and that platform is built on NetApp and they had just a phenomenal year with us, substantial amount of business in Europe and growing very very rapidly and clearly I think that's probably the most successful story in Europe of any Service Provider.

In the US, I think the model is somewhat different.

The Telcos aren't quite as engaged just yet.

There's a lot of intermediate size companies with a lot of promise but they aren't the big name brands and I think you're familiar with a lot of those.

One of them, Teramark, is sought out to build a niche, and they have a commercial business but they built a niche around federal.

We had the CIO of the Federal Government not talking to build anymore data centers looking to go to the cloud.

Teramark is trying to do that.

They built a practice in that area around NetApp.

So the Service Providers and systems integrators I think is progressing well.

I think we're still in the design in phase although a couple are generating substantial revenue for us but right now, I think we're quite pleased with the progress and we'll see how that's going to play out.

Clearly there are winners and losers and we'll invest in some losers along the way but I think T-systems is a winner and they are standardized on us and we have other winners on the way.

Great.

Thanks a lot.

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

Please proceed.

Mr.

Mark Kelleher, your line is now open.

Hi.

Thanks for taking the question.

Sorry about that.

The service margins bounced around quite a bit over the last few quarters and if I'm not mistaken that's a record number you just posted.

Can you provide more commentary on the drivers of service margin and do you expect that level seen in Q4 to be sustainable over the year, thanks?

Hi, Mark.

Steve here.

I guess reverse order yes, I expect that to be a fairly sustainable level.

All the vectors are pointing in the right direction in terms of our service business.

The reason why it jumped from the, the reason why there was a jump in the fourth quarter from the third was because our utilization of professional services was particularly high.

You'll notice that a year ago the same thing happened and it's almost exactly the same reason.

At the end of the year, we try to, our guys go out and really try to shut down the SOWs, get the work done, get this complete so we can move on to the New Year.

There's just a lot of pressure for them to do that, and typically they get a lot of work done on those SOWs and allows us to close them out and then build them, so that's pretty much what happens.

That said, I think that kind of a level is something that you can count on going forward.

Great.

Thanks.

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

Please proceed.

Thanks and congrats to you.

Maybe you could talk a little more about the strategic significance of Bicast and any metrics you can give there just in terms of employees or operating expenses, thanks.

Well, I think it's in the grand scheme of things it will be probably minimal to the operating expense, they're probably about 60 or 70 employees so the attractiveness there is that we're certainly seeing emergence of customers that want to build large repositories of just broad non-hierarchical data, medical images, e-mails, video, what have you, and they staked out over a number of years have built a pretty compelling product, and they have staked out a niche in a number of the healthcare companies, so for us I think healthcare is clearly a strategic vertical.

The content repository makes a lot of sense, and our objective there is to take that technology and embed it within our core offering so right now we'll sell it, bundled together but ultimately we want to integrate it, and consistent with our unified storage story, it's not only about unified data protection, and also yet another protocol to add to that, so strategically, over the longer term, we see this as a technology tuck in add functionality to our core offerings so we provide a unified set of solutions to our customers off a much broader set of applications.

In the near term, most of the transactions that they pursue are relatively heavy from a storage perspective in terms of a lot of capacity behind them, and I think that they are clearly going to be open up opportunities in terms of our existing install base and I think they enable us to penetrate some accounts, leveraging their technology with ours, but the long term strategic goal wasn't any short-term revenue contribution.

It's really the long term integration to our product offering.

Thanks for your thorough answers.

Oh, thank you.

This concludes the Q&A portion of today's conference.

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

Tom Georgens, Chief Executive Officer.

Please proceed.

Okay, well thank you very much for joining us today.

We look forward to seeing you again roughly a quarter from now, and I look forward to answering all of your questions yet again.

Thank you very much for your interest in NetApp, and thanks again to the employees of NetApp that made all of this quarter's results possible.

Thank you for your participation in today's conference.

This concludes the presentation.

You may now disconnect.

Good day.