NetApp Inc (NTAP) 2011 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the NetApp first quarter fiscal year 2011 earnings conference call.

My name is Crystal, and I will be your operator for today.

(Operator Instructions).

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

Tara Dhillon, Vice President, Investor Relations.

Please proceed.

Good afternoon, everyone.

Thank you for joining us.

With me on today's call are 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, our financial tables, and the non-GAAP to GAAP reconciliation.

Concurrent with today's press release, the supplemental commentary we published contains many of the metrics and analysis we previously provided during our live call.

Our goal is to provide additional time for review of the data prior to beginning the call.

This allows us to focus on more strategic commentary and perspectives from our CEO and CFO, as well as a longer Q&A period.

As a reminder during today's call, we will make forward-looking statements and projections, including our financial outlook, our expectations regarding future market share, and our beliefs regarding the benefits that our customers will realize from using our products, all of which involve risk and uncertainty.

Actual results may differ materially from our statements or 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, that competition may increase in our target markets, and that our results may be adversely affected by general economic and market conditions, some of which are beyond our control.

All numbers mentioned are GAAP, unless stated otherwise.

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

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

Steve?

Thanks, Tara.

Good afternoon, everyone.

The NetApp team produced the strongest Q1 in our history, with non-GAAP operating margins well above our target, and with revenue near the high end of our targeted range, despite a 0.7 percentage point sequential currency headwind.

The strength of our business is apparent, with revenue growing nicely, robust gross margins, and strong cash performance.

For the second quarter in a row, NetApp generated product revenue growth of over 50%.

And, despite a decline from Q4, product margins remained strong, relative to our historical levels.

The rapid growth in product revenues, combined with strong product gross margins, is a very good indicator of our current competitive position in the market, and is very consistent with our market share gains.

The 51% product revenue growth is also a leading indicator for the strength of our business over time, because of the maintenance streams that are attached to our product sales.

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

While the overall gross margin remained strong this quarter, non-GAAP product gross margin did decline by just over 1.5 points from Q4 levels.

This was due to the foreign exchange impact of a weaker Euro, sales of less richly configured systems, and some volume effects on our manufacturing operations.

On the other hand, non-GAAP service gross margin was up by more than 3.5 points, as support contract revenues continued to grow faster than support costs.

Our non-GAAP operating expenses declined 4% from Q4, as the abnormally high levels of variable and incentive compensation associated with FY 2010's outperformance were reset with the start of the new fiscal year.

That said, expense levels will rise in Q2, as we realize the full quarter effect of the hiring we did in Q1, along with the impact of our annual merit increase, which went into effect at the beginning of Q2.

We also plan to continue hiring, primarily sales and engineering resources, albeit at a more moderate pace.

Turning to the balance sheet, I'd like to point out that our cash and investments increased by nearly $200 million in Q1, despite the cash payment for the Bycast acquisition, and the record payout of variable compensation.

The big contributors to the cash balance were the high levels of net profit, the reduction in our receivables balance highlighted by our 30 day DSO, and an unusually high level of employee stock purchases and stock option exercises.

The combination of stock option exercises and employee stock purchases added $140 million of US cash to the balance sheet this quarter.

Those stock option exercises did have the negative result of increasing our share count by approximately four million more shares than expected.

We don't expect this level of additional dilution going forward.

In terms of free cash flow, Q1 ended at 12% of revenue, below our annual target of 17% to 22%.

As we noted on our last earnings call, this was anticipated due to the seasonal outflow of cash associated with the payout of record variable compensation resulting from the Company's outperformance in FY 2010.

We are still committed to our annual target free cash flow range.

Looking forward, the midpoint of our target revenue range of two to six percentage points sequential growth for Q2, implies our third consecutive quarter of 30% or more year-over-year growth.

At the midpoint, it implies year-over-year product revenue growth of over 40%.

Of course, we are taking into account the current economic uncertainty that remains in the market.

But we were not expecting an economic tailwind in Q1, and we're certainly not expecting it in Q2.

In up markets or down markets, we believe NetApp will take share.

The strength of our overall non-GAAP gross margin is expected to continue in Q2.

This, combined with the high rate of revenue growth, is the primary driver of the continued outperformance of our non-GAAP operating margin.

With expenses increasing in Q2, we expect operating margins to be in the range of about 18% to 18.5%.

Also, without the renewal of the federal R&D tax credit, our tax rate is expected to remain at 16.3% going forward.

To summarize, we expect continued momentum in our business, particularly relative to our competition.

And, while we continue to invest in sales and R&D, we expect the combination of strong revenue growth and solid gross margins will keep our operating margin higher than our long-term target, though probably lower than this quarter's level.

So at this point, I'll turn the call over to Tom for his perspective.

Tom?

Thanks, Steve, and good afternoon.

I'm very proud of the results the NetApp team delivered again this quarter.

Despite an unclear economic backdrop, NetApp produced the best Q1 in our history, traditionally our most challenging quarter of the year, and we began our fiscal year 2011 with significant momentum.

In fact, at the midpoint of our target revenue range for Q2, we will have posted 30% overall growth, and over 40% product revenue growth for three consecutive quarters.

Our focus is on gaining share, and our results indicate that we are achieving clear customer preference, as IT organizations transform their data centers.

Last quarter, we highlighted a metric we have been using internally to measure our progress in the market, the concept of a two-year compare.

Looking at this quarter's revenue compared to the same quarter two years ago, eliminates a distortion of weak compares, and more accurately represents our sustained growth rate.

Looking beyond our performance to the industry at large, on this metric, all of our major competitors range from down double digits to up only slightly.

For each of those already reporting this quarter's earnings, there's actually a decline in their two-year growth rate from last quarter's compare.

NetApp's growth in this period was 31%, an increase of six points of growth over our same two-year compare last quarter.

This relative outperformance, probably our largest since the dot-com bubble burst, is convincing evidence that NetApp is indeed gaining share.

As of last quarter, the performance was well balanced across all geographies, with each one growing in excess of 30%.

Despite overall strength, we did see some areas of weakness in EMEA.

We spoke on the last call about our caution regarding the macro environment, and we are pleased with the reported results, despite some headwinds.

We remain similarly cautious, looking into the upcoming quarter.

However, our confidence in our competitive position remains unchanged, and we intend to gain share, independent of macro factors beyond our control.

We have spoken at length about our demonstrated success in virtualized server environments, and that continues.

As customers transform their data centers to the virtualized model, a new set of decision criteria emerges.

NetApp recognized this several years back, and has been the innovation leader in bringing unique solutions to the market.

Among them, our technology we co-develop with Cisco and VMware to enable security and data privacy, in a shared infrastructure environment.

The realization of the full promise of virtualization by enabling application mobility, and tightly integrating this functionality with management tools customers are already using.

All of this is built on a platform of integrated storage efficiency technologies that allows our customers deploy with 50% with less physical storage than our competition.

We are also seeing good balance in our workload penetration beyond server virtualization.

Although somewhat related, desktop virtualization is becoming more common, and we have customers that have virtualzed tens of thousands of desktops in mobile devices.

This is a workload class, where our win rate is exceptionally high.

Beyond these, we are also seeing strength in more conventional workloads, including database, file services, technical computing and Microsoft applications.

The economic slowdown has deferred investments, and tech refreshes are long overdue in many of these areas.

Our value proposition around efficiency, flexibility, and complexity reduction is clearly resonating with new customers.

And having proven ourselves with existing customers, they are now inviting us to participate in applications and much larger deals, that we would have not have been considered in the past.

Our partner, ecosystem, remains a key component of our success.

From a go-to-market perspective, our indirect business remains robust, and our distribution partners remain at or near record percentages in our overall revenue mix.

Our OEM partners, Fujitsu and IBM are growing, with IBM up a point in the mix over Q4.

We continue to achieve design-ins with key systems integrators around the world, as we become more integrated into the solutions and practice areas they offer their customers.

We also continue our joint development and sales activities with our alliance partners, most notably, VMware, Cisco, and Microsoft.

Overall, our go-to-market strategy has never been as balanced as it is today, between our direct sales, indirect sales, and alliance relationships.

I would contend that we have better channel diversity than any competitor.

And an area such as US, federal and Germany, where we have achieved significant scale and concentration, we have established number one market share positions, despite lower sales investment levels.

Internal operations remain focused and disciplined.

The manufacturing team has increased unit shipments nearly 80% from a year ago, and while world-wide component shortages, yet still return lead times and inventory to their typical levels.

Our DSO performance of 30 days is indicative not only of our outstanding collection efforts, but reflection of our invoice linearity and strong customer satisfaction and partner relationships.

In addition, our product quality has never been better.

In fact, a recent survey by Storage Magazine ranked NetApp number one in enterprise array quality.

While we still have operational improvements to make on many fronts, and some areas as yet unaddressed, our initiatives have made exceptional progress, and are key components of our financial results.

Once again, we posted a quarter that outperformed our historic 16% operating margin.

This is primarily a result of the highest sustained gross margins in the history of the Company and 30% revenue growth.

as opposed to any sudden change in philosophy regarding spending.

While we are aggressively driving efficiency and productivity enhancing activities, investment in strategic areas of the business remains robust, as evidenced by the headcount growth of over 600 people last quarter.

We are firmly committed to taking full advantage of the market share gain opportunity in front of us.

The combination of deferred tech refreshes creating impending demand, and the data center transformation enabled by virtualization, is creating an urgent and undeniable shift in customer preference toward NetApp solutions.

Capitalizing on this transition remains our top priority, and we are pursuing it with levels of investment that are aggressive, but within our ability to effectively manage.

Should our revenue and gross margins remain robust, operating margins will continue to remain above our historic levels.

If revenue slows, we will re-evaluate our market opportunity, and adjust our expense levels accordingly.

Our accelerated return to our target operating margin levels last year, should alleviate any doubt about our ability to manage expenses when necessary.

However, right now, we are clearly winning in the market, and our investment priorities remain unchanged from last quarter.

I would like to close by thanking the now 9,000 employees of NetApp.

The team maintained it's focus despite the challenges of high growth, supply line shortages, corporate efficiency initiatives and unsteady macro economic indicators, to produce the best first quarter in our history.

On prior calls, we have been cautious about the macro environment.

That remains unchanged.

Our response is to focus on taking market share.

Regardless of the economic backdrop, we fully expect to continue to gain share, as customers turn to NetApp to enable the modernization of their IT infrastructure.

At this point, I will open up the floor to questions, reminding you to please limit yourself to one, so we may address as many people as possible during our allotted time.

Operator?

(Operator Instructions).

Your first question comes from the line of Keith Bachmann with Bank of Montreal.

Please proceed.

Hi.

Thank you very much.

Steve, I wanted just to get some color on the gross margin on how you think the trends are there.

You called out services, which clearly was pretty good this quarter.

But if you could dig down a little bit on the drivers, particularly as we look out to the October and January quarters, how should we be thinking about the current level of gross margins, including the potential impacts of product mix that may unfold?

Thanks.

Okay.

Keith, let me start by giving you a quick bridge from the fourth quarter to the first quarter, and explain in a little bit more detail why our product margins are up.

Great.

There's really two big items there.

Both are about 0.9 of a point.

The total drop is 1.7.

The first item there.

is the net impact of foreign currency.

This is the foreign currency impact, offset by our hedge, most of it was associated with the Euro, so that was 0.9 of a point.

Product configuration was the second big item, that was also 0.9 of a point.

And this includes things like software mix and richness of the hardware configurations, some discounting, et cetera.

So that was -- those two items right there explain most of it.

Everything else tended to wash.

There was a slight unfavorable volume impact, but that was offset by some other favorable manufacturing transactions.

As we move forward, I would expect product gross margins to stay kind of in the range it's been in.

Maybe right where it is today, maybe slightly higher as we look out into next quarter, and then hovering in a one to two point deviation of where we are.

So I think we're in pretty good shape.

I don't see anything on the horizon that's going to significantly change our product gross margins over the next couple of quarters.

Okay.

Thank you, Steve.

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

Baird.

Please proceed.

Thank you.

Maybe a question on your traction in Web 2.0.

Have you seen increasing wins there?

And I guess could you talk about just your success here, given multi-tenancy and everything else.

Thank you.

Well, Web 2.0 covers a lot of ground.

Clearly, we're doing -- some of the largest service providers in the world, some of the largest consumer brands that you're well aware of, that you use every day, are big consumers of NetApp technology.

In fact, if you looked -- depends on where you want to go with Web 2.0.

But if you are talking about consumer services, whether you are talking about handheld devices, and business services attached to that, I think we're pretty well positioned in those particular markets.

And I would suggest that we clearly have a dominant share in those particular categories.

As far as broader infrastructure, as if you're referring to Google and things like that, they clearly have a home-grown infrastructure that's a -- that's at this point, off limits, at least in terms of their search business, to companies like NetApp, and other commercial players.

But overall, I think in the Web 2.0 space, if you check off the big brand names that are buying commercial products, I think you'll find that NetApp is extraordinary well positioned.

Obviously, you can add Yahoo to that mix as well.

Thanks, Tom.

Our next question comes from the line of Richard Gardner with Citigroup.

Please proceed.

Great.

Thank you.

Steve and Tom, I was hoping that you could talk a little bit about linearity throughout the quarter.

I know that there was a reference to that in your prepared remarks.

But can you talk about whether you saw the same type of pause mid-quarter, around the European situation that Cisco talked about on it's call, and how orders basically trended throughout the quarter?

Thank you.

Yes, let me talk about linearity, which is an invoice linearity phenomena, that's what drives our receivables.

So our invoice linearity, which to some extent is a reflection of the orders we're seeing, was remarkably -- was remarkably linear during the quarter.

In fact, the last five weeks, was exactly what a five-week would result in, if you calculated the math.

So there's no question that that linearity helped us, with respect to managing our receivables, as we were able to collect a lot during the quarter.

As far as orders were concerned, I didn't denote any significant linearity deviations in the quarter.

It was a typical first quarter from my standpoint.

And even peeling back a layer, and looking down into the regions, I didn't see anything that was significant, save the currency effects of Europe, which I think everybody experienced.

But aside from that, I didn't see anything.

The one thing I would add to that is, first of all, to be perfectly honest, I wouldn't want to underestimate our week by week, intraquarter analysis of dynamics, of business getting weak, and getting back again.

I think we don't quite have that granularity of the business, we clearly have a runway business, but the week lumpiness is really driven by big deals.

The one thing I would say about Europe is, clearly we're starting to see -- clearly there's a lot of headlines around Europe.

And while we turned in a remarkably strong revenue quarter in Europe, we did see some areas of weakness.

For one, we hear a lot about southern Europe.

For us, that's a small market, so the impact on us I think is pretty modest.

But we are certainly seeing talk of austerity, on behalf of the European governments, and probably the place where we saw that was the UK.

So the UK is a meaningful market for us, and a slowdown there clearly has some impact on us.

But southern Europe is a place where we have no market share.

And frankly my response is, if you have no market share, the macro economics don't really matter that much.

And I think we have opportunity to win business there independent of macro.

So all in all, I think in the aggregate, we had a good EMEA quarter.

And I think we were strengthened by areas that had been previously weak.

But nonetheless, we do see in the overall landscape, particularly in the government spending side, some changes, particularly in the UK.

Thank you.

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

Please proceed.

Yes, thanks.

Thanks for taking the question.The question's on the inventory side.

Looks like you guys had a pretty solid management of inventory this last quarter, down about 20% sequentially.

Steve, I think last quarter you had alluded to the fact, that some of the shipments got reversed, and put back on to your finished goods line.

You actually made the comment that you would carry a similar level of inventory, exiting this quarter as you did last quarter.

And I kind of read that, as somewhat of a pipeline coming into this quarter.

So the question is, help me understand the inventory decline, and whether that actually did play out, where you are carrying a similar level of inventory, as you had alluded to in the commentary last quarter?

So, I guess simply put, I think from that dynamic, I think that came to pass.

I think the inventory picture, we went through a period of relatively significant supply shortages across the board, and we were doing a lot of things to protect ourselves.

We were running into, obviously, piece parts and sheet metal and semiconductors.

And we did a lot of long term purchases, and a lot of hedging against potential demand mixes, so we wouldn't get caught short.

I think in the end, we certainly -- certainly our performance wouldn't indicate that we left much material on the dock, or much revenue on the dock, because of supply line issues.

But the price we paid, I think, was a build up in inventory to protect ourselves.

As we see the supply line constraints relaxing to some degree, then the need to protect ourselves with longer term procurements, and longer term protection on inventory goes down.

And I think that's the big thing we saw in the inventory number, rather than any broad manipulation, or any timing of finished goods.

Thank you.

Our next question comes from the line of Brian Marshall with Gleacher and Company.

Please proceed.

Great, thanks guys.

Nice quarter.

I was wondering if you could talk a little about your assumptions for the October revenue guidance, of up 2% to 6% sequential, and what you're baking in for specifically EMEA, perhaps US federal and the indirect channel?

Thank you.

So we don't typically disclose all of our geographical projections and whatnot.

Suffice it to say, that if there was a serious problem in any significant area like Europe, or like one of our major verticals, we wouldn't be able to make these kind of projections.

Thank you.

Our next question comes from the line of Louis Miscioscia with Collins Stewart.

Please proceed.

Yes, give us very good color, about what's happening with the UK with the government or austerity programs there.

Just maybe going back to John Chambers comment's about just customers in general, starting to get very cautious, or not giving a lot of visibility in their spending trends.

Obviously your guidance implies, that things seem pretty decent for NetApp.

Maybe if you could go in a little deeper what CIOs or CFOs are telling you about what they expect to do for the rest of the year?

So -- I think a couple things.

One of which is that, our view of the market is through our customer base, and our prospects and our channels.

So I can report what we see there, and what we see there, is as I described it.

I would say at the overall climate, in the majority of the geographies is largely unchanged.

I think that's your phone ringing in the background.

Okay.

And so I talked about specifically where we saw weakness.

And I think you would be correct to imply, that the other areas I did not call out, we've not seen any change.

Certainly not through the contacts that we deal with, which clearly represents our installed base, and our prospect list.

Clearly, FX is a problem, and there will be volatility associated with that.

That's hard to predict.

On the broader question about CIOs -- and are they slowing down I can't say, that I see that.

I will say, that we all get up in the morning, and we all read the headlines, and most days they're not as good.

But what I have been saying on the last few calls is that business levels are better than the headlines would indicate.

And it's been that way for a long time now.

So I don't know whether that's a function of our value proposition, or who we do business with, or the channels that we've developed.

So I think that's helping us.

The other thing our momentum in a relatively slow growth market clearly has been -- really has helped us attract other channel partners, who also want to help distribute our product,so I think that expanded our coverage a little bit.

But all in all, I would say, while the headlines are not pretty, I'm not seeing that translate into -- into CIO behavior.

In fact, if I had a more detailed summary of CIO discussions, CIO discussions are much more higher level than that.

And that is, what they're effectively seeing is, is that they're under tremendous pressure by the CIOs to basically support the business requirements of the company.

People want to do acquisitions.

They want to be flexibility.

They want to make changes in pricing.

They want to make changes in strategy, and frequently IT is the low pole in the tent.

And likewise, I think competitive pressures are forcing -- putting pressure on IT budgets.

And I think IT budgets are under a lot of pressure.

So the combination of meeting the flexibility of the business, along with the inefficiency and reducing that, and making IT more cost effective, that's a pressure that people are seeing.

And if you layer on top of that kind of a slowdown that's been extended, IT infrastructures are aging.

So they have an aging inefficient infrastructure.

They need to move to a new model.

They're under tremendous pressure to support the ability of the business philosophy at the front of them.

That's primarily the dialogue that I have with CIOs.

They may be told some day that budgets have been cut back, but right now they're responding to the pressures of the business.

Okay.

Thank you.

Good quarter.

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

Yes, thanks.

Just have a question on the operating margins.

Nice to see margins were up to 18.8 this quarter.

You guys are talking about 18.3 for next one.

How should we think about your comments, I think from the last call, that basically was around 17.5% margin target for fiscal 2011.

That would basically imply margins will go to 16.5% range for the back half of fiscal 2011.

Is that kind of what you guys are expecting right now?

Well, I think we want to do this one quarter at a time.

And the simple fact of the matter is, as long as gross margins are strong, and revenue growth is strong, that's going to create a pretty big umbrella.

We're spending aggressively underneath that, but nonetheless still producing ever increasing operating margin.

So as long as the revenue growth remains robust and remains strong, and we continue to guide yet another quarter of 30% plus growth, then there's really no way for these operating margins to go down.

I think we're spending aggressively.

We believe in this opportunity.

We're certainly not pulling back.

But I think that there's a limit to which we can do prudently and do effectively.

So at the end of the day, as gross margins stay high and revenue growth stays high, the operating margin is going to stay high.

And each time we keep forecasting a 30% growth quarter, then I think that we're just going to push out, the downward pressure on the operating margins.

So for now, there might be a little bit of movement.

We just had our biggest hiring quarter of all time.

We'll absorb that for a full quarter of expense.

But overall, it's the fundamental strength and the robustness in the top line of the margin that's creating this.

There is no other philosophical change here.

As long as that stays strong, then I think you're going to see gross margins in this range.

So just to clarify, I mean -- you definitely do not --

I am going to have to cut you off at one question.

I'm sorry.

All right.

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

Please proceed.

Yes.

Thanks.

Can you comment on two things.

I noticed in the release it said V-series was down 38% I believe sequentially, and your petabyte shift in fiber channel were down.

There were many really good numbers.

Those were two that stood out, that were going in the direction I wasn't -- I wanted to know why those were down, and what that means, if anything?

Well, I think V-series has got a couple of moving parts.

First of all, beside the fact it was up 40% something year-over-year, if I remember the number.

So I think that obviously, big deals will move around.

There will be some lumpiness, but in terms of the overall trend, it's unmistakably positive.

And I don't think we're fretting over it at this point.

The other question on fiber channels being shipped.

It's kind of an interesting dynamic, because overall petabytes were up, significantly, despite the fact that it was a seasonally down quarter.

And I think there are a couple things in play.

First of all, a lot of the fiber channel demand or enterprise demand is going to move toward SaaS, so the SaaS was up significantly.

So we kind of put SaaS and fiber channel in the enterprise class drive space.

And then more broadly, I think there's another idea at play and that is -- the other thing that I think is at play, is that we're starting to see with the advent of the high attach rates of our flash memory, we're starting to see flashes of cache, in excess of 20% of the eligible systems.

The rational there is, if you can have a big enough cache, you can soak up a lot of the random IO work load.

And that's really the only reason to buy fiber channel drives.

So we are seeing capacities grow up, shifting from fiber channel to ATA, thereby eliminating a tier of storage, making the systems easier to manage, and it's being driven by flash.

So I think all of that's a good thing.

But overall, I think you need to think of our mix as mostly SaaS plus fiber channel, in terms of the enterprise drive space.

But at the end of the day, I think flash is going to diminish the use of enterprise drives in these types of systems, simply because of it's ability to soak up the IOs per second, and obviously the semiconductor is a lot faster than the rotating media.

And storage is primarily going to be used for permanent storage without a performance requirement on it, it's going to go serial ATA.

And that's --- that's a trend that I think we are leading.

I think our flash attach rate is by far the highest of the major vendors.

And I think we're leading this -- and basically it drives a level of simplification, and it eliminates tiered storage in a tremendous number of environments.

All right.

Thanks, that's interesting.

Your next question comes from the line of Jason Ader with William Blair.

Please proceed.

Yes, thanks.

I have two very quick questions.

So it's really about the size of one.

Number one, service margins, where do you see those going, Steve?

They were very high this quarter.

And then also the G&A line, that was down pretty substantially, where should we see that going?

Okay.

So service margins are probably I think in a pretty high range right now.

And I don't expect to see them expand a whole lot from here in the next few quarters.

I think that you should see it hover right around where it is.

It may even step back slightly a point or two.

So I think we're kind of at the range right now.

I think we're kind of in a range that we're going to operate in within the next couple of quarters.

With respect to looking forward at the G&A line, we did have a big step down from the fourth quarter, a lot of that had to do with the incentive comp, et cetera.

We have a lot of concentration in that particular line.

But I'm looking forward to it inching up slightly, low single digits, and I'll take it a quarter at a time.

So I'm only going to go a quarter out there.

Thank you.

Since you asked two questions, you'll get two answers.

On the professional services side, component of service, part of the movement of that I think has been by design.

I think we said on this call before, certainly said publicly, of our intention of professional services to focus our activities on customers that insist on getting professional services directly from NetApp, and likewise significant projects that only NetApp can execute on.

A substantial amount of the general territory, professional service activity, we've spent a good part of the last two years training up our partners, and transferring that business to them.

So that is a lower margin mix for us but attractive business to them.

And we find ourselves gaining partners that are well trained in our product.

And we find ourselves competing with them less for business that they care about.

So part of the professional services move, or part of the overall service margin move is a result of a conscious effort on our part to rethink our professional services strategy, to one that's more focused on high value engagements, and also more compatible with our channel partners.

Thank you.

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

Please proceed.

Yes, thanks.

Good afternoon.

Another segment where the headlines have been negative is the US public sector, but your results were incredibly strong, whether you look at them sequentially, or year-on-year.

And you've got a number of -- it appears like Brocade and IBM blaming federal for some weakness.

What do you think's going on in your business versus the rest of the market?

Do you think we're seeing a year-end federal budget flush and is it sustainable?

Well, it's certainly the -- it's certainly the federal season.

And so we're pushing up on the end of their fiscal year, of course.

And I certainly don't want to comment on other people's commentary.

But our view of the market, and our view of the momentum in our customer base is still very positive.

So at this point, I certainly read the headlines, I certainly read the commentary.

Some of that consolidation is around customers that we have, so some of that is actually good for us.

So all in all, at this point while I read the headlines, and we certainly have the appropriate caution, and we probably inspect the results, and question the field at a higher rate than we normally do, the overall actual realized business level appears to still be very, very strong.

So at this point I'm not signaling any weakness in that territory.

Next question, please.

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

Please proceed.

Thanks very much.

Wanted to ask about the relative weakness in the mid range versus the high end and the low end.

Is that a reflection of any changing dynamics within your business, or perhaps you can comment on new customer acquisition as, did that help drive the strength at the low end?

Thanks a lot.

There's a fair amount of quarter to quarter volatility.

I think that the fact that in this particular quarter, I mean, as we go out through the year, we seem to do all the permutations.

This one is the one where the low and the high are successful.

And I think there's a bunch of dynamics at play.

I think the low end is probably the one with the most dynamics.

And that is the channel play, the strength of our channel partners, the strength of the emergence of some new channel partners that have taken us in that direction, is probably indicative of our penetration to the mid-sized enterprise which was very strong, excuse me, very strong this quarter.

So I think the low end is probably an element of just greater and greater and greater channel penetration as a Company.

I think as far as the rest of the products, I don't necessarily think of the rest of the products in terms of entry, mid-range and high end.

I just kind of think of this as small, medium size and big, and customer have different requirements.

So I would not read anything into it.

I think the mid-range is still 50% of the business.

But all in all, I think rather than skewing all to the bottom or all to the top, the fact that the top and the bottom, probably tells me that there probably isn't much going on in the market.

Next question, please.

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

Please proceed.

Thank you.

Good afternoon.

Tom, I want to come back to your earlier prepared remarks regarding NetApp's ability to penetrate both new and existing customers in work loads or applications, maybe historically you were not given the opportunity to.

Can you talk about, is this being driven by, one, NetApp's own sales efforts?

Or is this because the partnerships with Cisco and Microsoft and VMware that are helping out?

And then the corollary is, these type of installations are they higher margin, kind of higher return revenue streams longer term, once established?

So I think that there's a bunch of components there.

I -- previously told people that kind of the anatomy of a NetApp sales call, is that we'll go into an account, and the story we tell is very different than what the competitors tell.

And typically the response to that is well, that's great if you can do that, but I'm not so sure I believe you.

And our response to that is, well, give us a project to prove ourself.

And then we insinuate ourselves and we grow.

And I mean that's how NetApp grew, post dot-com bubble to, obviously, the great recession -- actually we had very, very high growth rates, and so we had a lot of customer acquisition, and most of it came through that model.

And that is insinuate ourselves in, and then prove ourselves for more and more and more applications.

And I think that what we're trying to do over the last couple of years, certainly since the beginning of the slowdown on financials, is really go after expanding our installed base, and doing new customer acquisition.

And that's why it's been -- such a big, high priority for us.

And lot of the storage 5000 analysis came out of our searching for just how concentrated we were.

So I think a couple things happened.

First of all, as we enter new accounts, one thing that is happening is we're entering accounts with bigger and bigger deals.

And there's no doubt that our alliance partners are helping us, because the combined credibility is greater than either one of us alone.

There's no doubt about that.

So I think we're a bit more credible.

I think we have a bit more crisper value proposition and we're also aligned with some partners.

So the amount of first time transactions with new customers that are much larger, is actually much higher than it's ever been.

But I think more broadly, even the other customers that we enter on a more, can you prove yourself point of view, I think we're opening that up.

So we may enter on file services or VMware, and then bid on Oracle database or bid on SAP , or bid or other types of things.

In terms of the margin profile, it's probably safe to assume that first time transactions with new accounts, because typically they involve unseating somebody else as an incumbent, those tend to be more challenging from a margin perspective.

And clearly once you've proven yourself, and customers realize your value, and they're willing to factor that value into the pricing discussion, things like being willing to accept less physical storage from NetApp, than a comparable bid from our competition because they've already realized that innate -- they've proven the value of deduplication.

Those things do help us.

So it's probably safe to assume that repeat purchases at new accounts are probably better margin deals, than brand-new, breaking into new

Next question comes from the line of Brent Bracelin with Pacific Crest Securities.

Please proceed.

Thank you for taking my question.

Tom, I wanted to go back, and try to put things into perspective.

If I go back to 2004, 2007 time frame, NetApp was able to sustain, I think 30% plus growth through share gains.

You were hiring, I think 200 to 500 employees a quarter.

Op margins were in that 15% to 17% kind of range.

I guess part A, do you see NetApp entering another two, three year sustainable share gain cycle?

And B, is NetApp at the scale where you can sustain share gains and 18% Op margins going forward?

Or should we, as we model the next couple years out, think about the balance between kind of that long-term target of 16% and the 18% where you're at today?

Okay.

So all of you are trying to outsmart me with these two-part questions.

(Laughter).

So just a few things on, what's different between what we used to be growing 30%, as opposed to what we're growing 30% now.

I think one thing that's different from a business model perspective, is that our gross margins are 4 points higher now than they were then.

And I think that's clearly driving the operating margin.

So part of that is a reflection of that we've got high margin stuff coming off the balance sheet, which is certainly contributing to the higher gross margin.

The flip side however, is the stuff coming off the balance sheet was put on a long time ago, when we weren't growing 30%.

So ironically, despite our high growth, the stuff coming off the balance sheet has actually been slowing us down, and our product growth rate has actually been higher.

So I think that as time goes on, when the ins -- start coming in at a higher growth rates than the outs.

Then we'll start to see a deferred coming off the balance sheet grow faster.

But in the near term that's actually an impediment to our growth, but we've been able to overpower it by simply outstanding product growth.

As time goes on, one thing you need to factor in between that period and this period, is what is the overall aggregate growth rate of the industry.

And if the aggregate growth rate of the industry is flat to negative, it's hard to maintain 30% growth.

It takes a lot of share gains to do it.

But on the other hand, if it returns back to those numbers, I think on our Analyst Day ,we basically did just a brief analysis of the industry.

That basically said that if we can gain simply a share point per year, and you assume the IDC estimates for the next five years, and that's 15 to 20% product growth rate right there.

And this year we're clearly going to gain well more than a share point.

And you can debate whether it's going to be sustainable, whether IDC is right or all those other type of things.

But right now, our focus is on gaining share.

And if we're gaining a 1 point to a 1.5 point a year, I think we're going to be one of the few companies of our size that's growing at a high rate.

Whether it's 20% or 30% is really going to be a function of what the overall growth rate of the aggregate industry is, and I'm probably not prepared to predict that.

Our next question comes from the line of Jason Maynard with Wells Fargo.

Please proceed.

Hi, good afternoon.

Maybe to just follow up on the share gain commentary.

When you look at the virtualization market, are you seeing any dynamics playing out, where your partnerships with Microsoft, and the work you're doing on the desktop side, tying into some of the server virtualization deployments?

Well, I think that they clearly play in, if we are -- if we have won the server virtually says deployment, because it allows us an easy entree to have this next conversation.

If it's an account we do not have a presence,and we're on the outside looking in, and clearly that's a bit more challenging of a scenario.

But on the desktop virtualization side, the value proposition is pretty compelling.

The Zero space copies allows you to do desktop virtualization storage for cheaper than what the raw drive would be on your laptop.

That's a pretty powerful story.

And there has been some really public comments by some of our partners in that domain, about how cheaply we can do that, and how compelling that is.

I think that's why our win rate is pretty high.

Nine of the ten largest banks on Wall Street have selected us for virtual desktop.

But I think there's no doubt that virtualization in genera, is a very, very strategic trend in the data center.

And if you were connected to that, and you were provider to that, that's what's enabling them to modernize.

That is what is enabling them to build a big homogeneous infrastructure capable of running multiple apps simultaneously.

That is how they are driving out costs, that is how they are extending flexibility.

That is the core of the modernization that's going on.

So if you're connected to that, then you're party to all the other dialogue that's going on in the business.

So if we went in server virtualization, now we're in the door, we're credible, we're enabling the most strategic initiatives they have under way.

And it opens up the door to talk about some of these other applications they have in place.

Okay, Thank you.

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

Please proceed.

Good afternoon.

Thanks for taking my question.

Real quick, as you look out at the market and your goals for driving future growth, can you talk about the market opportunities that you think will be the primary drivers?

You've mentioned virtualization, virtual desktop.

You guys acquired Bycast, and so you clearly see the Grid Medical, Medical archive.

And then you've got the Scale-Out NAS products that you're working forward with.

Can you talk a little bit about of those three, do you see any of those as stand-outs, as areas that would drive particular growth, or market share gains going forward should you successfully execute?

Well, I think as a time frame associated with all of them, we've seen data that would say that somewhere between 60%p and 80% of all storage is going to be deployed in in these virtualized infrastructures.

It's pretty clear we have to win there, because if we don't, there isn't enough rest of the market to satisfy our growth aspiration.

On top of that, I think there's plenty of opportunity to continue to innovate in that particular space.

That said, I think over time there are clearly other storage consuming spaces that are going to emerge that are different workload types.

I think certainly the healthcare vertical, but more broadly the idea of very, very, very large numbers of objects, whether they be video objects or e-mail objects, or whatever, medical images, you name it.

So I think the bulk storage of large number of objects that can be effectively managed is an important one.

And that's really what drove us down the Bycast route, is they built a very powerful vertical in the medical side.

But I think there's also applications for that in a lot of other places, including Web 2.0, media, there's a number of government things that we're pursuing, pharmaceuticals, you name it.

So I think that the management of very, very large objects, if you look at accounts like ours like Yahoo, and other ones that I can't mention, we're talking about people that have billions and trillions of things to manage.

And it's going to take sophisticated things to do that.

But I think that the core business applications that are virtualized is a key one.

Data bases, unquestionably, a key one.

So business applications, I think in the near term, is still the biggest storage opportunity.

But going forward, whether it be the consumer cloud, whether it be the enterprise cloud, likewise, large archiving applications of tremendous amount of data.

I think those are all significant pools of data going forward, that we want to participate in that.

Thanks.

Your next question comes from the line of Kevin Hunt with Hapoalim Securities.

Please proceed.

Hi, yes, thank you.

Just wanted to follow up on the OpEx question that someone was asking earlier.

If you just look at your total OpEx was down roughly $20 million or so sequentially, yet you hired more people this quarter than you did in the last year.

I think I just said in the entire history of the Company, actually, in a quarter.

So just wondering if you could kind of talk about those two effects, of were those sort of late in the quarter hires that will kick in fully in the future?

Or is the sort of higher bar on performance incentive comp sort of more than offset that?

So, this is Steve here.

Yes, basically the hiring was pretty much linear throughout the quarter.

So it wasn't back end loaded necessarily.

There wasn't anything unusual about the timing of the hires.

I think the biggest phenomena here, and you can see the impact on the balance sheet as well, is the fact that we had all this compensation that we had accrued for our incentive compensation program for the employees.

In fact, it was a record for the Company.

And the fact that, basically that flowed out.

And we went back to a normal accrual rate, based on a standard program that we have, was the big difference.

So we come off of fourth quarter, when the ICP was being accrued at an accelerated rate, back to a standard quarter, when it's substantially less than that rate.

And now we see what it's like going forward.

So that's the biggest single effect.

Now, obviously that gets neutralized, or the clock gets reset, if you will, only one time at the beginning of the fiscal year.

So going forward now, we'll just continue to build up the accrual as we go.

Although to be perfectly honest, our intention is to outperform.

The other thing I would add is that in that 640 number, this is also a new college grad season, and it was also the Bycast acquisition.

So those two items combined is about 200.

And Bycast was early in the quarter and the new college grads pretty much started in mid-May and spread out.

So they were probably a little bit skewed toward the beginning as well.

Okay.

Thank you.

Next question comes from the line of Alex Kurtz with Merriman and Company.

Please proceed.

Thanks for taking the question.

Tom, could you just talk about your view of the 3 PAR acquisition a day ago, from by Dell, and A, what does that mean for your relationship with Dell, and sort of how does that make you guys think about M&A going forward?

Well, I think as far as our relationship with Dell, it's at best passive.

I mean, they're a competitor and we certainly sell into Dell environments.

So I don't think we have much of a relationship to jeopardize.

It's not bad, but they're just a normal competitor.

I think obviously the relationship question applies more directly to EMC.

And I think we can debate is it bad, is it very bad, but suffice it to say it's probably not good for the relationship with EMC.

-- with a couple other smaller vendors out there, is there a tuck-in acquisition you guys are thinking about in a specific area of the storage environment?

Or are you guys still thinking about just generating cash, and keeping on the balance sheet for now?

No, I think that the transaction probably doesn't change our thinking in any meaningful way.

I think that the business being bought out probably was not a surprise to anybody, probably the price indicates it's probably -- there was probably more than one person interested.

And good for 3 PAR for extracting that value.

I think Dell, it's a lot easier to bundle the EqualLogic with the server business than it is with 3 PAR.

I think 3 PAR -- Dell will certainly open up a lot more doors that they couldn't open on their own.

But 3 PAR, the technology is still going to have to win on it's merits against all the normal competitors.

And it's probably going to be a little bit more exposed storage sale than EqualLogic was.

As far as our thinking, we're always looking for tuck-ins.

Certainly nothing about this changed our tuck-in belief.

And as far as larger transactions, I think that if the time is right and the price is right, and the affinities are there, I said our thinking on acquisitions is, it has to be something that has some affinity to what we do.

It has to be something that either our sales force can sell, or something that by virtue of having it in the portfolio, we can move more of our existing product.

So I'm not looking for dissimilar assets, just to be holding Company.

I don't think that has worked for anyone in our space.

On the other hand, we're always interested in both large and small, and things that have got an affinity for our core business that we can leverage.

And I think that the Dell 3 PAR deal probably doesn't change the timing of that any.

All right, thanks.

We will take our last question from Paul Mansky with Canaccord.

Please proceed.

Thanks for squeezing me in.

Your primary competitor has been broadcasting a series of product introductions expected over the next few quarters here.

I know that you obviously refreshed your lower end a little less than a year ago.

Should we be thinking about a mid or high end refresh soon?

And if so, did that have any bearing on mid mid-range performance in the quarter?

I don't think so.

There's no doubt that hardware releases have more of an impact on our business than software releases.

But it's not like we're going to have something next week for people to buy.

So I don't think that that was the big factor.

And I think we're all in this -- this normal horse race of upgrading our platforms.

So I think you will continue to see new platforms from NetApp, and you will see new platforms from all of our competitors.

At the end of the day, I think the platforms matter, but the software matters more.

And I think the software differential is really what's driving our performance right now.

I don't think that gap is going to get closed.

Thank you very much.

This concludes our question-and-answer session.

I would now like to turn the conference back to Ms.

Tara Dillon.

Please proceed.

Thank you for joining us today, everyone.

We will be projecting to announce our earnings in November, and our targeted analyst date for our coming Analyst Day will be in March, March 22 of 2011.

And we hope you will join us then.

Thank you.

Ladies and gentlemen, that concludes today's conference.

Thank you for your participation.

You may now disconnect, and have a great day.