NetApp Inc (NTAP) 2013 Q1 法說會逐字稿

Welcome to the NetApp first-quarter fiscal year 2013 earnings call.

My name is Anthony, and I will be your operator for today's call.

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

Later, we will conduct a question-and-answer session.

Please note that this conference is being recorded.

I would now like to turn the call over to Kris Newton.

Kris, you may begin.

Good afternoon, everyone.

Thank you for joining us.

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

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.

As a reminder, during today's call, we will make forward-looking statements and projections, including our financial outlook for Q2, the benefits to us and our customers of our products, our expectations regarding future competitive position, and expected benefits of partnerships and alliances, all of which involve risk and uncertainty.

Actual results may differ materially from our statements and projections for a variety of reasons, including general economic and market conditions such as the macro economic environment, and matters specific to the Company's business, such as customer demand for and acceptance of our products and services.

We describe these factors in our accompanying press release, which we have filed on an 8-K with the SEC, as well as in 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 into today's discussion.

All numbers discussed today are GAAP unless stated otherwise.

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

In a moment, Nick will walk you through some additional color on our financial results, and then Tom will walk you through his perspective on the business this quarter.

I will now turn the call over to Nick.

Thank you, Kris.

Good afternoon, everyone.

Overall, first-quarter financial performance was in line with our expectations.

Results were influenced not only by Q4 to Q1 seasonality in the business, but also by a weak macro environment and FX headwinds.

Revenue of just under $1.45 billion was at the midpoint of our Q1 guidance range, and non-GAAP EPS of $0.42 exceeded the high end of our previous guidance.

Product, SEM, and service revenue were all within the ranges of our Q1 projections.

SEM and service revenue was up sequentially and up double digits year over year.

The decline in product revenue drove the overall reduction in our net revenue from Q4, as well as from Q1 last year.

NetApp branded revenue of $1.24 billion and OEM revenue of $209 million were each down slightly on the year-over-year basis.

OEM revenue was up sequentially.

However, the weak macro environment and FX impacted this revenue, as well as our branded revenue, which was down 18% from Q4.

The effects of lower business volume was evident across all geographies in Q1 on both a sequential and year-over-year basis.

Asia-Pacific remained a bright spot with 9% year-over-year revenue growth.

Non-GAAP gross margins of 60.3% were as expected, up from Q4, and consistent with both the Q1 guidance and target range we discussed at our Analyst Day in June.

Non-GAAP product gross margins of 51.4% reflect lower Q1 product volume, as well as a mix influenced by slightly higher OEM revenues.

SEM and service margins were within their projected range, with a sequential increase in service margins due to a slightly higher concentration of hardware maintenance contracts.

Non-GAAP Q1 operating margins at 12.5% were higher than our guidance range due to lower operating expenses.

Non-GAAP operating expenses were up 6% from Q1 last year but down 3% sequentially, reflecting conservatism in spending across the business.

For Q2, though, we expect a slightly higher spending level as annual employee merit increases take effect.

W also expect to continue to maintain a level of conservatism in spending given the overall business environment.

Our Q1 effective tax rate of 17.3% was in line with our expectations and is based on our most recent projections of our geographical distribution of revenue and profits.

Non-GAAP EPS of $0.42 was $0.03 over the high end of our prior guidance.

Turning to the balance sheet, we ended the quarter with a cash and investments balance of $5.4 billion, an increase of $43 million from Q4.

Days sales outstanding was equal to Q1 of FY 2012, and inventory was up due to specific raw materials purchases we expect to utilize in the second quarter.

Deferred revenue decreased by $48 million on a balance of approximately $2.8 billion, consistent with the lower business activity we expected for Q1.

That said, deferred revenue was up, just under $400 million from Q1 last year.

Cash from operations was $229 million for the quarter, and free cash flow was 12% of revenue, up from 10% a year ago.

Traditionally, Q1 is slow with respect to cash flow, as cash generation is offset by payments of Q4 variable and annual incentive compensation.

Overall, cash flow was also reduced by $150 million, as we repurchased just under 5 million shares of stock during the quarter.

Diluted share count decreased in Q1 by approximately 11 million shares, due in large part to a lower average share price.

The accounting for the shares associated with our convertible notes had a minimal impact of about 200,000 shares, and the warrants had no impact this quarter.

As you may recall, 80% of the convertible notes are hedged.

You can find a table on our website which shows the impact on diluted share count for a range of stock prices.

Turning to guidance, our target revenue range for Q2 is $1.5 billion to $1.6 billion, which, at the midpoint implies 7% sequential growth and 3% year-over-year growth.

We expect consolidated non-GAAP gross margins of approximately 60% to 61% and non-GAAP operating margins of approximately 13% to 14%.

We expect our blended, consolidated, non-GAAP effective tax rate to be approximately 17.3%, bringing our non-GAAP EPS estimate to approximately $0.45 to $0.50 per share.

With the full impact of the shares we bought back last quarter, diluted share count is projected to decrease to about 370 million shares in Q2 based on our average stock price of $32.44 for the first 10 days of the quarter.

This will include about 700,000 shares from the convertible notes.

Recall that the impact of the note hedges is not included as an offset but does have a favorable impact on EPS.

So at this point, I will turn the call over to Tom for his thoughts.

Thanks, Nick, and good afternoon, everyone.

Overall, our business performed essentially as we expected.

Despite our typically challenging Q1, macro and FX headwinds, and generally longer sales cycles on smaller transactions, we delivered revenue at the midpoint of our guidance.

Recognizing the uncertain environment, the team demonstrated strong execution discipline in managing expenses, as well as generating a sequential increase in gross margin, to produce better-than-expected operating margin at earnings per share.

Our APAC and US public sector were the strongest geographies year over year.

APAC grew 9% from Q1 a year ago.

Business in APAC was mixed, with some countries turning in strong double-digit growth and others not performing as well.

In US public sector, our state, local, and higher-end businesses continues to be strong, but we continue to be affected by lower spending in other segments.

After a strong performance in fiscal year 2012, we experienced a decline in Americas Commercial, and we continue to see softness in EMEA.

The biggest news of the quarter was the launch of our agile data infrastructure.

NetApp's Data ONTAP, the market-share leader among storage operating systems, has the industry's richest data-management and storage-efficiency capabilities.

We have added to it the architectural capability of clustering to deliver unprecedented levels of performance, scale, and non disruptive operations.

With around 125 customers over 10 petabytes, 4 over 100 petabytes, and the largest approaching 1 exabyte, nobody has demonstrated the ability to manage data at scale like NetApp.

Clustering further enhances our capability in this space.

The performance of non disruptive operations enabled by clustering will also allow us to participate in opportunities deeper in the data center where previously we may not have been considered.

With storage architecture that can optimally host multiple disparate workloads and service-level requirements, organizations can adapt in the face of unpredictable data growth and dynamic business demands with reduced complexity and cost.

Data ONTAP is the only operating system that enables customers to build an agile data infrastructure.

The ONTAP family 8.1 has seen deployments triple this quarter as customers realize the value of our latest features.

Our newest release, ONTAP 8.1.1, adds four key elements.

Infinite Volumes to support the needs of big data environments; Flash Pools to optimize performance for demanding workloads for the use of Flash; Dense Shelves to meet the power, space, and cooling requirements of large data centers; and encrypted disks to address security-conscious applications.

Along with the rapid customer adoption and innovation in the 8.1 family, we are also seeing solid momentum with cluster node adoption.

Cluster nodes are up 40% from Q4 2012, on top of just over 60% sequential growth the prior quarter.

Clustering is not just another feature.

It is a new approach to storage infrastructure.

Other clustering approaches have existed for a while and are targeted at stand-alone niche workloads.

NetApp's unique strategy is to mainstream clustering, by combining it with superior data management functionality, enabling a single architecture to serve the demands of many workloads.

At this point, adoption is following several avenues.

We have customers with an immediate need for performance and scale.

Others have targeted clustering for specific workloads.

And finally, some who have fully accepted the vision of ONTAP 8 and have standardized [their] clustering for all new applications.

In all of these customers, we see deployments ranging from pilot to full production.

We continue to aggressively pursue innovation in our Flash strategy as well.

We have consistently said that Flash will be used at every layer of the stack, and NetApp will play at all of these levels.

For flash in a storage array, we introduced Flash Pool in Q1, which gives customers the opportunity to optimize the use of solid-state and hard disks to achieve the performance and available necessary for business-critical workloads.

At the controller level, NetApp has offered Flash Cache since 2009.

We have seen strong adoption of Flash Cache, having sold over 17.5 petabytes of flash storage, accelerating over 1 exabyte of hard disk drives.

On the server side, our stated strategy partner with server flash hardware vendors and add value through software.

Our recent announcement with Fusion-io is an example of execution against the strategy.

You can expect to see more detail from us on this topic of host-based flash shortly.

Also in Q1, we introduced the FAS2220, our newest entry-level system, building on the success of the recently introduced 2240.

The fully refreshed FAS2000 family saw a 41% year-over-year increase in units shipped.

The upper end of the 3000 family also grew from a year ago, but we saw an expected product mix shift at the boundary of the 2000 and 3000 product lines, resulting in an overall decline in 3000 units.

The FAS6000 family and total V-Series units were consistent with Q1 of last year.

Branded E-Series units are up significantly from its introduction a year ago.

The strength of the 2000 series is reflective of our strong partner relationships.

The 2000 family is key to the channel, and we are continuing to gain traction.

The mix of direct and indirect channels remains steady from Q4, with 78% of revenue coming through the channels and OEMs.

Together, Arrow and Avnet contributed 30% of our total revenue, consistent with last quarter and up 15% from a year ago.

The OEM contribution was 14% of total revenue.

Our OEM business remains steady, slightly down from Q1 a year ago, but up 3% from Q4 of last year.

And we continue to expand our OEM business and add new OEM partners.

We had another outstanding quarter with FlexPod, further enhancing our partnership with Cisco and our joint channel partners.

Our FlexPod business grew almost 90% year-over-year.

To date, we have almost 1,300 FlexPod customers and are seeing a clear ramp in repeat business.

We are seeing strong traction across the board in all geos and verticals.

The greatest demand for FlexPod comes from customers wanting to run mixed workloads.

In Q1, NetApp and Cisco announced the launch of Premium Partner Framework, a global channel initiative to accelerate FlexPod momentum, designed to deliver increased differentiation, streamlined multi-vendor interactions, and enhanced profitability.

We continue to strengthen our relationship with Cisco and are seeing the results of this strong partnership in the marketplace.

The value of our best-of-breed partnership strategy is playing out in customer environments.

Our work with ING DIRECT, the world's largest direct savings bank, is an example of success of this approach.

Developed collaboratively by NetApp, Cisco, and Microsoft, working with a systems integrator and the customer, ING's Bank-in-the-Box private cloud solution features Microsoft applications built on FlexPod.

Using NetApp-specific innovation, ING DIRECT was able to reduce test environment provisioning from 12 weeks to 10 minutes, dramatically improving developer productivity and business agility.

Overall, I remain confident in our strategy and our ability to grow our business and gain share over a multi-year period, regardless of the macro environment.

With the significant effort of integrating clustering with ONTAP functionality behind us, we now have a platform for accelerating innovation.

The big breakthrough enabled by clustering is bringing the ONTAP feature set to a broader set of business applications that have seen little innovation from conventional storage solutions.

NetApp is the only vendor that can unify structured and unstructured data at scale, which not only makes customers' information accessible, available, safe, and cost-effective, but also empowers customers to use data to operate and transform their businesses.

The clustering capability, combined with the data management features, will preserve our leadership as we enable our customers to scale their business without limits.

At this point, I will open up the call for Q&A.

As always, I ask you to be respectful of your peers on the call and limit yourself to one question so we can address as many people as possible during our remaining time.

Operator?

Thank you.

We will now begin the question-and-answer session.

(Operator Instructions)

Kulbinder Garcha, Credit Suisse.

Thanks very much.

My question for Tom is that in previous downturns, macro periods of macro uncertainty, you guys had always had the mantra of investing through it.

And it did drive share gains.

It sounds like you're being a bit more cautious right now.

And I'm just wondering is that reflective of the lack of visibility that concerns you have as we go through this fiscal year?

Or something else going on in?

Then -- and my follow up just for Nick on gross margin.

As product gross margin reached new lows, can you explain what's going on there?

Is it a pricing dynamic, a mix dynamic?

Any kind of break out there would be helpful.

First of all, I'd reiterate that I hope to have just one question each so we can get through the entire list today.

I think on the question of investing through it, the last time we went through this downturn, we actually did a restructuring.

We clearly actually cut back on expenses for a while, and we used that, frankly, to enable us to re-prioritize and invest in key priorities.

So where we are today is that we've not done a restructuring, as you can see from the numbers.

But we are also investing in growth opportunities for us.

In terms of re-prioritizing our existing activities, that is aggressively going on.

In terms of specific near-term growth opportunities, whether it be channel programs or things of that like, we are also funding those.

We aren't in a total clamp-down by any means, and certainly we are not restructuring at this point time.

But clearly, we are trying to arrange our operating expense towards what we believe is going to generate near-term growth.

So there definitely is a re-prioritization going on.

I wouldn't want to give the message that we're purely hunkering down.

We are clearly being conservative, and we're clearly being careful, but we're trying to find a way to fund the things that are really going to make a difference.

Why don't I answer the question on gross margin as well?

We expected a range of gross margin for the quarter, Kulbinder, in the 60% to 61% range, and you can see on the results here we've fulfilled that.

We came in at 60.3% overall.

And if you look at the margins in the different categories of product, SEM, and service, they were all pretty consistent with what we expected.

So yes, the product gross margin is down from Q4, and that is a mix and volume-type of driver that's causing that to happen.

But that was in line with the expectations we had for the quarter.

Clearly, the OEM mix and obviously the reduced absorption as a result of the lower revenue levels are factors there.

Thank you.

Aaron Rakers, Stifel Nicolaus.

Yes, thanks for taking a question, guys.

I appreciate in your supplemental information, you break out the branded and OEM piece of the revenue.

But it would appear that that includes both the SEM as well as the services piece.

As we look at your competitive positioning, I think it would be helpful to try and understand to meet that.

More specifically, how that might break down between product revenue?

Any kind of color you can get on the growth rates for that between, I think, what's disclosed as configured versus non-configured or how you might look at the product OEM revenue would be helpful.

Thank you.

Yes, not sure what the question was.

But I appreciate the feedback, first of all.

So I don't want to diminish that.

I think from the point of view to bear in mind is the OEM and the branded is that both the OEM and branded have both an E-Series and a traditional FAS component.

Part of the rationale of doing it this way is, particularly in some OEM accounts like IBM, which are both a FAS OEM and a branded OEM, we are somewhat less concerned about which product moves.

Clearly, a year ago, prior to the acquisition, we had a clear preference for one over the other.

In this particular case, we're concerned of the overall health of our partners like IBM as opposed to any individual product offering.

It's probably safe to assume, I'll let Nick chime in on this, is that the SEM and the service component of the OEM business is a much smaller percentage of the total revenue than it is on the branded side.

In fact, overwhelmingly on the product side in those businesses on the OEM front.

That's right.

And the OEM revenue that you can see here is basically flattish, right, from Q4.

And we're looking at the overall OEM now.

So this is inclusive of the traditional N-Series as well as the E-Series OEM that we've left a year of integration, and we've talked about breaking this into the two pieces.

But we'll take your feedback and think about that supplemental commentary for the future.

To Tom's point on the SEM and services side, OEM business really has very little of either one of those components.

Brian Alexander, Raymond James.

Back to gross margin, the product margin was down 500 basis points year-over-year.

Understanding product revenue is down 7%, and that's a big factor.

Maybe if you can talk about how much of the year-over-year decline in gross margin was due to volume versus pricing versus mix?

And how should we think about the trajectory of product gross margin, specifically next quarter and over the next few quarters, in the context of your 60%, 61% overall gross margin target?

Thanks.

Let me just start on that, and then we'll talk about the future here for a second.

When we look at that 60% to 61% for the second quarter, we are expecting in the range of about a consistency on the SEM side and consistency on the services side.

So what that implies is because that the mix also changes a bit as we go into second quarter, there'll be some increase on the product gross margin.

So that is consistent.

That is consistent, actually, if you look backwards over a number of quarters.

It's also consistent with a bit of a more richly configured mix as we go into second quarter each year.

That's how we think about the go-forward.

The year-over-year is obviously impacted by OEM business.

It is impacted by mix, and really, on both the customer side and the product side.

Those are some of the main pieces that are going on versus last year.

Yes, I think probably the other thing that's a factor here to some degree is I don't believe that direct pricing is completely normalized.

And I think that's reflected in this as well.

Because in some cases, some of the drive pricing increases have not been passed along to customers.

And as that sorts itself out, we certainly see drive pricing, at least the drive pricing behavior, returning to a more normal state.

I think we still expect to see some upside on the gross margin from that perspective.

And likewise mix, basically the dramatic explosion of our low-end business, up 41% year-over-year, is also a factor, including a key component of that is actually a product at the very, very low end.

Although all those factors continued, I think there are a number of things that are different.

Clearly, pricing in environment is not trivial.

Teasing all those apart and attributing them on a line item by line item basis is a little bit on the complicated side but clearly something that we want to watch.

But I do see upside capability both on drive pricing and on mix on utilization, and frankly, the impact of new products on the functionality we have on our product gross margin going forward in a favorable direction.

Jayson Noland, Robert Baird.

Great, thank you.

Wanted to ask about FlexPod.

Tom, do you expect to see any positive derivative benefit following the VMware acquisition of Nicira?

Any impact from VSPEX and EMC?

We are hearing a lot about FlexPod in the field and wanted to ask for more color.

Yes, I certainly can't comment on Cisco's behavior relative to Nicira or even the Lenovo deal with EMC.

What I do know is that we have a lot of momentum.

And I think we've said from the beginning that as far as a partnership is concerned, I think the NetApp-Cisco partnership is one that is probably the most sustainable of them all.

I think we have much better line from a product direction point of view and our belief of Ethernet-based storage.

I think we are much better aligned from a go-to-market perspective and that we are very channel-centric.

And I think that there isn't any fundamental strategic overlap or product overlap there to create tension.

As a result, I think a lot of those things are working together for us, even independent of any actions by EMC.

Clearly, that was one of the bright spots for the quarter.

I think there's still a lot of upside as we get more and more engagement on a worldwide basis so we get to see some more repeat purchases.

Clearly, I think we're very, very pleased with that relationship and have a very, very large amount of momentum.

I think that really the key message here is that technology is positioned against the server vendors, and the server vendors' value proposition is going to be one of integration.

And it isn't said that integration doesn't have value, but the customers are willing to sacrifice only so much innovation and product functionality in order to achieve that integration.

If we could go with another like-minded best-of-breed player like Cisco and integrate our technology very, very tightly, then we can go in and basically nullify the integration story and really talk about best-of-breed and the value that it brings to business.

And I think the other key part of this story is really the integration with other partners.

We were just awarded Microsoft's Cloud Partner of the Year award, bringing Microsoft into FlexPod, likewise SAP and Citrix and Red Hat, and really bring broader solutions around this platform.

Whether it be the partner ecosystem or whether it be the tight integration and really the compatibility of our business models, clearly, this has been a very, very strong story for us all year long, and it continues into this quarter.

Operator, next question, please?

Steven Milunovich, UBS.

Thank you.

Tom, following up on the analyst meeting, your talked about the Storage 5000 in to your protect-and-grow accounts.

I assume you are not going to give us a quarter-by-quarter update on that, but it did seem to suggest an improvement in both breadth and depth, which should lead to better revenue growth over time.

How do you feel about that> Is the macro offsetting that?

Are the sale cycles lengthening so much, or do think that's going to play out over time?

Obviously, the numbers are pretty volatile from quarter to quarter.

We still came off three very, very strong new customer-acquisition quarters to finish last year.

We tend to start off slow, because a lot of the Q4 activity is really round harvesting deals we have been working on all year long.

But that said, I think the new-customer acquisition is what fuels the next generation of grow accounts, the way the growth of the business comes from.

So what we did see, though, is pretty good numbers on the channel side.

And like I said, the Storage 5000 itself, specifically your question, is still very volatile, but the channel side of new-customer acquisition was still very good.

Clearly, we see longer sales cycles.

Clearly, other people are reporting that, and we still see that as well.

And I think that's one of the issues with some of the larger accounts, because we are talking about much, much larger transactions, and large transactions get a lot of scrutiny.

But overall, I think that part of the engine of the business and our channel business, Arrow and Avnet, which are roughly 30% of our overall revenue, up 15% year-over-year.

I think the breadth of our channel and the expansion of our business and frankly, the channel partners that Cisco has helped us cultivate out of that relationship, have all been very helpful.

But the big enterprise accounts, clearly, large transactions certainly are getting a lot of scrutiny.

Certain segments are clearly more problematic than others, but overall, within expectation.

I think we certainly knew what to expect going in.

We expected some of the large accounts to do very well and other ones to struggle, and clearly, that's what we saw.

Brian Marshall, ISI Group.

Great.

Thanks, guys.

When you look at your bid shipments each quarter, if you look at the year-over-year numbers for the July quarter the last five years, it's averaged north of 60% pretty consistently in terms of year-over-year bid-ship and growth.

And this past quarter was obviously almost flat, only up 4% year-over-year.

The question becomes obviously, we are in a tough macro environment, but is there anything going on here?

Clearly, we had a big deceleration with respect to bid shipments and subsequently obviously didn't decline as much as we historically saw.

Is there a different of dynamics that are changing here for the Company?

Love to get your viewpoint there on what's going on.

Thanks.

I don't know if I would overreact to one quarter in this environment.

I don't think there's anything fundamentally different going on.

I still think that clearly the drive situation had some impact on that as the year went on as probably normal cost curve -- certainly cost curves to us were different than in prior years.

And likewise, the cost curves to our customers are different than in prior years.

I think that there is a dynamic there.

For NetApp, we saw a big pickup in our units at the low end, which clearly don't have as many disk drives, but they still carry a fair amount of other componentry in there.

But the actual capacity numbers are a little bit less.

On the other hand, when I look at some of our big consumer customers that consume a lot of product, they had pretty good quarters.

For now, I wouldn't read anything into the numbers, anything too much.

Certainly, we are not.

And we will see how this goes on.

In a somewhat different environment, both from a cost perspective, from a macro perspective, and a product mix perspective, I think we need to be careful that, of overreacting to one quarter.

Alex Kurtz, Sterne, Agee.

Thanks for taking the question.

Tom, what's your current view on your acquisition strategy, and what markets are you thinking about, if any, to deploy your cash?

Thanks.

I think the broader story around our acquisition strategy, about we want to look for things that have got affinity to our core business that we can apply leverage to, either something that our channels can sell, or by virtue of having it in our portfolio, we can move more of our product.

More broadly around -- as we look at it, I think that just an ongoing cadence around smaller technology companies that we can tuck into our portfolio to either fill gaps or complete a solution or help us integrate with partners.

I think we will continue to do that.

And I think I've said you'll probably see a little bit increasing rate of that as time goes on as we get bigger proportional to our size.

So I think that will continue.

As far as larger transactions, those I think will be asynchronous and opportunistic.

There is certainly no strategy change, but they will be a function of the fit, obviously the price, the executability.

And I think that those will become opportunistic.

If there's one available tomorrow, we will move.

If it's not available tomorrow, we won't.

I think what you will see more is probably more of a regular cadence around smaller technology companies and large deals that remain opportunistic.

But the overall story that we talked about in the last two Analyst Days that we really aren't looking to just add components to the portfolio, even good assets.

It really needs to be something we can add leverage to, that's something that we understand, we know how to sell, and that we can add value and momentum to overall.

Amit Daryanani, RBC Capital Markets.

Thanks a lot for taking my question.

I had a question, when I think about the July quarter guidance you guys have, it obviously had a lot of conservatism built into it, which turns out to be the right thing.

When I look at the October quarter guide of up 7.5%, it appears a lot fuller to be historical to seasonal patterns we've seen.

Could you talk about what enables you to feel better with the October quarter?

Is it the macro getting better, or are you just getting better new wins given ONTAP 8.11 deployments right now?

Thank you.

I think the macro assumptions, as you can well imagine, probably hard to find optimism on the macro front.

I think simply put, I think if we look at the macro front, EMEA is still a concern.

I don't think it's necessarily deteriorated, but still there's a lot of uncertainty around the range of potential outcomes the.

We are coming into the end of the US fiscal year, and obviously, the election, and the fiscal cliff at the end of the calendar year.

My gut feeling is that this fiscal cliff will somehow get resolved and we will work our way through it.

I think the trajectory in the US will be somewhat more of the same.

And I think probably if there was new news since the last quarter, it is probably somewhat more negative headlines relative to the Asian economies, particularly the export economies.

As we look at it going forward, I don't think we're betting on any type of macro turnaround.

I think we're looking at a product portfolio.

We're looking at our partnerships.

We're looking at our positioning in the field, obviously the feedback from the field, and putting that all together.

So from our perspective, I do believe that it's up from here.

And I think that our guidance from Q1 to Q2, admittedly, after our reset of guidance for Q1, I think going back to normal seasonality appears to be what we see.

Amit, It's Nick.

Let me add a couple points to that.

And we talked last quarter overall about how we do we forecast and how do we bring together this guidance.

And it's a combination of a bottom-up look across all the geographies, across our channel business around the world, as well as a top-down look that incorporates things like foreign exchange and the macro.

So we look at all of those pieces in bringing that together, and that's what we have done here.

The normal seasonality is one of the things we look at against that.

I think on the macro side, as Tom said, it's pretty consistent there.

And then on the FX side, when we look at foreign exchange from quarter to quarter, where we had degradation going on between April and the time we gave guidance at the end of May, at this point in time, it's kind of flattish as we look into the second quarter.

So built in, again, those elements of the business from the bottom up, FX, and macro, maybe that gives you a little bit of sense of the pieces there that we brought together to come together with this guidance.

Ananda Baruah, Brean Murray.

Thanks for taking the question.

To piggyback off of that one, Tom, how is the linearity as you saw through the quarter, and what have you seen so far this quarter as well?

Thanks.

Obviously, it's early days.

It is 2.5 weeks into this quarter.

And I would say to basically break our quarters down onto months is a little bit misleading.

That would apply a bit more science than I think is really appropriate in the data.

So I didn't see anything dramatic.

It wasn't like we blew out the early months and coasted in or the other way around.

I would say it was pretty normal.

If the question is do we see either a positive or negative trajectory heading into this quarter, I would say it's probably still substantially unchanged.

I would say there's probably nothing notable about our monthly cadence last quarter.

Andrew Nowinski, Piper Jaffray.

Thanks.

Tom, you noted strong early adoption of Cluster-Mode with a number of your customers.

But can you comment on whether Cluster-Mode is actually getting you into some new verticals that perhaps you didn't have a large footprint in prior to 8.1, such as the telco or service-provider verticals?

Thanks.

I think in the service-provider vertical, I think NetApp has been very, very strong.

On that particular one, I wouldn't give any ground.

Clearly, I think if you look at 8.1 customers, there are some customers in our traditional spaces where they will look at 8.1 and they will see the performance capability and for those that are clamoring for performance, they will jump on it right away.

We have customers that have been in production on this technology for quite a long time, full production, large clusters.

And I think that there are other people that are looking at this technology and they are targeting for specific workloads and they're doing proof of concepts.

The ones that are going to deploy this technology at a lot of scale that have not used NetApp before will tend to go down the proof-of-concept route.

And we certainly have a lot of that activity that's not yet reflected in the customer adoption numbers.

And then there are customers out there that -- some of which are long-term NetApp customers, some of which not -- that are sold on the clustering technology that made this a standard for all new workloads that they put online.

If I look up and down across the list, this isn't weighted by size of opportunity.

But a fair amount of the Cluster-Mode wins that we have are in fact brand-new customers to NetApp, or at the very least, brand-new applications with existing customers to NetApp.

I think the ones that are in full production today, that adopted the technology on day one, those are the ones that are familiar with the NetApp technology.

The other ones are an interesting mix.

The other thing that is probably a little bit different about this technology is that we've talked about clustering in the context of NAS for a long time.

What this is bringing is clustering technology to SAN.

That is a very, very different technology, and as a result, it's generating a lot of interest.

This business probably has a little bit more activity on the SAN side than the pure NAS side in our core business simply because this is really an innovative technology.

And not only is clustering in the SAN world innovative, it's all of the other features of ONTAP brought to clustering in the SAN world that is innovative.

And that's why we spoke at length at Analyst Day about the opportunity to open up a lot of new applications around workloads where we haven't previously been considered.

Because now we can marry that rich feature set of ONTAP, which doesn't exist in the SAN world, and we can marry that with clustering to deliver high performance and high availability, and I think that is really the exciting thing about all of this.

And clearly we see those, but those types of big bets in big accounts usually start with proof of concept, and that's what we have underway today.

Katy Huberty, Morgan Stanley.

Yes, thank you.

Can you talk about what the pre-purchases were that drove inventory up this quarter and whether that might set you up for better component pricing over the next couple of quarters?

Thank you.

Yes, Katy, there's a variety of things that go on there on the inventory side, including the new products that we introduced, right?

That's going to drive some inventory.

Really, this is a matter of looking across the components, across the entire spectrum, and getting ourselves in position for all of that.

I wouldn't go too far into the what will that do on the margin side, et cetera.

That will all be built into our guidance.

And our expectation is that that inventory turns number will come up as we go through Q2 for sure and that inventory balance will come down.

Likewise, obviously, we are operating off a lower COGS number this quarter because of the business level, so that clearly hurts the ratio as well.

Brian White, Topeka Capital.

Hi, Tom.

When we think about the flash market, do you feel you have all the tools to address this opportunity?

And how should we think about this new partnership with Fusion-io and what it means to NetApp?

I think the market will evolve and time will tell how many tools are necessary.

But I think as we see it now, we see flash on the host, we see flash on the array, we see flash in the storage containers, we see solid-date disks, and NetApp is going to participate on all of those.

If there are other avenues of flash and deployment for flash beyond that beyond that, then clearly we will participate in those as well.

But right now, if you look at our offering, our belief early on was that in the array products that flash deployed as the cache is the most effective way to deploy solid-state technology.

I think that we certainly stand by that today, and if anything, the industry has moved our way.

Likewise, there will be flash on the host, and that's really what the Fusion-io discussion is about.

Our view is that flash on the host, if it's going to be permanent storage, that's going to look like a disk drive to the application, then that needs to be brought into the broader data-management capability.

It needs to be backed up.

It needs to be replicated.

So our view is that flash on the host, that's going to fit that permanent storage type of model where it's going to look like disk drives, we want to do what it's going to take to bring that storage into our data-management capability.

The opportunity for us is really around the software.

If we have to make and sell hardware in order to participate in that software opportunity, we will.

And that's really what the Fusion-io relationship is about.

That is clearly, they've got a strong presence there.

It's an opportunity for us to partner to bundle our software with their hardware to create a solution that enables broader data management as opposed to a one-off solution specifically for any individual host.

We still believe that the opportunity there is really around selling software value-add, and being a data-management provider in the enterprise, and partnering with hardware vendors to enable us to do that, allows us to leverage their presence and their technology and likewise, our software differentiation.

Obviously, we hinted in the prepared text around some more announcements, so you will actually see some specifics about that as opposed to a general technology collaboration.

You will see more specifics around that pretty soon.

Mark Moskowitz, JPMorgan.

Yes, thank you.

Tom, your prepared remarks as well as your press release highlighted continued investment in the channels and a really important part of your overall growth strategy for years.

Want to get a sense, is the incremental investment being highlighted, is that really in response to competitive dynamics or just a lack of the direct sales force evolving as planned?

It's more a response to opportunity.

One of the things that we see in the channel is that the more we invest, the more we expand our coverage, there is opportunity out there.

And it's a big, deep market.

From our perspective, if I look at the work of Arrow and Avnet, which have become a very, very significant part of our business, and Avnet's still growing 15%, clearly there -- clearly that market is far from saturated by NetApp.

We don't appear to be coming to any limit, so the idea is that incremental investment there still will uncap market opportunity that we don't currently see.

So there's pretty much -- I don't want to convey that there's lack of confidence in our direct selling motion.

It's just that in the channel, it is fast.

There's a lot of customers, and even though some of them are slowing down, there are other ones that are speeding up.

So the ability to basically touch more accounts, touch more opportunities in a leveraged model is still a big opportunity for us, and that's just in the US.

The ability to expand our coverage on a geographical basis outside of the US is still a very, very large opportunity for us as well.

We want to do that.

Clearly, we need to do it in an effective way.

We need to bring on credible partners that are going to vest alongside of us.

But I still think that one of the biggest challenges, not only for us but for everybody in this market, is basically coverage and to reach as many customers as we can.

That's why we continue to do that.

I don't want to blunt the competitive question.

Clearly, in the aftermath of the breakup of the Dell relationship and EMC, clearly we see EMC in the channel.

We see Dell in the channel, but we are not trying to invest to overpower those guys.

I think our existing partners are doing just fine, and we're looking to add more coverage to it.

The only other thing I would add to that is that when you look at the pathways mix, and we talked about the pathways here, these are fulfillment channels.

So our direct selling force is involved in many of these transactions that may ultimately get fulfilled through the channel.

It's something to probably keep in mind with respect to direct versus channel.

Ben Reitzes, Barclays.

Thanks a lot.

Can you guys talk a little bit about in terms of your guidance what you're think about in the competitive environment?

You talked about demand and whatnot, and your product revenue trends with the decline diverged from your largest competitor.

Does your guidance imply that you guys from a competitive standpoint start growing like you had in the past, in line to better than your competitors?

Thanks.

I think I would go back to Nick's initial response.

I think we take a look at the momentum of the business.

We take a look at a bottoms-up analysis of the individual accounts.

We look at the coverage map, the macro, and those types of things.

I think that the competitive dynamic and who we compete against every day is going to stay the same.

I don't see any player retreating.

I don't see any player advancing.

I think we are going to assume the competitive dynamics in the product set and the vendor set are substantially the same.

I think that part of this is clearly, we have refreshed the entry-level part of our product line.

We've got very, very strong alliances now with Microsoft and Cisco and VMware, and I think there's a lot more for us to leverage there.

We talked about some of these channel investments to expand our coverage.

I think with the -- assuming no change in the competitive landscape, I think that there's a number of leveragable opportunities.

And I think we've also advanced our own product set along the way, not to mention the release of 8.1.1, which has a new feature sets as well as clustering.

I think that our competitive position certainly is better than it was three, six months ago.

And I also believe that our opportunity to expand our coverage is there as well, and that is what is fueling where we are.

Plus, the pure bottoms-up analysis of an account-by-account analysis, particularly around the major accounts.

Bill Shope, Goldman Sachs.

Okay.

Great, thanks.

I wanted to dig into the Q1 performance a bit more on the revenue line if I could.

It's certainly comforting that your overall revenue was in line with your expectations going into the quarter.

But it's been just stated product revenue is down 7% year-over-year and 23% sequentially.

And I think that's below most expectations out there.

Could you dig into the dynamic a bit more on what you saw in terms of product demand throughout the quarter relative to your expectations?

And looking at the competitive landscape at least for the first quarter, do you think you were able to outgrow the market, or do think once we get all the numbers in, we'll see that the market was down 7% as well?

I think in general, the items coming off the balance sheet are going to come off the balance sheet no matter what.

Therefore, in order to have made revenue number then, the performance of the product revenue had to be within our expectations, because they're really are no other knobs.

I think we ended up more or less what we said we were going to do.

There's a little mix of the OEM business, which is primarily product revenue that will factor in that will modulate that a little bit.

But for the most part, in order to get to the revenue number, the products have to perform as we expected.

As I look at the overall market and what will HP report and what will Dell report and how it will all play out, it's kind of hard to separate their overall storage businesses from the individual lines of business, particularly the way they present themselves.

But I think it's probably safe to assume that in our toughest quarter, Q1, I don't know how the rest of the industry is there, and I'm not going to make the claim that they're all going to perform at a growth rate that's less than what we did.

The one thing to do bear in mind is that this is our weakest quarter.

Q1 is always our most challenging quarter, both from a market-share perspective and from a comparison perspective.

Certainly historically, it's been the most difficult quarter for us to execute on.

And the other thing that's probably a little bit different and somewhat of a mitigating factor for NetApp is the areas where we have been historically strong, like our VM business and like our federal business, we are probably a little bit overexposed to those areas, which are weaker than for the other guy.

But nonetheless, I think from a industry-comparison perspective I don't think that -- the numbers are the numbers.

I don't think that we are going to claim we outgrew the market or outgrew any individual products.

It's a challenging quarter for us.

It's always been, Q1, and we expect it to be up from here.

Brian Freed, Wunderlich Securities.

Good afternoon.

I wanted to delve a little bit more into your Flash Pool technology.

One of the gating factors in flesh adoption has been the absence of right cache.

Can you one, talk about how this positions you, what you think are the barriers to entry for other folks to develop a solid right cache?

And also, what would be the potential impact on HDDs in terms of how many you'd need in a flash point implementation?

Yes, I don't believe that the lack of right caching, particularly in the NetApp ONTAP architecture, the way we do it, consolidate and coalesce writes, which is different than anybody else, has the write anywhere name, has been a significant barrier to our technology.

I just don't.

In fact, I can't think of a single situation that I've personally been involved in where that has been an issue.

I really don't think that that's a factor.

I think the broader question of what having storage in the array does is it helps us with predictable performance, particularly in the fail-over case, because it eliminates some of the rewarming of the cache in case you have a sail-over to another controller.

I think there's a number of ways where this helps us plug -- a bit easier to do than on the plug-in cards basically in our Flash Cache product.

In addition, it allows us to put a lot more solid-state disk into a machine that you can do in the form of a plug-in card.

In terms of the overall market and the impact of flash versus solid-state disks, one of the things that we have seen is a very, very small amount of flash can accelerate a very, very large number of solid-state disk, assuming that the algorithms by which the cache is loaded are very, very effective.

I talked about we have 17.5 petabytes accelerating an 1 exabyte of hard drives.

I think if the algorithms are effective and you use the flash to the fullest, then two things.

You get rid of enterprise writes once and for all.

You can go to ATA drives on a pure basis.

If you get your working set actively stored in flash, then -- if you could do that, then you don't need enterprise drives.

You don't need storage sharing.

You don't need any of that stuff.

You can just go to ATA drives on the back end.

And simply put, when you want the data, it needs to be fast, and when you don't want the data, it needs to be cheap.

I think that one of the strengths that NetApp has is the ability to very, very intelligently manage that cache.

And I think that's why we been so successful with the Flash Cache product.

Now where are some cases where the working sets are too big to put in that, in which case I see a clear need for the solid-date disk.

And likewise the solid-state disk helps in high-performance, high-availability workloads where the solid-state disk can be shared amongst many controllers.

I consider this to be an extension.

It's not a departure.

It's not a competitor to Flash Cache.

The other thing I should point out is that it is still a cache.

And I think that is unquestionably the most effective wait to deploy semiconductor memory.

Because that way, it's always dynamic.

It's always going to store your most active data, and that's the way to get the most price-performance out of it, and it allows you to best optimize price-performance in your overall storage array.

We have time for one more question.

Rajesh Ghai, ThinkEquity.

Yes, thanks.

I had a question on your talent redemption.

Tom, you earned -- NetApp continues to be ranked consistently in the top as far as great companies to work for, but doesn't seem to have helped you with talent redemption.

If you look at the new stories that are still emerging in the valley, a lot of them have significant number of NetApp engineers.

Do believe after all the attrition you've seen over the past couple of years you have the talent to drive your solution agenda?

And what you're trying to do that's different that could arrest this decline, over time?

Yes, I think there's obviously the individual stories, but overall attrition this quarter is not substantially different than attrition a year ago.

In fact, it's effectively the same for all intents and purposes.

So, frankly, if you were going to start a storage company, who would you want to attract people from?

It would be NetApp.

I think that from some perspective, I think our track record and our history, both in terms of the culture that we have developed and the performance of the Company, makes us attractive, and people are going to try and draw people away from NetApp.

I get that, and I would rather be a net creator of talent and an exporter of talent than the other way around.

In some cases, I think that we are a natural target for those companies.

With the right incentives and the right opportunity, it makes sense.

I think around higher-level people, if that's what you are talking about, I think they all fall into different categories.

We have had some people that have been here for a while that have either retired or pursued CEO opportunities or things that are the last chance in that career to pursue, or time is right in their career.

They've done great work for NetApp, and we wish them the best of luck in where they go.

Other people haven't panned out, and we have made changes.

And there are other people that were great contributors here that saw an opportunity someplace else.

I don't think that anything has really changed.

We always regret to see good people leave.

But we also appreciate the great work that they've done for us, and we certainly don't stand in the way of great opportunities.

There are some people that like the idea of a start-up that joined NetApp a long time ago and want to relive that.

I say that every case has a story, but in the aggregate, I'd say the current dynamics are not a whole lot different than they have been.

To answer your question, NetApp has been a -- is a compelling culture, We spend a lot of time developing our people.

So to specifically answer your question, I feel like we certainly have the team to succeed and prosper in this market and continue to outperform.

All right.

Thank you all very much for joining us today.

We appreciate your time.

Thank you, ladies and gentlemen.

This concludes today's teleconference.

Thank you for participating.

You may now disconnect.