NetApp Inc (NTAP) 2013 Q2 法說會逐字稿

Welcome to the NetApp second-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.

We will conduct a question-and-answer session at the conclusion of the conference.

(Operator Instructions)

Please note that this conference is being recorded.

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

Ms. Newton, 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 Q3; the benefits to us and our customers of our products and services; our expectations regarding future customer demand for our product and services; and the 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 global macroeconomic environment and the continuing deliberations regarding future tax and fiscal policy in the US, 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 in today's discussion.

All numbers discussed today are GAAP unless otherwise stated.

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 for this quarter.

I will now turn the call over to Nick.

Thank you, Kris.

Good afternoon, everyone.

NetApp delivered financial results in line with our expectations for fiscal Q2.

Revenue of $1.54 billion was roughly at the midpoint of our guidance range.

We achieved gross margins of 60.6% and exceeded our prior guidance with operating margins of 14.4%.

Non-GAAP EPS of $0.51 exceeded the high end of our guidance range and we generated $269 million in free cash flow in the quarter, about 17% of revenue.

Revenue increased 7% sequentially and 2% from Q2 last year.

Year-over-year growth was negatively impacted by 1.5 points from FX.

Branded revenue was up 8% sequentially and 4% year-over-year despite the continued challenges in the macroeconomic environment.

OEM revenue was flat versus Q1 and down 9% versus Q2 last year, the result of a reduction in demand from OEM customers.

Product revenue was up 11% sequentially and down 2% year-over-year.

Both software entitlements and maintenance and service revenue were within expected ranges.

All geographies showed flat to modest year-over-year revenue growth with the exception of Asia-Pacific, which was up 14%.

On a constant currency basis, EMEA revenue was up 7% year-over-year.

Versus Q1, we also saw flat to modest revenue growth across the geographies.

In the Americas, we saw a 12% sequential increase comprised largely of expected growth in the US public sector and corresponding to the fiscal year-end of the US government.

Non-GAAP gross margins of 60.6% were slightly above the midpoint of our guidance range and benefited from the strength of our product gross margins.

At their highest rates since Q2 last year, non-GAAP product gross margins of 53.6% were driven primarily by increased sales of more highly configured systems.

Software entitlements and maintenance and service margins were within normal ranges.

Non-GAAP operating margins of 14.4% exceeded our guidance range and increased almost two points over the previous quarter.

Non-GAAP operating expenses grew 3% sequentially and 9% year-over-year as a result of our typical annual employee merit increases, moderately higher headcount, and targeted investments across the business.

We expect to continue to be judicious in spending going forward, given the current business climate.

Our Q2 effective tax rate remained constant at 17.3%, based on our geographic distribution of revenue and profits.

Non-GAAP EPS of $0.51 exceeded our prior guidance range by $0.01.

Our balance sheet remains robust with approximately $5.57 billion in cash and investments, growing over $900 million since Q2 last year.

Deferred revenue of $2.77 billion grew 14% year-over-year.

Accounts receivable days sales outstanding of 36 days was slightly better than Q1 as well as Q2 last year and rather than rebounding as expected, inventory turns remained low as we opted to keep inventory at higher than normal levels consistent with the limited visibility we have into orders in this challenging environment.

We expect inventory levels to return to a more normalized level next quarter.

Cash from operations was $336 million and free cash flow was $269 million, about equal to Q2 last year.

Our overall cash reflects approximately $200 million of stock we repurchased during Q2.

Diluted share count decreased in Q2 by approximately 3 million shares.

The accounting for the shares associated with our convertible notes had a minimal impact of approximately 1 million 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.

Regarding capital allocation, I am pleased to announce that we are continuing our share repurchase program with an additional $1.5 billion authorized.

The return of capital to shareholders through our repurchase program is an important part of our ongoing capital allocation plan.

We repurchased approximately 6 million shares of stock during the quarter and ended the quarter with approximately $148 million remaining of our prior repurchase authorization.

Since inception, we have returned just under $4 billion to shareholders through our repurchase programs.

Separately, our convertible notes become fully convertible in March and are due in June 2013.

We are actively evaluating our options for retiring this debt.

These options range from paying off our notes by drawing from available cash to issuing new debt, which may be in the form of convertible notes or conventional debt.

Turning to guidance, our target revenue range for Q3 is $1.575 billion to $1.675 billion, which at the midpoint, implies 5% sequential growth and 4% year-over-year growth.

We expect consolidated non-GAAP gross margins of approximately 60% to 61%, and non-GAAP operating margins of approximately 15%.

We expect our blended, consolidated, non-GAAP effective tax rate to be approximately 17.3%, bringing our non-GAAP EPS estimate to approximately $0.53 to $0.58 per share.

Diluted share count is projected to decrease to about 365 million shares in Q3, based on our average stock price of $27.66 for the first eight days of the quarter.

This does not include any shares from the convertible notes since the average stock price is below the $31.85 strike price.

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

Tom?

Thanks Nick and good afternoon, everyone.

In what is unquestionably a challenging environment, NetApp produced a solid quarter.

As Nick described, we are roughly at the midpoint of our revenue guidance and our EPS was above the range.

We saw meaningful sequential increases in revenue, gross margin, product margin, operating income, operating margin, and cash flow.

Our branded business was very strong this quarter, driven by the power of the value proposition and the momentum of cluster Data ONTAP.

We have been making selective investments to drive growth, the results of which we have started to see this quarter.

We continue to make strides expanding into large accounts growing our Storage 5000 presence in both new customer acquisition and driving larger NetApp footprints within existing accounts.

We saw an almost 20% increase in deal sizes over $1 million from Q2 of last year.

Data ONTAP enables NetApp to provide unique, innovative capabilities to the largest data storage installations in the world and we now have more than 150 customers over 10 petabytes and our largest customer exceeds 1 exabyte.

We continue to see momentum in Data ONTAP 8.1, deployments of which almost doubled in Q2.

Of particular importance is the acceleration in units of clustered ONTAP, which has more than doubled sequentially, and we now have both well over 1,000 clustered nodes.

Clustered ONTAP combines the richest data management functionality of ONTAP, the industry's number one storage operating systems, with clustering to enable nearly unlimited scale, performance, and non-disruptive operations.

Clustered ONTAP has clear advantages in traditionally strong NetApp segments like virtualized private cloud environments and large-scale NAS, as well as being disruptive to legacy solutions and workloads where NetApp had previously not been considered.

Clustered ONTAP is the only architecture that can unify both structured and unstructured data at scale, as well as move data transparently in the cluster, eliminating the need for complex data migrations associated with data growth and hardware refreshes.

Our Flash solutions continue to demonstrate strong customer traction.

Our offerings enable IT administrators to deploy controller-level, disk-level, and server-level Flash with the same enterprise data management tools used to operate the rest of their NetApp storage infrastructure.

Our controller-based option, Flash Cache, continues to be a strong seller.

In Q1, we introduced Flash Pool, the ability to optimize price performance through the innovative deployment of solid state disk and hard disk drives.

The demonstrable customer benefit and ease of deployment are generating tremendous customer interest and hundreds of deployment.

In the second quarter, we announced Flash Accel to enable customers to utilize server-based Flash to accelerate application performance.

We also announced an expanded alliance partner program to include server caching partners at a resell agreement with Fusion-io.

To date, NetApp has sold 22 petabytes of Flash as a cache, accelerating over 2 exabytes of hard disk.

Turning to platforms, the recently refreshed FAS2000 family remains a strong performer with units shipped growing 54% year-over-year.

As we discussed on last quarter's call, we always see a migration towards newly-announced products when they overlap older products families.

We continued to see this in Q2, as some of the low-end in the 3000 family moved to the 2000.

The upper end of the 3000 was flat with last year, and last week we announced a refresh of the FAS3000 product line with the introduction of the FAS3220 and FAS3250.

Compared to previous systems, the new systems improve performance by up to 80%, increase storage capacity by as much as 100%, and offer more than 30% better price performance.

Our flagship FAS6000 product line performance was also robust, growing units 20% from Q2 a year ago.

Our branded E-Series product line continues its ramp with unit growth more than doubling from last quarter.

The branded E-Series business showed a healthy diversity of application workloads and sizes in the second quarter.

We also took advantage of the outstanding E-Series performance characteristics to win a large all-Flash array deployment in a highly competitive bake-off against all the usual suspects.

The price performance and density profile of the E-Series makes it a good foundational building block on which to build dedicated solutions that meet the requirements of extreme workloads.

We are pleased to see the booking and pipeline progress over the last few quarters.

Achieving broad account coverage through partner leverage is also key to our strategy and we have a long history of commitment to the channel.

Our OEM and channel business increased 5% from a year ago, growing to 82% of total revenue.

Together, Arrow and Avnet grew 12% from Q2 a year ago, contributing 34% of total revenue, an all-time high.

Over the past couple of years, we have had a specific focus on telcos and service providers and today our partners offer more than 200 cloud services based on NetApp technology.

While our telco service provider business is growing in all geos, the Americas stood out in the second quarter with the telco service provider business almost doubling from Q2 a year ago.

Our OEM business was flat from Q1 but down 9% year-on-year, in line with the announcement of several of our OEM partners.

Go-to-market leverage extends to our Alliance partners as well.

Our focus as a best-of-breed storage provider enables us to create complementary and sustainable strategic relationships with our ecosystem partners.

During Q2, we participated in the VMworld, Oracle OpenWorld, and Citrix Synergy, and announced integration with each of these company's latest offerings.

Also in the second quarter, we expanded our FlexPod solutions to include Express Pod, an entry-level version, as well as support and validation for VMware vSphere on clustered ONTAP.

Our FlexPod business continues to grow rapidly.

November marks the second anniversary and now we have more than 1,500 FlexPod customers, almost quadruple the number a year ago.

The idea behind FlexPod is to lower the barrier to acceptance of new technology through deep integration of technology and support with other best-of-breed vendors.

Beyond just infrastructure, FlexPod extends to applications as well, with notable integrations with Microsoft, VMware, Red Hat, Citrix, SAP, and Oracle.

Overall, despite a difficult macro backdrop, we demonstrated progress on each of the strategic elements of the business.

The acceleration of clustered ONTAP, enabling an agile data infrastructure, demonstrates the impact of our strategy of having a single operating system serving a broad and ever-increasing set of customer workloads.

A single OS for a large set of workloads reduces complexity in customer environments and gives us tremendous development leverage, enabling ongoing organic innovation.

For specialized but rapidly growing workloads that are not served by ONTAP, we now have E-Series, which is starting to show traction.

To maximize the monetization of our compelling innovations, we have chosen a partner-centric strategy and we have seen our indirect business grow both in size and as a percentage of our business.

Similarly, we are building a set of growing and sustainable ecosystem relationships with NetApp as the core storage provider.

Execution on each one of these items will enable us to grow our market share.

Finally, I would like to extend my thanks to the entire NetApp team for despite the economic headlines remaining focused on things that we can control -- innovation, execution, and serving customers.

I would also like to express my sincere appreciation to the over 12,000 employees of NetApp for our strong placement in the World's Best Multinational Workplaces list by the Great Place to Work Institute.

NetApp's unique culture is a differentiator that helps us produce great results for NetApp customers and partners and we strive to be a great Company with which people want to be associated.

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

As always, I ask that you 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?

(Operator Instructions)

Shebly Seyrafi, FBN Securities.

You did pretty well on the product gross margin.

I think you said it was due to more highly-configured systems.

Can you talk about the outlook going forward?

Do you expect that to continue?

And maybe you can also touch on drive pricing if that could help you?

Specifically, can you, for example, stay above 53% going forward?

Thank you.

Yes.

Hello, Shelby.

Nick Noviello, here.

Good to talk to you.

Thanks for the question.

So on product gross margin, recall that we were at 51.4% last quarter, up to 53.6% this quarter.

There is always going to be a combination of things going on.

Absolutely more highly-configured systems in the quarter will drive product gross margins north.

We've talked in Q1, Q4, Q3, into last year, about the impact of drive pricing and the fact that we would expect that drive pricing impact to start mitigating and it did start mitigating this quarter.

There is still a little bit there but is nothing like what was there in the prior three.

So there is a combination of things that have impacted us.

In addition, I would point out that the branded business was up this quarter.

The OEM business was not.

So, you've got a combination of what we're selling to customers, be it highly configured.

You've got OEM versus branded, you've got drive pricing.

All of those work together.

In terms of what we would expect go-forward, the guidance would anticipate that our product gross margins are at or a little bit above this type of level.

So the 53%s are in the math, if you will, for the guidance range for the quarter three.

So, and versus what we showed at our Financial Analyst Day, which was an approximate 55% over time, we feel like we're making progress and expect to continue to make progress towards that over time.

Kulbinder Garcha, Credit Suisse.

Maybe a question for Tom.

Just with respect to capacity growth, I think that was still about 16% this quarter, which is way below the long-term trend.

And how do you -- I assume the industry is growing much faster than that -- how do you explain that, can you give any insight as to what's going on.

Is it just a weird comparison?

That would be helpful.

Many thanks.

Yes, I don't think that we are an outlier, so I wouldn't be so sure that the industry is growing faster than that.

We didn't see a dramatic mix in the type of systems that we sell or in pricing and you can see in gross margin that, that held up.

So I don't see really anything really dynamic in that mix.

So I just think that we are looking at a growth rate in this industry that is not as high as it's been in a while.

None of the major player storage business -- in fact most of them are under water, so I think growth is lower and I think you're seeing it reflected there.

But I wouldn't say that there's anything specific about our business that has changed that would indicate those -- that you should expect to see something different in that particular dimension.

The product mix stayed substantially the same.

Probably more of a skew towards the lower end, which might have a little bit lower capacity, but we've had that skew before.

So I'd say nothing dramatic has changed, probably just a little bit more of a mix of the lower-end units is probably -- if it were going to impact the number, that would be it, but I would say nothing fundamental is different about our business.

Aaron Rakers, Stifel Nicholas.

On the product cycle discussion, you talked about the high-end of the 3000 Series being flat year-over-year.

Was there any kind of pause in front of the launch from last week?

And also, on top of that, how do we think about the 6000 product cycle as that would be next in line to be refreshed over the coming quarters or months?

Well I'm not going to preannounce any products.

I really don't think that there was a pause in the revenue in the face of the new products coming along.

I would venture to guess that there was probably some partners in some account that may have held off, but I wouldn't say it was material.

So, I wouldn't bake in some type of depression of last quarter's numbers and some uptick in this quarter's numbers.

We see a product refresh.

Product refreshes are good for the business.

We've certainly seen the impact of the 3000 family refreshes favorable to us and that's reflected in our guidance going forward.

So overall, I don't think that there was a pause.

I don't think it had that big of an impact.

Probably some, but I wouldn't change the numbers as a result of it.

Andrew Nowinski, Piper Jaffray & Co.

Congratulations on the great quarter.

Just wanted to get a little bit more color on the Flash side of your business, particularly since your new hardware has much more Flash integration.

So first, is Flash Accel in your resell agreement with Fusion-io driving growth at existing customers or are you seeing it gain traction in new accounts?

Thanks.

Well Flash Accel is something we are talking to customers about now but Flash Accel is not shipping at this point in time.

So what we see is the other elements of the portfolio, which are indeed robust.

Flash Pools, which we announced last quarter, I believe, and Flash Cache before that.

So clearly, the challenge in front of us is how do we optimize price performance and the way to optimize price performance is put the high utilized data on the Flash and the less utilized data on less expensive disk, typically Serial ATA.

And that is really what we are trying to do.

And it is, how we do that, whether it be server-level Cache, which is where Flash Accel will fit in, controller-level cache, disk-level cache, and the data to management to optimize the data placement so we can have true discrimination in price-performance between the highly valuable, highly in demand data, and the less important, more archive-oriented data.

And that is the value-add that we provide.

So as I think about our Flash strategy in the long run, I do believe that Flash will exist at every level of the hierarchy, including perhaps even more levels than currently exist.

But overall think that in order to not be just a niche product around specific individual workloads, the real challenge is how do I manage the full hierarchy across my enterprise.

And from NetApp's point of view is that no matter where the storage lies, whether be on Flash or hard disk, we want Data ONTAP to be the management tool to manage that ultimately and basically optimize the price performance infrastructure-wide and ultimately enterprise-wide.

So that is how we see it.

We are excited about Flash.

We have a lot of momentum and it's actually been a key selling point and of a lot of our product at this point, it is in every unit item.

Brian Marshall, ISI Group.

It looks like CacheIQ's website, unfortunately is already being directed back to NetApp, so fast move on that.

But was wondering if you could talk a little bit about your strategy with respect to how you're integrate their appliance with respect to your NAS offerings and is this part of the bigger picture with respect to getting more market share and revenues with respect to the overall Company coming from basically the Flash architecture?

Thanks.

Well you should think about CacheIQ as more of a technology tuck-in.

We got a talented, proven engineering team and we have some interesting technology that we want to integrate.

So as we think about that technology going forward, it's really more about the intellectual property and how it can be integrated into what we currently sell to really go after certain use cases that we currently have.

So as far as a standalone product, our primary focus, frankly, is integration to our broader IP set.

So, think about this as a technology tuck-in and a proven, talented engineering team.

Amit Daryanani, RBC Capital Markets.

Could you maybe just touch on your expectations for the 5% sequential growth in Jan quarter and your -- specifically, I'm just trying to understand, what do you see in terms of a IT budget flush and how do you see the public vertical tracking after a fairly good seasonal October quarter for you guys?

Thank you.

Overall, we see the same thing that you see.

We are clearly pleased about how the quarter played out for us but that doesn't mean that we aren't seeing the same dynamic that everybody else was seeing.

Difficulty getting big deals closed, obviously lengthening of sales cycles, but I think that we haven't been sitting idle.

We've been working very, very hard over the last six months, really to build pipeline, to expand our channel relationships.

So I think the macro is the same for everybody, that your guess is probably as good as mine.

We've got fiscal cliff, we have Hurricane Sandy rebound, we have all those things, and we took our best guess and roll it into our forecast.

But the other component here is clearly what we see in our own business relative to pipeline, the breadth of our channel.

We clearly had very, very strong acceptance of the new product.

Our Alliance Partnership with Cisco has been very, very successful for us.

FlexPod, obviously a lot of momentum and the expansion of our channel.

So for us, we've worked very, very hard on all of those fronts and just plain execute better as a Company.

So when I look forward, I wouldn't say that we are predicting any better macro environment than anybody else, I just think that there are things under our control that we are doing better now than we were six months ago and that is what is reflected in the guidance we just gave.

Ben Reitzes, Barclays Capital.

Can you just talk a little bit more about the differences in the US and the APAC?

US government was very strong.

How sustainable is that?

And then commercial looked like it was week and what are you expecting there?

Maybe that would pick up with new products?

And then APAC, was that below your expectations and can you discuss that segment as well and what you're thinking for the future?

So those three segments and the puts and takes?

Thanks.

Yes, if you just look at the geographic bookings, last quarter we were up in APAC and down everywhere else.

This quarter from a booking perspective, we were up everywhere.

So generally modest increase across the board.

As far as APAC is concerned, I don't think it is possible to make a general APAC statement.

We've got countries that are doing very, very well -- Japan, China, good growth rates.

We have other regions that are not doing as well.

So Japan -- Asia PAC is actually very, very uneven for us.

And frankly even in the US I would say the same thing.

I think that there are segments -- I talked about the telco service provider business that has been doing well for us.

But beyond that, I would say it's not really that sector-specific.

We've got companies in sectors that are doing well with us and companies that aren't doing well so it's very, very uneven.

And I'd say that's probably the trend around the world.

As far as government spending, US government spending was better than a lot of people had feared, but it wasn't like it was up 20%, either.

So I think we will stay in this range and we will see how this fiscal cliff plays out but I'm not really expecting it to get worse than where it is today.

I think government spending is going to be aggressive across the board no matter how the fiscal cliff plays out.

And I don't think it's going to take another step down from here.

On a global basis, I would say that government businesses globally are probably a little bit more challenging and probably not as stable as the US government.

So overall, I expect unevenness.

I expect to see our big accounts to have an account-by-account story.

The telco service providers remain strong.

I think Cisco said something similar last night.

And Asia-Pacific similarly, country-by-country, and I would say the same about Europe.

One of the things that has helped us is while the Southern European countries are important to our strategy in the long run, they are not big contributors to the number today.

And we've been doing better in the mature environments -- UK, France, and Germany, in particular, and that's helped us ride it through.

On a constant currency basis, we were up 7% year-over-year in EMEA and, under the circumstances, that is a pretty strong performance.

And Ben, it's Nick.

I would add to that and Tom talked about several areas.

Consistent with what we've done here, we forecast the go-forward at a very granular, area-based methodology round the world, round all of those sectors, round all of those selling geographies that we present to you, build that up and then look at it as well from a top-down perspective with the macro.

So we bring all of those pieces together in terms of the guidance we give and the guidance we gave you this time.

Ananda Baruah, Brean Capital.

Congrats on a solid quarter.

Was wondering, is there any reason that you saw for the more richly-config systems this quarter, any change in customer behavior of note?

Thanks.

No, I wouldn't say anything had really changed.

Some of our -- I can see a few things in the mix relative to certain customer activity, but I wouldn't say that anything dramatically has changed.

I would say that is probably within a statistical range and it could bounce back next quarter.

But all things considered I think that the product mix was typical of our Q2.

Yes.

Maynard Um, Wells Fargo.

If you could just talk about your M&A strategy, particularly in terms of how aggressive you expect to be maybe over the next year or so?

And then how do we think about the revenue generation model for any potential acquisitions?

Are they more IP acquisitions that you talked about like CacheIQ to help drive differentiation of the existing products or should we think of acquisitions as being more materially revenue generating?

Thanks.

Well, in the original category of the technology tuck-in, you should expect us to see -- do those and do those continuously.

In fact, just as we get bigger, you should probably see them at a modestly increasing rate.

So as we get bigger, you will continue to see us do technology tuck-in type acquisitions and things to expand our portfolio and integrate with our core technology.

That will continue at a roughly regular pace, probably slightly increasing over the past simply because of our size.

As far as bigger acquisitions that are material to the revenue flow, I think those are going to be asynchronous events that are going to be very opportunistic in nature.

There will be a function of availability, they will be a function of price, they will be a function of executability.

So I wouldn't say that the pace of those will either pick up or decline, I just think that they're going to be very, very opportunistic in nature and our stance regarding those has not changed.

So tuck-in acquisitions, you should continue to expect them, perhaps at a slightly increasing pace.

As far as bigger deals that are material to the revenue stream in the near-term, I would expect those to be very opportunistic and they could happen or not happen and I wouldn't put any frequency number on that, nor would I assume that our strategy has changed if we don't do one in a while.

Bill Shope, Goldman Sachs

Can you give us a little more color on demand linearity in the quarter?

As you know, many of your enterprise peers have noted considerable incremental weakness in the month of September.

First of all, did you see that in the month of September, and in October did you see any signs of stabilization or a rebound that help you to put up the numbers you did?

Well, I would say first, while I look at the numbers constantly.

Constantly means many, many, many times a day, and we primarily look for -- at least what I look for is basically year-over-year performance, but I would say that I would not apply too much science to that methodology.

There's still a lot of variability of deal timing and calendarization and things of that nature.

If I had just a general trend, I would say that the quarter started a little slow and finished stronger but I probably would not want to put any more color to it than that.

And as far as a specific slowdown in September, we did not see that but like I said I would not apply too much scientific rigor to our data points but in generally we finished stronger than we started.

Scott Craig, Bank of America.

Tom, can you delve into the channel a little bit more?

Like when you look at Arrow and Avnet, they're obviously outperforming the other partners, so to speak.

Are they doing anything specific that you can work on with the other partners or is it you're directing more funds to them?

How should we think about the channel dynamics there between Arrow and Avnet and the others?

Thanks.

Well there's a few things at play.

One of them is their investment in the business.

As they seek for growth engines for their business, they need to look who in their partner base do they believe they can get some leverage from and then how could we work together to go after that.

So, I think that we put together some activities with both Arrow and Avnet, as a result of what we've been seeing, that are starting to pay dividends for us.

From another point of view, clearly some of their business is business that they generate, some of it is migration of existing partners to them so there is a balance of that as well.

But overall, we are completely committed to the fact that our business is looking to get leverage and leverage out of our partner community.

I think that there is a lot of trust that's been built up over the years and there's a lot of ability to co-invest over the long term with those guys.

So as we look to what are we going to do to expand our channels, clearly we've seen competitive threats from other people that we needed to respond to in a constructive way and we've done a lot of that.

And our big objective last quarter was to build pipeline and one of the ways we do that clearly is in our direct accounts, but also just getting more leverage through our channel partners.

So, I would say that it is not a coincidence that it's increased.

It's been an area of focus, it's been an area of investment, and they certainly have done a good job with us.

And as we look for opportunities to grow, clearly their coverage helps us.

And likewise as they look for opportunities to grow they're looking for a technology provider that they can basically be successful with, with their account base.

So both of those have happened.

And it's not just there, clearly internationally, as well, working on expanding our channels and our channel relationships and clearly the OEM business as well.

So overall, it isn't a statistical anomaly.

We've worked very, very hard on a number of fronts over the last six months and we are starting to see some impact.

Katy Huberty, Morgan Stanley.

Tom, you grew capacity shipped about 16%.

You commented earlier that you don't think the industry growth rate was that different but customers are talking about 30%, 40%, 50% growth in data so at some point they need to catch up with the growth in their business.

Do you have a sense based on history how long they can delay storage hardware orders before they have to spend to catch up?

Well, I don't want to say forever, but the simple fact of the matter is, is that storage spending at the end of the day is budget limited, it is not capacity limited.

I don't know if I've ever met a customer that stored every bit of storage they wished they could store.

They store what they can afford to store and when they're on the budget pressure, they will make other trade-offs.

One of which is to turn on more of our storage efficiency technology.

We certainly saw that to a great extent in the last downturn and I'm certain we see it to some extent this downturn.

So that's what would be one of the things -- so it's basically fully leverage the technology they've already bought.

The other side of that, clearly is that they keep data around for less periods of time or keep data on -- keep less copies of the data and the consequence of that is the utilization of the data, whether it be for data warehousing or decision making or decision support or things of that nature.

So, at the end of the day I think that, yes, there is a natural data growth of the creation of new data, but that doesn't mean that spending goes up automatically.

I could speak from a CEO's perspective, we don't sit around and say, we would love to invest in R&D, we would love to invest in sales and marketing but we can't because we have to spend money on storage.

What is more likely is we invest in our priorities and then hand a budget down to IT.

So I do believe that storage is a consumable and as a result, it puts enormous pressure on IT in that scenario.

So I do expect that storage will perform outperform the other sectors within IT but I wouldn't pretend that storage can overpower IT spending indefinitely.

So I do believe that IT spending does modulate storage spend but I do also believe that storage would be a disproportionate amount of the IT spend.

Jim Suva, Citi.

Congratulations to you and your team.

When we look at your commentary about you're seeing, what everybody else is seeing out there for IT spending, can you just comment a little bit about is that consistent with some IT professionals deferring or delaying some Q2 purchasing?

And on the same vein of the last question, is it just a matter of time, like two quarters.

Where historically they have to come back to spend or are you seeing any deferrals and if so could that help your forward guidance maybe in a quarter or two?

Thank you.

No doubt that there is deferrals of deals, particularly big deals.

And to be fair, we certainly had deferrals last quarter into the quarter we just reported.

So there is clearly some of the flow going on.

And the other dynamic is, people will buy the minimum necessary to continue to advance their business and that will drive some migration toward smaller systems.

I think we've seen that also.

So as I think about the business, clearly IT people are under pressure.

Storage being a consumable, utilization rates are going up.

I would agree that eventually that pressure has to be released and the question is will it be released all at once or a little at a time?

And I think that will be a function of the overall IT spending umbrella.

So, I see a lot of scrutiny on big deals and a lot of delays in deals and a lot of movement towards buying just incremental capacity and keep doing what we are doing.

So all of those things are in play.

So at some point, that will have to relax and certainly when we see some light at the end of the tunnel from a macro perspective, I do expect a lot of pent-up demand, but I believe that we are going to have to see some economic vitality before that becomes a material impact on the business.

Brian White, Topeka.

Tom, last night Cisco highlighted a closer relationship with NetApp in the future and I'm just wondering, how do you see this relationship evolving over the next 12 to 8 months.

And I just want to be clear, today, you're really focused on FlexPod with Cisco or is there something else?

The most visible thing clearly is FlexPod.

There are other products in the Cisco portfolio that NetApp is working with, but FlexPod is primarily the big public one that we see.

We said from the beginning that first of all Cisco and NetApp are more aligned on technology around storage than some of the other players.

Clearly we see ethernet-based storage as something that is one of our core competencies and something that we want to promote and likewise the same with Cisco.

So in that perspective from a technology perspective we are very, very much aligned.

From a channel perspective, being that both companies have substantial partner relationships that were primarily indirect, we have a lot of synergy in terms of our go-to-market.

We have helped them with channel partners that we've had that are now stronger with Cisco and certainly the reverse is true, where previous Cisco channel partners who didn't have a lot of interest in storage are now big parts of our go-to-market strategy.

And the last piece, which we can't be lost on this either, is that our focus and our domain is not overlapping with Cisco's strategic intent for a fair period of time.

So the likelihood of conflict is lower and therefore I think there is more sustainability in this relationship also.

So I think we're better aligned from a technology vision, I think we're better aligned from a channel vision, and I think there is also sustainability, simply because of our different areas of focus.

So I think all of those things are not lost on them.

But, all the strategy talk is all well and good, but having 1,600 customers in two years and quadrupling year-over-year with FlexPod, that gets a lot of people's attention.

So more than anything else, just the raw business motion says that there is an affinity between the two companies and that together we can make business happen that we couldn't make happen on our own.

I think that is driving this very, very strongly.

So I'm excited about where we are going with Cisco.

I expect to see more investment from both of us on this.

I expect to see us integrating with even more software vendors to basically deliver more complete solutions.

And, yes, there are other elements of Cisco's portfolio that we are working with them on -- the media space and things like that, that I think will be interesting as time goes on, but in the near future it's really about FlexPod and expanding that ecosystem.

Brian Alexander, Raymond James.

Nick, could you talk about your appetite to increase the pace of the buyback given the $1.5 billion authorization and your healthy cash balance, about $2 billion in the US as of this quarter.

How should we think about the cadence relative to last year, which was really front-half loaded.

And if you do refi the convert next year, would you get more aggressive on the buyback or is that really mutually exclusive?

Thanks.

Yes, okay, thank you, Brian.

So a couple of points just to keep in mind.

Six months, year-to-date, we've done just under $350 million in share repurchase.

Our authorization was down to about $148 million so we re-upped with the Board, the authorization.

And I made mention in the prepared remarks about a substantial amount of repurchase over a period of time.

In terms of the go-forward, repurchase is one of the things we do in our capital allocation strategy and philosophy.

I went through in our Financial Analyst Day in June, the approach we've taken from the periods of FY '07 to '12 and shown balance, really, in capital allocation, with the most important piece being investing in the business.

And then investing through capital purchase and acquisition and then repurchase and return of capital to shareholders.

We want to be able to do all of those things.

This repurchase authorization is just another part of the puzzle.

Our primary strategy is to ensure that we offset any dilution from employee issuance and employee plans.

That is a primary strategy.

However, we reserve to do more or less as value or time permits or other things happen.

So, we want to be able to do all those things.

Your point on the debt, that is something that is coming.

We know that the period ends in June and we know that we have -- we will be retiring that convertible note and then we have a variety of options, basically retiring at as is and/or then going out and re-upping debt.

Frankly, every one of those things are available to us.

We are going to maintain that stance and as we move forward, we will let you know what our plans are.

Steve Milunovich, UBS.

As you know, there have been some concerns about the Company recently.

I wonder if you would take this opportunity to perhaps refute some of these concerns or even myths and just to pick a few, one would be that EMC is giving you trouble in the channel.

So people are concerned with their mid-range week this quarter, you would see it, which you didn't particularly.

Another would be concern about Flash.

Do you feel disadvantaged in your Flash product portfolio or not?

And third would be that a number of these start-ups would seem to be going after you first because it's a lower ASP, they tend to sell through the channel, some of them are former NetApp Executives, just curious if you care to respond to some of these concerns?

Okay.

And, yes, I guess I could add a bunch more.

Certainly it was a complicated quarter in terms of derivative indicators on NetApp whether it be partners or suppliers or channel relationships, as we go through those.

So, first and foremost on the channel, clearly EMC has entered the channel primarily to basically manage the unwind of the Dell relationship.

Right?

The Dell relationship was key to their strategy.

EMC had to basically claw that business back somehow.

We clearly see them in the channel and we pushed in that direction.

On the other hand, if you look at the channel momentum and the products that go through the channel, that's really where the volume and the big growth has been.

So, do we see them?

Absolutely.

Are they slowing us down?

Clearly there is a competition out there, but at the end of the day, the numbers speak for themselves.

And we are doing quite well in that particular dimension.

We are more than holding our own.

Now, the Flash strategy, frankly, I would come back to, what is exactly is it that you think they have that we don't?

We opened up early about our belief that the primary deployment of Flash in a storage system is in the form of a cache and we opened with that.

We saved ourselves going down some paths that didn't pan out for our competition and we turned it into an every unit item and a key differentiator for us.

So we were right on the technology, we were right on that strategy.

I think we executed well.

More broadly, Flash in the host, let's be really clear what our goal here is.

Our goal here is to bring things into the data management framework of Data ONTAP, so selling PCI plug-in boards at that level, we will do that if necessary, and we will partner with people to do that if necessary.

But our endgame here is that storage no matter where it lives, whether it be solid state or hard disk drive, wants to be part of the data management portfolio.

And clearly, you'll see other innovative for us going forward.

You've seen Flash Pools, which now has hundreds of customers and that's working out really well for us.

So for us I don't think that we are losing any business because of a Flash story because I don't see what a competitor has that we don't.

There will be more instantiations of Flash as time goes on.

You should expect us to participate in those.

And we expect Flash to be an integral part of the story and it will be a key for us, is integrated with everything else that we do to create a compelling data management that is enterprise-wide for the end user.

And I forgot what the last one was?

Oh, start-ups.

The start-ups are out there.

Not surprisingly, given NetApp's history and entrepreneurial culture that some NetApp people would go to those.

Some people need to scratch that start-up itch and I get that too and they are out there and we see them.

And we are fighting them aggressively.

But in the grand scheme of things, though, as we think about how the near to intermediate term plays out, winning and gaining share against a traditional market share players is really what is going to determine the trajectory over the next several quarters and that is really where our focus lies.

So we understand the little guys are out there.

We certainly have an understanding of what their strengths and weaknesses are and we are fighting them and taking them seriously, but it's really the major mature players, that's really where the battle is and that's where we intend to gain share.

Jayson Noland, Robert W. Baird.

Tom, you mentioned 200 cloud services now on NetApp.

I wanted to ask about cloud gateways, Microsoft bought StorSimple recently.

In this category, would NetApp offer a gateway and I recognize it's early days but your thoughts on Tier 2 data, et cetera, going off to the cloud on the back of a gateway?

Yes, let's start with the telco service providers, in general.

And probably a couple years now, we went out and we formed a vertical very, very field-focused team to focus on the telcos and the service providers as a fundamental strategy for us.

And part of that is to sell into those accounts as typical end users, but the other part is really to go after the service provider business.

In some ways that has a bit of a OEM feel in that you basically work a while to actually achieve a design in -- you have get design into their architecture, get design into their products that in parallel with their intellectual property development.

That eventually moves to a sell-through where actually they generate paying customers and the volume actually picks up.

And we are seeing some of that with the 200.

It isn't like they all happened last quarter.

They've been a long time in the process and now they are out in the market.

Some will be successful and some aren't but we are actually seeing material volume from quite a few of those and those are helping our business.

But the seeds of that business were sown quite some time ago.

I think that the work that we've done around creating a telco service provider vertical and field-focused team was really to set the stage for that early on and we are starting to see that result.

And it's a long lead time and fortunately we are patient enough to see it and we see some momentum there.

As far as the role of the cloud, I think that we are looking at all different types of options, whether it be back-up to the cloud, disaster recovery to the cloud, managing the hybrid cloud, some combination of on-prem, off-prem data, so there are a lot of models that are emerging including cloud gateways in the StorSimple case that you talk about.

I think it is safe to assume that the cloud will be part of the storage hierarchy of every major customer eventually.

I think it will be to varying degrees whether it be for proof of concepts or surging or archiving or back-up.

And being able to work with specific NetApp products and also with our service providers to bridge that with NetApp content on both ends is an actual part of our service provider strategy and is a big part of those 200 design wins that we talked about.

So I agree with you that the cloud gateways are going to be important but I think they are one of many integrations with the cloud to create a hybrid cloud for end users.

Rajesh Ghai, Craig-Hallum Capital

I wanted to follow-up on this answer and understand the strength in the telcos so as far the vertical that you earlier alluded to.

And related to the slowdown that we have seen in the [world] storage market in 2012.

With workload for the enterprise increasingly migrating to the cloud, are you concerned that the demand for the service provider vertical is not completely replacing the demand that may be lost on the enterprise side?

And also your association with the OpenStack Foundation, does that help you with that vertical, especially given that your top competitor is not involved in that right now?

Thank you.

Yes, I wouldn't say, as we look at the service providers and we look at the business that they are providing, I wouldn't say that, that is a direct siphoning off of our enterprise business in that direction.

I think if we were a dominant market share player, then there would be a conservation of storage and if it goes one place or the other.

I think that most of the service provider activity that we are doing is incremental to our enterprise business.

So I wouldn't make that linkage necessarily.

I think that overall, the amount of activity for our enterprise providers, particularly around traditional business applications is still primarily an on-premise activity.

If they look to the cloud, they are looking for proof-of-concepts, they're looking for speculative projects, they're looking for bursting of capacity, and to the extent that they're going to the cloud today, it's really around archiving and other types of things.

So for us that cloud is part of the hierarchy but I don't necessarily think it is draining off the NetApp workloads.

The NetApp workloads which have high I/O capability, those are going to tend to stay on-premise, at least in the big enterprises, at least today.

So, overall think that the service provider business is substituting some of the enterprise but I don't think it's anywhere close to a one-for-one or even worse than that, is actually generating some subtraction of capacity.

I just don't think that, that is the case.

As far as OpenStack, clearly, it is in our best interest as an ecosystem developer and also working with these other players, to embrace that technology and also to enable it.

NetApp has always been a standard space player and, as people build cloud services, if we can integrate tightly with that and enable them to accelerate to bringing their products to market, that make sense for us.

We can debate where OpenStack is in its maturity curve and how ready it is for primetime but I do know that a lot of the service providers and a lot of the co-development activity we are doing with service providers, a fair amount of it is in fact with the OpenStack framework.

Bill Choi, Janney Montgomery Scott.

Can you address the weakness in the direct business that we have seen in the past two quarters?

I found particularly interesting that you talked about building the pipeline with the direct.

Do have a much bigger confidence about the direct business coming back and is there any bigger, unusual backlog build that occurred here into the next quarter?

Thanks.

On the backlog question, no.

And backlog and all those things are calculated into the guidance we give.

One thing I would say about the channel is a substantial amount of our business that goes through the channel is demand created by our own people.

And probably the classic example of that would be our US public sector business.

So on the federal side, just about every bit of that business is actually fulfilled through a channel partner.

So that business is almost 100% channel yet in terms of the big transactions, our people are involved.

So I wouldn't associate the direct and indirect with touch and low touch.

We are involved in a lot of accounts.

We engage channel partners and our expectation for them is that they will take that help and ultimately leverage it in other deals where NetApp is not involved.

But large transactions, whether they get fulfilled or not through the channel, have a substantial amount of our own direct people here.

So in terms of weakness of direct, I'm not quite sure I would convey that terminology.

I don't think I would agree with that.

I will say that the big accounts, in general, are going to look like the macro overall, which is not that impressive.

So I think that the growth of the big accounts will tend to be slower than the rest of the business certainly in areas where we can do substantial channel expansion.

So overall, we are probably better covered in the big accounts, so therefore the coverage expansion there is probably not as great for us.

But on the channel I know that there are substantial numbers of accounts that are out there particularly in mid-size business that have no contact with NetApp or NetApp agents at all and that is one of the things we want to go after.

So, basically, I don't really necessarily look at much at the direct versus indirect business, I basically look at the performance of the individual accounts in the large account program and I look at the performance of our broad portfolio of accounts in mid-size business and that is more or less how I look at the business, independent of channel.

Thank you.

We have no further questions at this time.

I will now turn it back for closing remarks.

Thanks, everyone, for joining us.

Appreciate your time today.

Thank you, ladies and gentlemen.

This concludes today's conference.

Thank you for participating.

You may now disconnect.