NetApp F2Q09 (Qtr End 10/24/08) Earnings Call Transcript

Nov.13.08 | About: NetApp, Inc. (NTAP)

NetApp (NASDAQ:NTAP)

F2Q09 Earnings Call

November 12, 2008 5:00 pm ET

Executives

Tara Dhillon – Sr. Director Investor Relations

Daniel Warmenhoven – CEO

Thomas Georgens – President & COO

Steven Gomo – CFO

Analysts

Benjamin Reitzes – Barclays Capital

Aaron Rakers – Wachovia Capital Markets

Louis Miscioscia – Cowen & Co.

Louis Miscioscia – Cowen & Co.

Min Park – Goldman Sachs

Katy Huberty – Morgan Stanley

Shelby Seyrafi - Calyon Securities

Bill Choi - Jeffries

Mark Moskowitz – JP Morgan

Brian Freed – Morgan, Keegan & Company

Bill Shope – Credit Suisse

William Fearnley – FTN Midwest Securities

Thomas Curlin – RBC Capital Markets

Brent Bracelin – Pacific Crest Securities

Wamsi Mohan – Merrill Lynch

Chris Whitmore – Deutsche Bank

Alex Kurtz - Merriman Curhan Ford

Keith Bachman – BMO Capital Markets

Analyst for Kaushik Roy – Pacific Growth Equities

Clay Sumner – Friedman, Billings, Ramsey

Glenn Hanus – Needham and Company

Operator

Good day ladies and gentlemen and welcome to the NetApp second quarter of fiscal year 2009 earnings conference call. My name is Eric and I will be your coordinator for today. (Operator Instructions) I would now like to turn the call over to Ms. Tara Dhillon, Senior Director of Investor Relations; please proceed.

Tara Dhillon

Good afternoon everyone. Thank you for joining us today. Our call is being webcast simultaneously and will be available for replay on our website at www.netapp.com along with the earnings release, the financial tables and the reconciliation between the GAAP and non-GAAP numbers.

In the course of today’s call we will make forward-looking statements and projections that involve risk and uncertainty including statements regarding our financial performance in future periods, including Q3 of FY09, our expectations regarding future growth and market share and our expectations regarding our future headcount and tax rate. Actual results may differ materially from our statements or projections. Factors that could cause actual results to differ from our projections include, but are not limited to, customer demand for products and services, increased competition, and the material and adverse global economic market conditions that currently exist, particularly in the credit market. Other equally important factors are detailed in our accompanying press release as well as our 10-K and 10-Q reports on file with the SEC and also available on our website, all of which are incorporated by reference in today’s discussion.

We would also like to notify you that in accordance with SEC guidance published on August 22, 2008, NetApp will begin to disseminate material information about the company through our corporate website within the next several fiscal quarters. We intend to designate a separate portion of our website for purposes of these disclosures and will include a prominent link on our site to allow visitors to locate this information, which NetApp will routinely update. The website will supplement, rather than replace, NetApp’s current existing channels of information distribution.

Before we begin I would also like to highlight one administrative fact to clear up some confusion. Our current fiscal year does not include a 14-week quarter. Our fiscal Q3 ends on January 23 and our Q4 will end on April 24. It will be Q1 of FY10 that has 14 weeks, ending July 31.

With me on today’s call are Dan Warmenhoven, Chairman and CEO; our President and COO, Tom Georgens; and our CFO, Steve Gomo. Steve will review the second fiscal quarter financials and discuss our outlook for the third quarter of FY09, Tom will discuss our operations and our opportunities, Dan will share his perspective on the business and the market, and then we will wrap up with Q&A. At this point I’ll turn the call over to Steve.

Steven Gomo

Good afternoon everyone. Despite what has proven to be a more macroeconomic environment NetApp produced revenue and earnings within our previously targeted range. We are pleased with our performance on several fronts and remain optimistic about our prospects for long-term growth and market share gain.

That said, in the near term, the uncertain economic climate makes visibility and confidence of our pipeline less certain. Therefore, our focus will be on controlling the things we can control like gross margins and expenses, and returning to our target operating profit margin of 16% as soon as reasonably possible. Of course this is somewhat dependent upon future revenue levels.

But before we discuss the future I want to walk through our second quarter results. Please note that all numbers are GAAP unless stated otherwise. To see the reconciling items between non-GAAP and GAAP refer to the table in our press release and also on our website.

Total revenue for the second quarter was $912.0 million, up 5% sequentially and up 15% over Q2 of last year. FX effect decreased sequential growth by about 1.3% and improved the year-over-year growth by 1.5%.

Product revenue, of $570.0 million, was up 4% sequentially and up 5% year-over-year accounting for 63% of total revenue. Add-on software, which is a subset of product revenue, was 20% of total revenue. Revenue from software entitlements and maintenance was $153.0 million, or 17% of total revenue. Software E&M was up 6% sequentially and 30% year-over-year. Total software, the combination of add-on software and software E&M was 37% of total revenue compared to 36% in Q1 and 40% in Q2 of last year.

Revenue from services was $188.0 million and 21% of total revenue, up 7% sequentially and up 41% over Q2 of last year. Service revenues are comprised, primarily of hardware maintenance support and professional services. Revenue from the largest component, maintenance contracts, increased 6% sequentially and 39% year-over-year. Professional services increased 9% sequentially and 40% over last year.

Non-GAAP gross margins were 61% of revenue this quarter, up .3% from last quarter and in line with our expectation. Non-GAAP product gross margins were virtually flat. Non-GAAP service margins increased 46.7% as a result of higher professional services utilization this quarter. Non-GAAP software E&M margins were constant at 98.5%.

Turning to non-GAAP expenses, our operating expenses totaled $455.0 million, or 50% of revenue. Opex increased 2% sequentially and 24% year-over-year.

During the quarter headcount increased by 381 people on a net basis ending up with 8,380 employees. We accomplished our goals for hiring quota-bearing sales reps and we plan to keep that capacity in place. Given the current environment we do not plan to add any incremental headcount in the second half of FY09 and will consider replacement requests only on a case-by-case basis.

Also included in Q2 non-GAAP expenses are about $4.0 million in write-offs associated with our decision to cancel Accelerate, our first user conference.

This quarter, our GAAP income before tax includes the impairment of approximately $21.0 million in investments that had exposure to the lien and bankruptcy. Also included are the amortization of intangibles from acquisitions, net gains or losses on our other investments, and the effect of FAS 123R.

This quarter we also had a one-time reduction in our GAAP compensation expense as a result of a periodic review of the underlying assumptions in the Black Shoals formula. These assumptions were adjusted this quarter to better reflect our actual experience, creating a one-time catch-up which reduced our option expense compared to last quarter.

Non-GAAP income from operations totaled $101.0 million, or 11.1% of revenue, in Q2, at the low end of our projected range. Non-GAAP other income, which consists primarily of interest income, was $9.6 million. Non-GAAP net income, before taxes, was $111.0 million, or 12.2% of revenue.

Our non-GAAP effective tax rate declined slightly to 17% as a result of the Congressional extension of the R&D tax credit. The credit is retroactive to January of 2008 and in effect for two years. Our GAAP statements reflect the full impact of the retroactive portion of the credit while the non-GAAP statement reflects only the current portion.

We expect 17% to be our new non-GAAP effective tax rate going forward.

Non-GAAP net income totaled $92.0 million, or $0.28 per share. GAAP net income totaled $49.0 million, or $0.15 per share.

Now moving to cash flow performance, our cash flow from operations was $207.0 million, down 17% sequentially and down 9% from Q2 of last year.

Capital expenditures were down significantly to $27.0 million this quarter from $77.0 million last quarter.

Free cash flow, which we define as cash from operations less capital expenditures, totaled $180.0 million, up 4% sequentially and down 5% from Q2 last year. Expressed as a percent of revenue, Q2 free cash flow was 20%.

Turning to the balance sheet, our cash and investments totaled $2.3 billion. This balance excludes approximately $131.0 million of restricted cash related to our secured revolving credit facility. It also excludes about $69.0 million of auction rate securities which have been reclassified to long-term investments. The debt associated with our credit facility is $65.0 million and is classified as entirely a long-term liability. Approximately $1.1 billion, or 47% of our cash balance, is overseas.

The total deferred revenue balance increased $13.0 million this quarter to $1.58 billion, a 1% sequential increase and a 29% increase in the balance year-over-year.

Turning to DSO, accounts receivable day sales outstanding were 36 days compared to 45 days last quarter and 49 days in Q2 last year. Our collections were at the second highest level in our company’s history this quarter. Inventory turns were 18.3x this quarter compared to 21.7x achieved in Q1.

NetApp did not buy back stock in the second quarter. In the first quarter we achieved our objective of offsetting dilution from stock options and from all previous acquisitions. Given the uncertainty related to the economic environment we felt it was most prudent to conserve our available U.S. cash balances and keep our future options open.

Now before I turn the call over to Tom, I will discuss our outlook for Q3. Our outlook is based on current business expectations and current market conditions and reflects our non-GAAP presentation.

We are making forward-looking statements and projections that involve risks and uncertainty. Actual results may differ materially from our statements or projections for the reasons cited previously.

With reduced visibility caused by the recent changes in the macroeconomic environment, it is much harder to accurately predict a reasonable range for revenues in the third quarter. As a result we will not be providing specific revenue guidance, though Dan will share some thoughts about it.

What we can tell you is that we expect non-GAAP gross margins to hold at substantially the same levels as the second quarter and non-GAAP operating expenses to be roughly flat from Q2.

We have implemented several measures to reduce expenses, attacking both the discretionary and the structural elements of our operating expense deck. We will control hiring tightly and expect that attrition will reduce employee levels in the second half of the fiscal year.

We are also reviewing our capital purchase budget with the intent to reduce or postpone purchases and the associated depreciation stream.

Our diluted share count is expected to remain essentially flat in the third quarter depending upon the stock price.

Our primary focus going forward is to return to our targeted 16% operating profit margin as quickly as reasonably possible. We will, of course, somewhat dependent on future revenue levels.

With that, I will turn the call over to Tom for his operational update.

Thomas Georgens

NetApp performed well on several fronts this quarter. We continue to grow in the face of a more challenging economic environment, our SAN business had a great quarter, EMA was quite strong, and our indirect channel business set a new record.

At the same time, internally the NetApp team worked quickly to implement expense reductions, allowing us to rapidly respond to the changing economic conditions. We streamlined our expense structure in several areas, without compromising our ability to continue to gain share.

Going forward we will monitor the climate and its impact on our pipeline to make sure our actions and our expense levels match what we see unfolding. Our focus will be on increasing our operating margin. I will go into this in a little more detail shortly, but first I will view the highlights from the second quarter.

In Q2 EMEA contributed 32% of revenue, up 23% over last year. Asia Pac was up 3% year-over-year to 11% of total revenue. The Americas contributed 57% of revenue, up 13% year-over-year. Within the Americas the federal team had a record quarter contributing 16% of total revenue.

The indirect channel also achieved a record 67% of revenue primarily due to increase in business from federal and our distributors, Arrow and Avnet, growing to 21% of revenue with Arrow at 11% and Avnet at 10%. Our continued channel momentum is a result of investments of the channel and quota-bearing reps we started over a year ago. IBM was 4% of revenue this quarter.

On the product side total stores system units shipped were up 20% year-over-year as we continue to install more footprints and acquire more customers.

Entry-level units were up 45% and high-end units were up 16%. Our new mid-range product family, the 3100 Series, showed solid traction this quarter but has not yet fully offset the shift that occurred from the older 3000 Series to the newer 2000 family. Though down modestly year-over-year, revenue from the mid-range still represents over 50% of systems revenue.

The rapid expansion of our entry-level offerings is an indication of continued new account penetration, particularly through our indirect channels. We gained over 600 net new customers this quarter, mostly in mid-size enterprise accounts, but we were also gaining new Storage 5000 customers at a higher rate than at the last three years.

From a protocol perspective, orders with a fibre channel SAN, or ischemic component, totaled 43% of our bookings this quarter, up from 40% last quarter, with 33% including fibre channel and 16% including ischemics. 6% of those orders had overlap which included both protocols.

We are also seeing strong acceptance and interest in our SAN screen offering acquired earlier this year, as customers think to plan, optimize, and manage complex SAN environments.

Overall, the strength of our SAN business is driving by continued share gain in virtualized server environments, increased contribution from our federal business and our timely storage efficiency story which has seen no meaningful competitive response from the traditional architectures offered by the incumbent vendors.

NAS protocols were present in 61% of our storage bookings. Our GX operating system continued its expansion beyond typical high-performance computing environments into the automotive and federal sectors this quarter. This pipeline continues to grow and we remain on track to release our first converged operating system in calendar 2009.

To drive even more business on the virtualization front, in Q2 we announced a 50% guarantee initiative. Basically we are guaranteeing that customers will use 50% less storage with NetApp in virtualized server environments than they would with competitive storage products.

This quarter NetApp was named Citric Solution Partner of the Year for our virtualization capabilities and support.

We continue to roll out compelling examples of how the combination of NetApp storage efficiency features and our world-class SAN products produce best-in-class results. As evidenced, our V -Series platform had its best quarter ever as customers are using this solution to achieve greater utilization and functionality from their existing traditional EMC, HP, and Hitachi infrastructures. The V-Series is a great vehicle to introduce the value proposition of our software without requiring the customer to replace their current hardware.

We have now completed our roll out of de-duplication across our entire portfolio with the recent announcements of availability on the V-Series and our virtual tape library, or VTL.

Even before the de-duplication availability our VTL business enjoyed its second largest booking quarter ever on the strength of its other product attributes.

Our de-duplication continues to be the most rapidly adopted feature in the history of the company with over 7,600 more licenses downloaded this quarter and nearly 21,000 licenses to date.

Our professional services business also continues to outperform the overall company growth. As Steve mentioned, professional services grew 40% over Q2 of last year and at the same time our service margins increased.

Despite a difficult environment our large customers are still spending on technology and process improvements to drive lower costs in the future. They are increasingly turning to us for mission-critical application solutions and on-site administration. Our professional services team is integral to this activity, which is driving customer loyalty and increasing utilization rates across our services organization.

While we feel good about our competitive position, with the storage efficiency story being particularly timely, the overall environment merits considerable caution. The build out of our sales force, which we described at analyst day, is essentially complete. And we believe we have plenty of capacity in place to achieve our previous growth objectives when we return to a more environment.

With the build out complete, we have now curtailed headcount growth, we have eliminated most discretionary spending like travel and entertainment, we are reducing the size of our contractor Flex force, and we have reduced our capital spending plans in product development and IT.

Our focus in this uncertain environment is managing expenses, both above and below the gross margin line, to allow us to rapidly return to our operating model with more cautious revenue expectations.

After our extended period of rapid expansion the past few years, this should be achievable without weakening our long-term value proposition.

Despite our renewed emphasis on expense containment, we have not in any way relented on our objective to continue to gain share independent of overall market growth rate. Messages we delivered at analyst day around server virtualization, Ethernet storage, disk space back up, and storage efficiencies still play to our strength.

In this environment storage efficiency is particularly relevant. At Oracle Open World in September I shared with an audience of over 5,000 IT professionals the benefits that Oracle itself has realized using NetApp. Oracle runs nearly their entire company-wide infrastructure, over 700 machines, using both SAN and NAS on NetApp storage. They have been early adopters and co-developers of technology like thin provisioning, Flex cloning, and de-duplication.

As they transition from other vendor storage they have moved their storage efficiency from less than 40% utilization to over 90%, thereby cutting the unit cost of storage in half. In this difficult environment I have yet to meet a customer that did not want to hear more about this story.

To wrap up, I will echo Steve’s comments that it is very difficult to forecast the future in this environment, therefore, our focus is to leverage the investment we have already made in the field and strain expenses as much as possible and to continue to gain share.

With that I will turn the call over to Dan.

Daniel Warmenhoven

Looking at our business going forward from a very broad perspective, there are two opposing forces at work right now, one of which we control, and the other one we don’t.

The one we control is the amount of sales capacity we have added combined with the value proposition that we offer. At historical productivity levels, we have the sales capacity to deliver a billion dollar revenue quarter in Q3.

In addition, we have a value proposition around storage efficiency that is very powerful in budget-constrained environments. In normal times we would expect to achieve significant growth.

The opposing force is the global economic situation. It is very difficult to predict the depth and duration of the downturn. The uncertainty around customer IT spending intentions reduces our confidence in the validity of our pipeline. Therefore, we do not have the normal forecasting basis to provide revenue guidance for Q3 or beyond. We can only share with you the factors that will influence it.

Perhaps the best way to portray our situation is to contrast it with that of Cisco, which announced last week. Cisco said that their bookings in October were down from the prior year. Our bookings in October were higher than last year. Unlike Cisco, we have just completed adding some significant additional sales capacity which should drive growth. And also unlike Cisco, we are not share-limited in our markets and we currently have the strongest value proposition in our history.

Given these facts, we are slightly more optimistic than Cisco about the future. Our best guess is that Q3 revenue will be flat to slightly up from this past quarter. Given the high degree of uncertainty in that guess, we do not feel it would appropriate to provide an EPS forecast.

What we can give you is our commitment to keep our expense levels flat in the third quarter and to work on returning to our target 16% operating model and to get our message out to more customers about the unique NetApp value proposition. The path back to the business model is one of tight expense control and modest revenue growth.

Our strategy has not changed. We have confidence in our long-term growth prospects as well as our ability to gain market share. We will manage the business prudently while working to preserve the investments in place to maximize our ability to come out stronger on the other side of this current economic situation.

On behalf of the NetApp team I thank you for your support and your interest in NetApp. At this point I will open the floor to questions. Please limit yourself to one question and then return to the queue so we may address everyone in the allotted time.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Benjamin Reitzes – Barclays Capital.

Benjamin Reitzes – Barclays Capital

Dan, maybe if you could talk a little more about your order trends in October. You said they were up and that your best guess is flat. As you were talking here, Intel and other big bellwether dropped guidance quite a bit. These are two big companies and I’m wondering if perhaps do you feel like there is a possibility you could be on a lag or do you think you are finding out things in the same real time that these two big juggernauts are and if you could just kind of talk more about your orders throughout the quarter and just how you came up with your view that your best guess is you’re flat.

Daniel Warmenhoven

August was actually up pretty good year-over-year. It was pretty strong. I think we saw the effect of the initial sales capacity coming on board. September really softened up. Right after Layman Monday, things kind of just stopped. And then a recovery in October. October we were up about 7% or so year-over-year.

And again, I think this is the effect of lots of new sales capacity in the field. That’s why I drew the contrast to Cisco. We have added a significant amount of new capacity. We were driving for north of 15% year-over-year growth and we have completed that build out, which started in basically February of this calendar year, even before our fiscal year started.

And those people are now becoming productive and you saw that also in the new account list, over 600 new accounts. So our view is that we can continue to grow. And again, like I said, the pipeline is substantial, the capacity is substantial. What we don’t know is how the techs are convert to revenue.

I think we are in a transitional phase in terms of customer buying patterns. Most of our customers, as I’m sure you know, are not going to re-budget for the last two or three months of this year. And so there is a lot more ambiguity about what’s actually going to get approved through capital purchase committees and so on.

I don’t think we’re going to know exactly where we are until after we see their budgets get put together in January or so. I think our biggest risk this quarter is actually January. I think we will do well in November and I think we will do well in December. I don’t know if we will see some year-end budget flush. But January for us is always hard. I think it’s going to be particularly hard this year as customers try to close their budgets.

And keep in mind, our fiscal ends actually January 24, a week before the month ends. And that’s really pretty early for customers to have budgets in place and execute on it. So it’s lots of puts and takes.

The thing to me that really gives us a lot of hope for our future, even after this quarter, is the amount of that new capacity that’s in place.

Operator

Your next question comes from Aaron Rakers – Wachovia Capital Markets.

Aaron Rakers – Wachovia Capital Markets

I guess building on Ben’s question there and the commentary around capacity, as you look at what you laid out at the analyst day with regard to headcount growth and now noting that you are effectively done, I guess I am trying to understand why if we see some modest sequential growth going into January and then think about a seasonal April quarter why we couldn’t think a 15%+ op margin is doable. Are there still some fixed costs that are rolling into the model that you can help us understand?

Daniel Warmenhoven

It is possible. I don’t want to guide you to it, but it is certainly possible. Basically we are scaled right now. If you do some round numbers, a billion dollars of revenue with 61% gross margin and $450.0 million of expense yields a 16% operating income. So the question is how do you get to a billion dollars in revenue and that recovers the model.

If we grow 3% sequential, it occurs in three quarters. If we grow 5% sequential, it’s there, as you forecasted, in Q4. You pick the growth rate. I don’t think we are in a position to give you any specific number for what that growth rate is going to be.

But I think we feel as though we have kind of hit the floor, that the initial capacity should push for any downside and now it’s just a question of how fast can we push it up.

Aaron Rakers – Wachovia Capital Markets

And what is your function around attrition rate as we go into the back half of the year?

Steven Gomo

We have traditionally run just north of 10 as a company. With the downturn in the economy we have actually seen a reduction in that.

Daniel Warmenhoven

In the last downturn we actually had one quarter where we had no departures from the company.

Steven Gomo

So it’s softened dramatically. Right now we are anticipating something on the order of net 4% type of thing but we’ll have to see. That could change.

Operator

Your next question comes from Louis Miscioscia – Cowen & Co.

Louis Miscioscia – Cowen & Co.

I’m not sure if you are willing to go out this far, but as we look to 2009 why wouldn’t we unfortunately be in a really tough situation, that companies really start to pull back as the horribly ugly macro environment makes them really pull in their horns here.

Thomas Georgens

I think all of that is certainly possible. At this point, if we look at the trends, clearly we survived a very difficult September and October rebounded, probably to a greater degree than some other people. But I think Dan put it right in perspective, I think a lot of budget is still in place, I don’t think people went through a long complicated process to recast their budgets just for the final two months of the year. So the concern is what will January look like, will that be new budgets, will it be resolved early in the year.

So I think there are a number of factors in play and I think the macro is going to be a very difficult thing for us to predict. I think we made that clear in this call. But our focus is market share. Market share has no context. Up market, down market, we believe our competitive position around storage efficiency and around server virtualization, some of the other items, are opportunities for us to take share. And as long as there is an opportunity for us to take share, particularly with the added capacity we brought on board, then I think there is an opportunity for us to outperform.

But in terms of the aggregate market growth rate, I don’t know that any of us feel confident to really make any claims as to where that’s heading.

Operator

Your next question comes from Min Park – Goldman Sachs.

Min Park – Goldman Sachs

There has been a lot of anecdotal data coming out, that tightening credit may be hampering channel sales to a certain degree. And given your heightened emphasis on indirect business, have you experienced that in your own business and do you have any plans to help on the credit side to facilitate sales going forward?

Daniel Warmenhoven

Most of our channel sales are through fairly well capitalized distributors such as Arrow. I think Arrow was 11% this quarter. Avnet was 10% this quarter. IBM, Fujitsu Siemans, the U.S. federal guys are all the systems integrators like Lockheed Martin and Northrop Grumman. I mean these guys have big balance sheets, they don’t need the help.

In fact, that’s actually why there in place. Arrow and Avnet take the credit risk for the downstream resellers.

So no, I don’t think we have got any issues that way at all.

If anything, we will see some issues on the international reseller side. Last time when the Asian currency crisis hit, we extended them some extended terms, or we looked past their creditworthiness is maybe the way to put it. And put that in deferred revenue or basically hung it up on the balance sheet until they were able to pay.

But that’s the only case I can think of and that’s not going to be very wide spread.

Operator

Your next question comes from Katy Huberty – Morgan Stanley.

Katy Huberty – Morgan Stanley

How do you match up the comments that October rebounded with a meaningful drop in receivables at the end of the quarter, with linearity within the months or were you collecting faster given the environment?

Steven Gomo

I mentioned that we had the second highest level of collections in the company’s history and if the collection folks are listening, congratulations. We really knocked the ball out of the park this quarter. So you combine super collections with relatively slower growth, substantially slower than we have seen, obviously over the past couple of years, and you get to a situation where you can drive your receivables down and that’s exactly what happened.

Operator

Your next question comes from Shelby Seyrafi - Calyon Securities.

Shelby Seyrafi - Calyon Securities

I guess I want more color on your path to higher operating margins. You talked about the math being one billion in revenue with the constant gross margin in the $54.0 million or so in opex getting you there. It does work, but won’t you need to add sales people to get your revenues to $1.0 billion? How much of your opex is variable versus fixed?

Daniel Warmenhoven

It’s 45, $450.0 million, 45% I believe is the number in opex, it’s not $54.0 million as you stated. And sales capacity is something that grows over time, assuming you don’t have turnover in the sales force. A lot of people we just added are climbed and got through a productivity curve. If we hold constant right now they will gain the additional capacity of about 10% over the next two to three quarters. And what you will see is that total capacity will continue to increase.

So no, we don’t need to add any more sales people to achieve. Basically we were staffed to achieve a plan that had us well over $1.0 billion by Q4. We’re at basically $1.0 billion of capacity at Q3 and like I said, they will continue to become more productive as time goes on.

Steven Gomo

I want to add that we haven’t terminated our program to hire these quota-bearing reps. We basically completed the plan that we began before analyst day. So I don’t think the question is at all capacity it is really a question of productivity in this environment. Under normal environments we have the capacity to meet a plan that we had already set in place for analyst day in our internal forecast.

So at this point capacity is not going to be our issue it’s going to be productivity and what is the customer behavior going to look like.

Steven Gomo

I want to be clear, we didn’t terminate the capacity-building program in midstream. We actually completed the investment that we said we were going to invest in at analyst day.

Operator

Your next question comes from Bill Choi – Jeffries.

Bill Choi - Jeffries

Can you provide your typical revenue by vertical and discuss whether the pipeline uncertainty you are seeing is really any particular vertical and related to that you had $1.7 in allowance for doubtful accounts. Did you adjust that as far as that increase?

Daniel Warmenhoven

While Tom is getting the vertical numbers I want to comment on our vertical mix in a very high-level sense. Some of our verticals are not cyclical, like governments, telecos, health care. Some are more exposed to the macroeconomic environment. Certainly the tech sector which is heavily consumer-based these days with companies like Invidia and TI, etc. They are building largely components for consumer products. Certainly the financial services, which we’ve talked about in the past has been under some degree of stress. Automotive and major manufacturers, we haven’t heard any good news there lately.

But the point is it’s not 100% cyclic. A lot of our business comes from verticals like teleco and government that have a tendency to keep on front layer pads independent of macroeconomic business cycles.

That said, let me turn it to Tom. He has the verticals for you.

Thomas Georgens

In terms of the numbers, we talked about in the prepared text about government at 16%, financial services at 12%, overall tech at 13%, and those are the big hitters. Telcomm at 8% and then the other ones are basically low single-digits.

Bill Choi - Jeffries

And the doubtful account part?

Steven Gomo

We had just about under $2.0 million allowed for doubtful accounts this past quarter.

Bill Choi - Jeffries

Where was it? That’s obviously a sudden increase there. Can you talk a little more about it?

Steven Gomo

That was Lehman. Lehman was a customer.

Operator

Your next question comes from Mark Moskowitz – JP Morgan.

Mark Moskowitz – JP Morgan

I had a question in terms of the sales force build out. You have completed it and done a nice job there. But just curious, what type of stop do you have in place in terms of preserving your gross margins in this tough time. You’ve got a lot of folks on the ground that want to get out there and sell, what type of IT systems and theorems do you have in place to kind of keep the price protected?

Daniel Warmenhoven

The methodology is built into the approval process for any kind of discounts. The best example I can give you is take a look at what happened after the bubble burst back in 2001 and 2002. I think the gross margin fell one quarter to 58%, mostly because of volume-related effects. Then it bounced right back over 60% the next quarter.

It’s a very strong discipline in the sales organization to basically sell value. And that’s reflected in the margins. It’s obviously propped up by the software mix.

But when you look at the cost per gig of a basic system from us, it is extremely competitive with a bare-bones system from anybody else. So there’s not a need to discount that a lot. And there’s not a lot of margin to take it out of anyway.

All the real value is in the software and that’s a question of how much the customer is going to buy. And that’s all fairly proprietary; it only works on our systems. All together, the model seems to work. There are multiple layers of approval throughout the sales organization until you get to five layers up for a deep-discount deal and it keeps the discipline in place.

Operator

Your next question comes from Brian Freed – Morgan, Keegan & Company.

Brian Freed – Morgan, Keegan & Company

You continue to generate great free cash flow. I think you said it was 20% of revenue this quarter and historic getting 20% to 23%. Looking forward do you think that’s a sustainable percentage of revenue to drive to the free cash flow line or do you see a material change in that?

Steven Gomo

A lot of that obviously depends on revenue levels and profit levels which we are really not talking about at this point in time. You can expect that we are going to be a net cash generator and the only question is how much we are going to generate and that’s going to depend on business volumes and profitability.

Brian Freed – Morgan, Keegan & Company

Do you have a target?

Steven Gomo

Not that we’re sharing.

Operator

Your next question comes from Bill Shope – Credit Suisse.

Bill Shope – Credit Suisse

Off of that question, how should we think about the sensitivity of the deferred revenue portion of your cash flow? Do you think looking at the environment now, if it gets worse do you think you would see significant incremental pressure on that component of cash flow as users potentially buy systems with less software and services content?

Steven Gomo

I think what you are going to see is that it is going to be tied somewhat to the growth rate of our overall business. It tends to be highly correlated with our invoicing and base level of business. If the base level of business picks up you’re going to see deferred cash pick up.

Over the long haul, as we look forward, I would expect that our free cash flow will be 20% or north, when viewed as a percent of revenue. And we may have a quarter or two where we don’t hit that but over the long haul I think certainly we have the capability to deliver those kind of results.

Operator

Your next question comes from William Fearnley – FTN Midwest Securities.

William Fearnley – FTN Midwest Securities

Dan, in the past you have said you need to get yourselves into more deals so you can transfer the win rates into more opportunities. Are you getting more pitches to hit in terms of quoting proposals? Are there any significant changes in your win rates and/or share gains here? I mean, are you getting the pitches to hit, in terms of proposals and the decision cycles are being stretched out?

Daniel Warmenhoven

If you look at some of the metrics we look at, such as the new account activity, pipeline associated with new accounts, things of that nature, you have to conclude, yeah, we are getting more opportunities to participate. The feedback from the branding and awareness work we’ve done is that more of our potential customers are aware of NetApp so they are contacting us. There are more unsolicited hits on the Web, more EBC visits, our Executive Briefing Center visits. There is just more activity.

That said, it’s very hard to determine how that is going to translate. Our pipeline is basically is at an all time high and there is a higher percentage of that pipeline which is coming from what we would classify as new accounts. The thing we don’t have a good handle on is conversion rates.

I can tell you that last quarter our win rates, against the key competitors, actually improved. But we’re still not getting enough deals. The next question you’re going to ask is why did HP do so good? My answer is we don’t compete with them all that frequently. They’re doing a lot of bundled deals in the channel, it’s hard to intercept them.

And that’s really the issue. We have to get into more of those. And it’s not just a question of big deals that customers send our way, it’s also a lot of flow through the channel.

Thomas Georgens

From the new customer account perspective, we talked about 600 new accounts in the first half of this fiscal year. The percentage of our bookings coming from NetApp accounts is higher than it’s ever been before. Even our acquisition rate in the Storage 5000 has been modestly better than the last three years. We are clearly at higher growth rates but we are actually acquiring customers at a faster rate today.

So the new customer acquisition part of the equation I think is actually the good part of the story. The growth rate in some of the larger accounts, particularly in the financial services side, when you’ve got the big accounts growing at a very slow rate or roughly flat, clearly that drags on the overall number. But if we had some modest performance level or historical performance level from the large accounts, the ones where we are deeply penetrated, I think the growth rate would be quite strong.

So overall, the new customer account part of the equation here, I think is actually the thing that gives us the most optimism.

Daniel Warmenhoven

I do want to point out that in the period that occurred in 2002 and 2003, and we think it is starting to occur again, we got an opportunity to get into more new accounts during that period than ever before. And the reason was because the customers were open-mined to considering new alternatives.

When things are going good the focus of the customer on scaling and new apps and build out, it’s not a time to change your infrastructure vendors. However, when times get tough and the focus turns to grinding down the cost structure, you’ve got to do more with less budget, that’s the time when they start really thinking about can I do this with a more cost effective solution.

And that’s when they open the door us to actually demonstrate what we can do. So we’re actually pretty optimistic that new accounts are going to be a big piece of the game going forward. And as those rebound, we think when this recession finally ends and things turn up, those will fuel a significant growth rate again.

Thomas Georgens

Just to pile on on this point, is that the new customer account activity has been substantially on the SAN side of the business. The SAN side of the business was particularly robust last quarter. And the storage efficiency, that server virtualization part, is clearly there. But I think the storage efficiency story in particular resonates against the really large infrastructures. And as a result it’s actually the SAN environments that are really attaching to the story at a higher rate and the SAN part is clearly the fastest growing component of our business right now.

Operator

Your next question comes from Thomas Curlin – RBC Capital Markets.

Thomas Curlin – RBC Capital Markets

On the international side, I’m just curious what you’re seeing in terms of the demand trend, international versus North America. North America has been weakening for a while, but what do you see in Europe and Asia?

Thomas Georgens

In Europe we just came off a pretty good quarter. We actually grew over 23% in Europe. I think there’s a mix of factors in play. Certainly we’re very strong in the U.K. and Germany. There are other parts of Europe which are relatively new to us that represent, not quite greenfield, but certainly growth opportunities to gain share where we have less share than we have in the aggregate.

So I think some slowdown in some of the larger economies, the impact of the Euro, in terms of budget capacity, I think those are clearly weighing us in one direction, but there are also a lot of countries in Europe where we have not had a strong presence that we are actually growing quite well in.

So on balance Europe is doing okay but I think the large economy growth rates are clearly just as they are in the U.S.

Operator

Your next question comes from Brent Bracelin – Pacific Crest Securities.

Brent Bracelin – Pacific Crest Securities

Dan I wanted to follow up on the demand side, I appreciate the benefit of increased sales coverage, but what are you generally hearing from some of your larger enterprise customers? Are they asking for better pricing? Are you seeing them place smaller purchase orders? Obviously you had some large enterprise customers that you saw a slowdown for the last year. Have you seen them come back? What is your general sense in how long they can defer spending on storage? Is it 6 months, 12 months, 2 years?

Daniel Warmenhoven

It’s all over the map to be honest with you. This is quite a different period than it was roughly 6 years ago when the bottom fell out after the bubble burst. At that point there was a significant amount of unused or excess capacity in the storage infrastructure in most large accounts.

Now over the last roughly five years, most of those have turned to some form of storage on demand model whether it be purchases every quarter or whether it be a lease kind of arrangement where they just add to the lease or whatever it is. Typically the capacity they acquire is scaled to match their needs. So my guess is there is very little excess capacity installed in general and also in general, most of them are going to continue to purchase on a metered basis.

I think the real variable in this forecast going forward is to what extent do they continue into what I would consider re-engineering of their infrastructure, whether it be through server virtualization or re-engineering back up where they use secondary storage instead of tape or whether they push for more replication strategies for business continuity. That’s the thing that generates incremental demand.

So I think the underlying demand for basic primary storage is going to stay pretty constant. This is still a consumable. You fill it up, you need some more.

But that is not the big driver of high growth. The big driver of high growth lately has been secondary storage and that’s the big unknown. We don’t know whether customers are going to keep pushing for rapid ROI projects like eliminating tape or whether they’re going to sit still.

I will tell you another one that really gives us great optimism is this server virtualization. It has got typically such a fast ROI that we think that’s actually going to gain momentum and will really play to our strengths. So I personally think we’ve got the best server virtualization, complementary storage infrastructure around.

Thomas Georgens

I kind of see two dynamics at play. One of them is where you started the question and that is how are they going about satisfying their incremental demand, and I think they are satisfying their incremental demand as close as possible to actual utilization rates as they possibly can. So relatively small incremental purchase, the minimum necessary to get by, and they are basically looking one quarter at a time. And I think that is going to generate one level of growth rate.

The other dynamic that is significantly at play is that a lot of firms that are out there that realize that their budgets are going to be perpetually less than what they used to be and are looking to fundamentally lower the cost of their infrastructure. They have done large server virtualization projects which have changed the economics of their server infrastructure and they are looking aggressively at doing something similar on the storage side.

So the scope of those, the complexity of the transition, the times of ROI are all factors at the speed of which they go ahead, but the number of people that are looking aggressively, particularly resonating around our storage efficiency story and the ability to cut their cost of storage dramatically is really people taking a long term look.

So in addition to satisfying incremental demand, I think a big part of our story going forward is really getting customers to take a hard look at their broader existing infrastructure and plan to ultimately swap that out to get to a much lower operating cost place and I think NetApp can help with that a lot. And that might actually be our biggest opportunity through this downturn.

Operator

Your next question comes from Wamsi Mohan – Merrill Lynch.

Wamsi Mohan – Merrill Lynch

Can you comment at what level of revenue growth will you look for managing costs beyond the hiring freeze and everything you normally do in the course of your business. So if the market really struggles over the next year or so and there is actually year-over-year declines in revenues would you still try to maintain similar to increasing operating margins? How do you think about your costs in a real worst case scenario?

Daniel Warmenhoven

It is very difficult to speculate without having some having some more specific question about what you expect the revenue level to by. You just asked a question anywhere from modest growth to decline. I gave you the modest growth scenario. We are going to scale into it. But beyond that scenario, then we would have to stop and reassess and make the determination at that time. But it would be wild speculation at this point to make any kind of comments about how we would react in such a speculative question.

Operator

Your next question comes from Chris Whitmore – Deutsche Bank.

Chris Whitmore – Deutsche Bank

I know you typically don’t comment on backlog but given the uncertain environment can you give any color at all as to the backlog you built, or didn’t build, during the quarter? What does the backlog look like heading into fiscal Q3? And relatedly, what kind of conversion rate on the pipeline is built into that flat to up expectation for revenue going forward?

Daniel Warmenhoven

The backlog is a little better than it was coming into Q2. That’s all I am going to say about that one. It’s not depleted, it’s actually up a little bit.

The conversion rate is not even so much on the pipeline, it’s a question of productivity, total capacity. The pipeline at the start of the quarter is a leading indicator but all these deals that are done in 30 or 60 days are not in that initial pipeline. So you really have to look at total productivity available and typical based line of productivity rates. And at that point you can conclude well, you’ve got the capacity for over a billion.

Another question is what is the discount you take for decreased productivity as a result of either customer push outs or reduced spends or whatever it may be. And that is very hard to determine. It’s actually that point that kept us from giving a firm revenue guidance forecast for this next quarter.

Operator

Your next question comes from Alex Kurtz - Merriman Curhan Ford.

Alex Kurtz - Merriman Curhan Ford

Another look at the demand issue. Is the lack of near term visibility specific to the customer segment, meaning are you seeing more pain or weakness among your top enterprise accounts versus say mid-size enterprise or is the pain being felt across all segments?

Daniel Warmenhoven

I think it’s across all segments. I think we have more opportunity in mid-size enterprise. We’ve got more channel capacity focused there at this point and I think we are getting greater contribution there. But I think everybody is feeling the pain pretty much equally.

Thomas Georgens

I think the mid-size enterprises, there are just more of them and so therefore it’s a lot easier diversified way. You get some of the large top enterprise accounts and they represent substantial amounts of our revenue and you know the financial services as well as anybody. If they’re not spending it’s hard to make that up with a bunch of other accounts.

So clearly the drag on our growth right now is not our new customer performance, it’s actually some of our large top enterprise accounts, particularly in some of the verticals that Dan talked about earlier that appear to be feeling a lot of pain.

Operator

Your next question comes from Keith Bachman – BMO Capital Markets.

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Keith Bachman – BMO Capital Markets

I wanted to see if you could talk about regardless of scenario, how you see the distribution of revenues between the categories of product software and systems. This quarter products was weak but off a tough comp. Just wanted to try to understand how you see that relationship going forward, at least for the next quarter. And does FX have a different impact on the different line items?

Steven Gomo

FX does have a slightly different on the different parts of the revenue lines. Impacting the non-deferred stuff would be recognized in the period obviously is the key difference. In fact, as we move forward, if you look year-over-year we actually were aided by FX this quarter, on a year-to-year comparison. If you move forward one quarter we’re going to find a head wind in FX because of the big changes we have seen, particularly in those last three weeks of October.

As far as our product mix, given we’re not projecting any revenues for it, it’s kind of hard to comment about. I wouldn’t be expecting any significant changes in mix from we are this past quarter. We may see some slight shift but I don’t know of anything that’s going to change things dramatically.

Thomas Georgens

I don’t see any big mix changes either. I think this quarter we had sulfur up a little bit as a percentage of the revenue, we had services up a bit as a percentage of the revenue. But I don’t see any big changes. Clearly, as we go into the end of the calendar year, it’s IBM’s fourth quarter so I would expect some more activity from IBM. It’s a traditionally strong quarter for Europe. But I don’t expect it be anything that is going to significantly alter the model, as a result of what we’re seeing in the macro economy.

Operator

Your next question comes from Analyst for Kaushik Roy – Pacific Growth Equities.

Analyst for Kaushik Roy – Pacific Growth Equities

Considering EMC and [inaudible] grew more than 40% in the last three quarters, are you expecting to grow revenues two times the market growth rate for storage systems? And maybe you can comment on what kind of currency head winds you are expecting in the January quarter. Are you doing any kind of currency hedging?

Thomas Georgens

As far as the multiple of the market, I think philosophically we are clearly there. When the market is growing single digits, twice as much isn’t that impressive. Likewise if the market declines we don’t want to shrink twice the rate of the market. So our objective here is clearly on market share. In the first calendar of this year we passed IBM and HP for the first time to be number two in revenue market share and we want to exit this year as the clear number two.

As long as we are continuing to gain share than I think the fundamental business is healthy regardless of what the macro does. So I would say that number is very close to zero, the multiplier of the industry growth rate might not be quite so relevant but philosophically the focus on market share remains just as intense and our likelihood of achievement is just as strong now as it was on analyst day.

Steven Gomo

With respect to currency, yes we do hedge the currency and that is always netted into the number that I provide for you. If the currency stayed right where it is today, we would probably see something on the order of a 2% year-over-year headwind with respect to foreign currency.

Operator

Your next question comes from Clay Sumner – Friedman, Billings, Ramsey.

Clay Sumner – Friedman, Billings, Ramsey

Last quarter we talked a bit about software as a percentage of system revenue and you were talking about how last quarter you had strong new customer acquisition, traditionally new customers start I guess with one application and relatively low software attach rate and then grow over time. You had another quarter of strong new customers but can you share any metrics or talk about if you are seeing that traditional software-richening over time with the more seasoned customers?

Thomas Georgens

Certainly we have seen in this quarter attach rates of some of our software products increase a little bit. We actually saw, certainly within the bounds of normal variability we saw our software as a percentage of total revenue go up a little bit. So I would say that what we talked about last time we clearly see. And I see it in the attach rates, I see it a little bit in software moving, but I wouldn’t say it’s a dramatic move but I would say we haven’t seen anything different this quarter that would be inconsistent with what we said last time.

Operator

Your next question comes from Glenn Hanus – Needham and Company.

Glenn Hanus – Needham and Company

On gross margin, can you talk about puts and takes on the gross margins here that getting to flat, are you looking for product margins to be flat this quarter. Last quarter you were impacted by the mix towards the lower end and some lower volumes. Any color around that?

Steven Gomo

If mix and everything else were to stay exactly the same is it was in Q2, you would end up with the same type of margins. We are not making any projections about any mix shifts here, we are just saying that things are going to look pretty much similar to what we saw this quarter. There is no other puts and takes going on here.

Operator

There are no further questions.

Daniel Warmenhoven

Thank you for joining us and we look forward to doing the same again in 91 days.

Operator

This concludes today’s conference call.

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