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NetApp Inc. (NASDAQ:NTAP)

F2Q10 Earnings Call

November 18, 2009; 05:00 pm ET

Executives

Daniel J. Warmenhoven - Executive Chairman

Steven Gomo - Chief Financial Officer

Thomas Georgens - President and Chief Executive Officer

Tara Dhillon - Senior Director, Investor Relations

Analysts

Mark Kelleher - Brigantine Advisors

David Bailey - Goldman Sachs

Mark Moskowitz - JP Morgan

Keith Bachman - Bank of Montreal

Aaron Rakers - Stifel Nicolaus

Kaushik Roy - Wedbush Securities

Kevin Hunt - Hapoalim Securities

Brian Marshall - Broadpoint AmTech

Troy Jensen - Piper Jaffray

Katie Huberty - Morgan Stanley

Ittai Kidron - Oppenheimer

Ben Reitzes - Barclays Capital

Bill Fearnly - FTN Equity Capital

Paul Mansky - Canaccord Adams

Bill Shope - Credit Suisse

Brent Bracelin - Pacific Crest Securities

Rajesh Ghai - ThinkEquity

Chris Whitmore - Deutsche Bank

Jayson Noland - Robert Baird

Richard Gardner - Citigroup

Glenn Hanus - Needham & Company

Operator

Good day ladies and gentlemen, and welcome to the NetApp second quarter fiscal year 2010 earnings conference call. My name is Shimita and I would 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 live and will be available for replay on our web site at www.netapp.com along with the earnings release, the financial tables and the GAAP to non-GAAP reconciliations. As a reminder, we are also presenting slides concurrently with our audio remarks. They will be available for download on our Investor Relations site at the end of this call.

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 for the third quarter of fiscal 2010, our expectations regarding future customer demand and mix of customers, our belief regarding our market share and our growth rate and our expectations regarding our future relationship with Fujitsu and our expectations regarding Data on top eight and other new product offering.

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, our ability to increase revenue and increased competition. Other equally important factors are detailed in our accompanying press release as well as our 10-K and 10-Q reports on filing with the SEC and also available on our web site, all of which are incorporated by reference into today’s discussion.

Please note that all numbers are GAAP unless stated otherwise. To see the reconciliation items between non-GAAP and GAAP refer to the tables on our press release and on our website.

Now with me on today’s call are our CEO, Tom Georgens; and our CFO, Steve Gomo. Steve will review the second fiscal quarter financials as well as our targets for Q3. And then Tom will discuss additional operational results along with the trends we are seeing in our business.

I will turn the call over to Steve for his update.

Steven Gomo

Thanks Tara. Good afternoon everyone. Well the NetApp team delivered a quarter that exceeds our expectations in almost every geography and business segment. Our value proposition is clearly resonating with customers hoping to drive the highest growth margin level in our history, and thus our out performance on the operating income line. While the overall business environment appears to have stabilized, NetApp significantly outpaced both the markets and the competition. Now let’s walk through our results.

Revenue for the second quarter was $910 million up 9% sequentially and nearly flat as compared to Q2 of last year. Foreign effects increased our sequential results by just under 1 percentage point and decreased our year-over-year growth by just over 1 percentage point.

Wherever not for currency effects we would be one of the few companies in our industry actually generating year-over-year growth. Product revenue was up 10% sequentially and down 8% year-over-year to $525 million. Products represented 58% of total revenue. Included in product revenue is add on software which was 15% of total revenue.

As I indicated at our analyst day in October, after this quarter, we will no longer break out add on software due to the increase in our bundled product offering, which masks the distinction between software and solution. It’s no longer a useful indicator given that this metric is the low as it’s been in several years, yet our product margin are at an all time high.

Going forward, the best proxy for the impact of software on our business is our product gross margin. Revenue from software entitlements and maintenance, which is the deferred revenue element was a $170 million or 19% of total revenue.

Software E&M was up sequentially and up 11% year-over-year. Revenue from services was $215 million and 24% of total revenue, up 11% sequentially and up 14% over Q2 of last year. Service revenues are comprised mainly of hardware maintenance support and professional services.

Revenue from maintenance support contracts is a deferred revenue element and comprised about 63% of our services revenue this quarter. In Q2, it increased 7% sequentially and 20% year-over-year. The professional services component increased 16% sequentially, and was up 3% year-over-year.

On a non-GAAP basis, consolidated gross margin was a record 67.5% of revenue this quarter. This was nearly 4 percentage points higher than in Q1, primarily due to significantly higher than expected product margins as well as a healthy contribution from the deferred elements coming off the balance sheet. Revenue from deferred elements comprised about 40% of our total revenue compared to about 33% in Q2 last year. These deferred revenue elements carry a very high margin.

Non-GAAP product gross margins were up 6.2 percentage point sequentially to 63%. The competitive strength of our product offering was the primary driver this performance. The beneficial confluence of improved material cost, favorable product and configuration mix, stronger volumes and well-controlled manufacturing cost all contributed to this outstanding performance. Non-GAAP service margins increased to 54.4%, also receiving expected levels because of a jump in professional services utilization rates. Non-GAAP software E&M, gross margins were up just slightly, just 98.2%.

Turning to non-GAAP expenses, our OpEx increased 3% sequentially and was up 1% year-over-year, totaling $459 million or 50.5% of revenue. These expense levels are roughly 5% above the $439 million forecast we laid out for you at analyst day. This overage was caused by appreciably higher then planned accruals for commissions and incentive compensation related to this quarter’s out performance on both our revenue and operating income line.

However, true to the commitment that we made to you at the time there were no additional projects funded and no greater than planned hiring in this quarter’s expense deck. In addition to the Non-GAAP operating expenses, Q2 GAAP operating expenses include $33 million stock compensation expense, compared to $52 million in Q1.

Also included in the GAAP expenses, our amortization of intangible assets associated with prior acquisition, and the current period impact of prior restructuring action. GAAP other income expanse also includes, $12.2 million of non-cash interest expanse associated with our convertible debt, and a gain of $2.8 million on our Cavion investment. You will find a detailed list of these items in the GAAP to non-GAAP reconciliation on our website and in our press release.

Our head count at the end of the quarter was 8,105, an increase of 63 people. Non-GAAP income from operations was up 74% sequentially and 53% year-over-year to $155 million or 17% of revenue in Q2. Non-GAAP other income and expense, which typically consist mainly of interest income was only $4,000 this quarter primarily because of the low interest rate returns generated by investment portfolio.

Non-GAAP net income before taxes was $155 million or 17% of revenue. Our Non-GAAP effective tax rates remains at 16%. But the increase in the stock price during the quarter, weighing heavily on the treasury method of accounting per shares, NetApp’s diluted share count increased 10.9 million shares this quarter. Non-GAAP net income totaled to $130 million or $0.37 per share.

Moving to our cash flow performance, our cash from operations was $267 million, up 29% from Q2 last year. Capital expenditures were about $23 million this quarter, down from $25 million last quarter. Free cash flow which we define as cash from operations less capital expenditures totaled a record $245 million, up 36% from Q2 last year. Expressed as a percent of revenue, Q2 free cash flow was 27% of revenue, well above our targeted range of 17 to 22%.

Turning to the balance sheet, our Q2 cash and short-term investments totaled nearly $3 billion for net increase in cash and short term investments of $293 million over Q1. At the end of Q2, our cash and short-term investments held in the U.S. were 49% of the balance. The total deferred revenue balance of $1.7 billion reflects a sequential increase of approximately $7.3 million this quarter and a 9% increase in the balance year-over-year.

With respect to DSL, accounts receivable day sales outstanding were 32 days this quarter compared to 39 days last quarter and 36 days in Q2 last year. Q2 collections were extremely strong, resulting in an accounts receivable balance that is 93% current, which is also a record. Inventory returns were approximately 20 turns, the same as achieved in Q1 and up from the 18 turns in Q2 of last year

Turning now to the outlook for our third quarter of FY10, our forecast 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 risk and uncertainty. Actual results may differ materially from our statements or projections for the reasons cited previously.

The economy continues to show increased stabilization and the predictability of our close rates continues to improve. More importantly, our business is experiencing strong demand for our storage efficiency value proposition which resonates particularly well with customers during tight budget constraint times.

That said, our second quarter business benefited from a record contribution from the public sector business as well as from Europe, both of which are expected to fall off seasonally in the third quarter. This will be modestly offset by an expected increase in the business we do through IBM. Therefore, we are expecting Q3 revenue in the range of $935-$955 million.

To reiterate what I pointed out at analyst day you should not expect to see “normal historical sequential seasonality” going into Q3. It’s not logical to compare the sequential growth achieved when the company was growing the top line at about 30% per year to the current slower company growth rate in a more challenging economic environment.

Turning to non-GAAP consolidated growth margins. We expect them to pull back to approximately 64% given that the windfall of beneficial effects that I described earlier are not all expected to continue.

We plan to pass most of the material cost savings on to our customers and are not expecting to maintain configuration mix at such a favorable level. We also expect to have a higher mix of revenue from IBM in Q3, which is neutral to our operating income target but lower than our average corporate gross margin. Also, because product revenue is picking up momentum, the differed revenue element will be a smaller portion of revenue in Q3.

We are forecasting third quarter non-GAAP OpEx to decline modestly to about $445 to $455 million range subject to adjustment based upon what we see happening in the economy and in our pipeline. As a result, our non-GAAP operating profit should return to roughly 16% in Q3. Our share count is expected to increase by about 5 million shares. We expect non-GAAP earnings per share to be between $0.36 and $0.37 per share.

Now at this point, I’ll turn the call over to Tom for his comments.

Thomas Georgens

Thanks Steve. I am very proud of the NetApp teams performance this quarter. We achieved several records including record gross margin, record DSOs, record revenue from the public sector, record SAN contribution and record free cash flow. We also exceeded our operating income target and did so a quarter faster than planned. In addition, the mid-point of our target revenue range for Q3 would be a record revenue quarter.

Before I walk through our operating results, I’ll give you our view on what is happening in the current marketing environment. With the overall economy appearing to stabilize, we are seeing more and more customers begin to have forward looking discussion again.

Rather than just figuring out how little they need to buy in order to fulfill a near term demand, they are now starting to talk about their next generation virtualized data center architectures. While not all of this is translating into spending just yet, our performance this quarter indicates we are better aligned to the direction our customers are heading than our competitors.

We believe there is pent up need for tech refreshes across the industry and we are not only capitalizing on those in our own installed base but we’re also intercepting many of our competitor systems as they come up for renewal. This upgrade cycle is just beginning and represents one of our largest near term opportunities to gain share.

Turning now to specific operating results, you’ll see early signs that spending by our large accounts has begun to thaw. Total revenue generated by the Americas was up 3% sequentially and down 4% from Q2 of last year, contributing 55% of total revenue.

Within this, our public sector team had a record quarter of 32% sequentially and up 1% year-over-year producing 16% of total revenue. We now believe we have achieved number one market share in the US public sector, driven by strong growth in existing accounts as well as multimillion dollar wins in new accounts.

Led by a stellar performance in Germany, where we also have number one market share, Europe had the second strongest quarter ever up 21% sequentially and up 10% year-over-year to 35% of total revenue.

Asia-Pac was up 3% sequentially and down 7% year-over-year for a total of 10% of revenue. All major geographies were up sequentially, and on a constant currency basis we were up about 1% year-over-year in a quarter where most major competitors were down double-digits.

Direct revenue was 33% of total revenue this quarter, up 14% sequentially and flat year-over-year. Our indirect channel contributed 67%, up 6% sequentially and also flat year-over-year. Within the indirect channel, Arrow grew to 12% of total revenue and AppNet contributed 11% of revenue again this quarter. Our IBM-OEM relationship contributed 4% of total revenue and we expect it to be around 6% for the upcoming quarter.

The top 100 accounts increased in the mix this quarter, accounting for about 44% of total revenue, a little higher than previous quarters. While this is an indication that large accounts have begun buying again we remain committed to growing business with newer and smaller accounts to continue our efforts to diversify our revenue stream. This top 100 concentration should moderate next quarter as the public sector decline seasonally in the mix.

With respect to protocol trends, this quarter 48% of our configured system product revenue was sold with only NAS protocols. 19% was sold with only SAN protocols and 34% was sold at unified storage, which includes both block and fire protocols. While it was our expectation that unified configurations will continue to grow in the mix, we are still seeing healthy growth in our NAS attached rates. Whether configured as NAS only or unified, in Q2, our NAS rank was driven by rapid growth in VMware over NFS deployment, which grew 220% year over year.

According to our system reported data, almost 40% of NetApp machines in virtualized environment are now running the NFS protocol. A departure from earlier days when virtualization deployments were largely SAN. Our success in virtualization on SAN has been well demonstrated but the customer understanding of the additional benefits are running NFS placed to our strengths in unified storage are NAS and should position up well in the future.

Even though we have see some movement of virtualization deployments to NFS, our SAN revenue continues to grow faster than both NAS and unified achieving its highest ever level of contribution to our business this quarter. This quarter, in a number of our largest NAS account, we have succeeded in crossing over into the SAN infrastructure and one large new deployment.

We had several multi-million dollar SAN, only wins, including a large US Telco who spent $13 million to refresh their data center using NetApp. A $5 million SAN transaction that were in the largest proprietor a web2.0 companies in the US and a $3 million deal with the largest bank in Italy who is expanding across Europe. We believe that the midrange SAN products from the traditional SAN vendors who have damaged demonstrated a little recent innovation are going to be particularly vulnerable in the coming tech refresh.

From the platform perspective, the sales of high-end units came back strongly this quarter, growing 24% sequentially although still down 18% year over year. This was enabled by improved customer sentiment and spending in larger accounts. As well as the strength in the public sector, which has a higher concentration of high-end systems. Our midrange unit shift grew both sequentially and year over year while low-end units were up 4% sequentially and down 13% year-over-year.

Overall, units shift grew up 4% sequentially and down about 6% year over year with the client driven by a movement towards fewer but larger systems. Our V-series platform, which is our controller in data management software without any disks, once again, delivered tremendous performance.

This product is designed to provide NetApp data management and storage efficiency in front of large footprints of legacy SAN products offered by our competitors. It allows customers to experience NetApp functionality without a big initial investment and can pay for itself almost immediately with the space reclaimed when our space efficiency technologies are enabled.

Unit shifts are up 68% year-over-year, despite our largest pSeries customer switching to full NetApp FAD systems and is no longer buying the SAN unit from the competitor. One of the fastest growing segments of this business is the deployment in front of EMC mid range systems. In addition to large number of query on deployments we now have more than two dozen V-Series units sitting in front EMC DMX machines.

The growth, in fact the mere presence of this business is evidence that we offer set of features that cannot be matched by the traditional SAN offerings. Further, the increased presence in front of large frame arrays proves we can deliver this value even in the most demanding environments from an availability and performance perspective.

The final indication of improving customer sentiment I will point out, is that short term renewals of both contract maintenance and software entitlements have moderated. When your contract renewal is declined as a percentage of business while initial purchases of three year contracts increased providing initial indications at the tech refresh cycle may be underway.

Looking forward one of the key components of our strategy to broaden our market reach is to deepen our partner relationships. An important step in this process is the announcement this morning of an expanded partnership with Fujitsu. As you saw in our press release, we are looking to enhance our global relationship we joint product development, joint go to market efforts, and providing integrated solutions to our customers and partners, specifically in the areas of virtualization and data management.

In addition to expanding our partnerships we are feeling positive about our technology portfolio as well. NetApp is uniquely positioned to capitalize on the virtualization and cloud computing trends that will be essential to the future of the data center architectures.

In addition, this quarter saw the announcement of Data on Tap 8, the first combined release of our 7G and GX operating systems. Well not an immediate revenue generator, that enables even greater development leverage gone forward by having a single code base and it provides a robust platform for another decade of data management innovation.

Well those of you who were not at our October 8th annuals day, to get more information about our technology and our go to market strategies, you could find a video replays of our presentations on our IR website.

To summaries my perspective on the quarter - we beat our plan, we beat Wall-street’s expectations, we out performed our largest competitors but that is not the same as growing. We are committed to deliver year-over-year growth in the second half of our fiscal year 2010, when most of the industry has retreated from that goal and towards mainly a sequential growth.

Despite the achievement of our target operative model and impending return to true growth we intend to remain cautious regarding operating expenses. We do not expect the record gross margin to remain at this level, partially by design as we become more aggressive in driving growth and partially due to uncertainty about the economic environment.

Even if growth margin is moderate being proven about expense growth who allows to maintain the 16% operating margin model, the team has worked so hard all year to achieve. Overall it was a solid quarter and we defiantly feel we have momentum heading into the second half of our fiscal year.

At this point I will open up the floor to questions. As usual we will ask you to limit yourself to one question so that we may address everybody during our allotted time.

Thank you. Operator.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Mark Kelleher - Brigantine Advisors.

Mark Kelleher - Brigantine Advisors

With the quarter results coming in meaningfully over the guidance provided in early October. I was just wondering if you could talk about linearity in the quarter. Was there a late serge of demand that surprised you?

Thanks.

Steven Gomo

We need to see there, yes it was a little stronger than we had anticipated in the last three weeks. We were doing really well right up to the analyst day and be fare we did not know this is going to continue with the way it had particularly given us a best business end of the month - the month end of September, but the commercial business really finished very-very strong and we actually I think end up revenue about $220 million during those last three weeks. Yes we were little surprised that how strong it was.

Operator

Your next question comes from David Bailey - Goldman Sachs.

David Bailey - Goldman Sachs

You have comments in the past that you price may be little bit more aggressively than you needed to and it seems like better pricing helped gross margins this quarter. Does that price of strategy still hold - I mean you made some comments about new pricing a little bit more aggressively to drive growth can you talk about that a little bit?

Steven Gomo

Yes. I think at 67 point of gross margin, I think the discipline now we put in the system around this counting or had some very frank conversation with the sales organization and communicated them the impact of more discipline, I think its fully paid off. On the last call we were hired was marginal so, higher than we thought and we indicated that do some more aggressive pricing in certain situation I don’t think we can price them more broadly, and with that discipline dissipates.

But I think that we were committed to aggressively pursuing from deals and we did that, but nonetheless numbers could remain strong. I think Steve talked bout components and product mix and like to see a obviously the role of referred but all I think we did in fact pursue aggressively a number of deals but the over all gross margin remains strong.

So all and all, I think the value proposition is fully resonating and it all starts with that is defending the price and supporting the price of the faith of the customer. I think we got a really good job there, and even though we have indeed pursued some very-very aggressive deals the average gross margin remains strong.

David Bailey - Goldman Sachs

And as I mentioned the guidance that we gave for the third quarter EBITDA, we expect the margin to reseal a little bit from the high watermark we just set and part reason for that is, we are going to be giving some of those cost saving that we think our fundamental or long term we are going to passing those through to our customers.

Steven Gomo

The thing is we don’t want to do this to just probably drop prices, that are what you getting at. We fully not going to do that. On the other hand there are set of programs that we can run without partners to generate demand. And those things will come at cost counter revenue which will impact gross margin. But the other things we have in mind to stimulate demand at this point I suppose to brought pricing change.

Operator

Your next question comes from Mark Moskowitz - JP Morgan.

Mark Moskowitz - JP Morgan

Could you talk little more about the OpEx just given the substantial increase in span exposure should we think about R&D sequentially going up as the complexity of some of those solutions within your customers may be requires more R&Ds in terms of new products on the road.

Steven Gomo

I won’t go there, I think, I don’t think that’s the growth of our standard that’s going to impact our R&D investments. Currently we have been investing a lot of R&D in our SAN business to drive the functionality.

I think we feel good about our competitive position but I thin overall the mix of SAN versus NAS we have an integrated architecture so the vast majority of the features of, I should say unified architectures, so the vast majority of features are common to those are result I think the strength and SAN I think have to do with the previous investments we made to drive the competitors for the products and I think just for the importance sales force confidence, I think the sales force is very confident dealing with the product now.

So I think if anything the R&D investment will stabilize in that dimension as we made a progress that we have.

Operator

Your next question comes from Keith Bachman - Bank of Montreal.

Keith Bachman - Bank of Montreal

Steve I want to go back to gross margin if I could on products in particular, you had about a 10% sequential increase in revenues for products and yet I think your cost of goods sold even on a dollar basis was down sequentially; and I just want to try to understand more, what was the key drivers there and then what changes as we look at the next couple of quarters, was there any kind of one time events in there, either on a materials basis or otherwise. I just want to try to get a little more color on the product gross margins specifically.

Steven Gomo

Okay. Let me, I will try and quantify some of the commentary that I had in the script there Keith. So, starting with the big items, probably material costs themselves were the biggest issue, it just has to do with the timing of when we receive a cost increase versus when we can pass it on to our customers. So, that was about a 2% point favorable benefit going from Q1 to Q2.

The configuration we saw this quarter were very rich. And really across the border, across all segments and up and down the line for that product line for that matter, remember B-Series had one of its strongest quarters ever was very large in the mix, and the V-Series has a very-very favorable gross margin structure.

Warranty was favorable by about a point compared to the prior quarter. Our quality is getting better and we recognize that based on our analysis of the expected warranty charges we are going to take in the future.

Volume was favorable along with our manufacturing variances that was about seven-tenth of a point. IBM was down in the mix this past quarter that was about a half a point and discounts were slightly favorable the last quarter; they were about four-tenths of a point favorable. So, all of that adds up to just over 6% point and pretty much I think, captures the quantitative aspect of what I said in the script.

As we look forward, a lot of these events are going to continue or they may manifest themselves in different ways, but I don’t think we are going to continue to see this extremely rich configuration mix we saw across all part, all segments and certainly the level of V-Series that we saw. So, we are expecting that to come down. We expect IBM to rise in our shift in this quarter, because IBM is going to have a strongest quarter with us coming up, and IBM has a much lower gross margin than the corporate average.

I mean the materials benefit by talking about we are actually going to be passed back to customers through pricing adjustments that we make. Our volume and manufacturing variances we’ll probably keep the volume where it is but the manufacturing variances aren’t going to be sustainable. So, we are going to give about four-tenths of a point back there.

And finally, as Tom pointed out, there will be some selected discounting that we do. Our targeted customer accounts or targeted sales situation and that’s going to be just under a percentage point that will probably come out because of that.

Operator

Your next question comes from Aaron Rakers - Stifel Nicolaus.

Aaron Rakers - Stifel Nicolaus

I guess one of the questions I have is on the services side of the business and it might segue into the gross margin there as well. I think last quarter you guys had mentioned that you were proactively moving some of your professional services business to your partners.

If I look at it I think you have stated that trend was expected to continue. With professional services up to 16%, did you pull back on that plan? Have you changed your approach there and was that the predominant drive of your growth margin in the services segment?

Steven Gomo

I think at the professional services side we are clearly, our focus remains and in fact we continue to move in the direction focusing our professional services team towards very specialized high-end, very specific customer engagement.

On moving some of the other professional services business whether it would be in the mid sized enterprise what we call general territory, and likewise our installation business we then move that to partners. In a lot of cases that’s important profit opportunity for them historically found themselves competing with them for professional services business, and we intend to continue that. So, there’s been no reversal it’s not we’ve actually moved further on that dimension.

The overall services line that you talk about include the support contractors as well I believe. So those are all merged in. The professional services business that we’re trying to exit, just to put in context is really around installation and consulting in the general territory. And those are only a few percentage point of our business.

Operator

Your next question comes from Kaushik Roy - Wedbush Securities.

Kaushik Roy - Wedbush Securities

So Tom your biggest competitor EMC just announced a joint venture with two of your strongest partners, Cisco and VMware. Can you comment how it impacts your product development and partnership especially with VMware. Thank you.

Thomas Georgens

Okay, you broke up a little Kaushik, I think you asked me about the EMC, Cisco and VMware. That’s a we could spend the whole call on that subject. But to kind of simplify it, I think you need to look at the motivations of each of the individual players.

I think from VMware’s perspective I think that if anything they want to remain neutral. And I don’t think that they are an advocate or a strong supporter of creating anything that’s going to favor VMware or favor EMC and Cisco. Cisco is a great company and it’s got a track record and they are a formidable competitor but doesn’t change the fact that they don’t have any market share in servers lot yet, and HP and IBM actually are partnering more closely with Microsoft.

So I think VMware have already made independent and they have actually put that in writing that they certainly intend to maintain the relation they have had with NetApp and continue to cooperate both from a technology perspective and a go to market perspective. And I expect no change there.

I think Cisco role in this, is clearly they want to ride the VMware momentum and likewise EMC has got a big installed base, they want to leverage. So I think the go to market appeal partnering with EMC makes a lot of sense to them.

On the other I think that EMC from a storage perspective brings elite to this relationship and their primary motivation of being engaged by Cisco is around the go to market side. So at the end of the day this relationship doesn’t produce anything for the customer and to be perfectly honest I think what Cisco is going to find is once they move away from EMC’s stronghold accounts, they are going to find that their transforming is hindered by EMC. In fact EMC is the attendants of the transformation and the goal that I have given our team is that I want to form the same relationship with Cisco that we have with VMware.

In other words a very neutral stand from corporate but I want to be engaged with their sales teams and turn to customers everyday demonstrating our value, and I want to basically be in a position that outside of EMC stronghold accounts we do more business with Cisco than EMC does.

Operator

Your next question comes from Kevin Hunt - Hapoalim Securities.

Kevin Hunt - Hapoalim Securities

I just want to clarify again on the gross margin versus OpEx question. So you are kind of saying you are basically going to get back down to that 16% operating margin and the question really is if you do see a gross margin trending above kind of expectations would you then ratchet up those OpEx expense or would you kind of let that flow through or may be can you just help us understand what your kind of spending times would be in different scenarios going forward?

Steven Gomo

Okay. Well, first of all I want to enjoy the statement of moving back down to our 16% operating. Actually with regard to the gross margin target through basically very-very high growth margins. And while I think that attribute to a lot of hard work that we’ve done over the last year I think it’s a tribute to our product success and the value of proposition that we have out there.

I don’t expect that the gross margins are going to remain at that level indefinitely and what we don’t we do as a company is bake in a permanent operating expense that necessitates us to have very-very high gross margins at that level to meet our operating margins target.

On the same token is that we don’t want to pass up an opportunity to invest in our business. So, the focus that we have right now going forward is what can we do to short term activities, perhaps activities that are rebated nature I think that would stimulate demand that are above the line and like wise short term OpEx things that we could do to stimulate growth.

So, what we want to do is we want to maintain the 16% target and reserve the flexibility and we could still maintain that target even at a lower gross margin. So, I do expect that we are going to do things, we are going to leverage the fact that we have this option available to us, the high gross margin and use that to stimulate sales but I don’t think we are in a position to think about adding permanently to our long-term run rate until such time as we believe we can achieve that at more normal gross margin level.

Operator

Your next question comes from Brian Marshall - Broadpoint AmTech.

Brian Marshall - Broadpoint AmTech

My question with regards to IBM and the gross margin degradation that we are going to see in the generated quarter, I guess by my calculation IBM probably represents a little bit less than half of that 350 basis point decline. So, I guess wanted to clarify that.

And two, you know if that’s the case, I guess trying to figure out if the 64% gross margin is actually maybe conservative or sustainable if not conservative looking at the end of the future past January. Thanks.

Thomas Georgens

We’ll honestly give you more detail. But I think that our gross margin performance on bookings on the accounts other than IBM are probably going to have a bigger impact and where we ultimately ends up at IBM. IBM will still be 6% of our business and it’s neutral from a operating margin perspective although lower on a gross margin. But I think the gross margin story is going to be written on the rest of our business, not just IBM.

Steven Gomo

Right Brian. I mean I don’t see your model in front of me, so I don’t know what your responses are, but revenue is going to virtually double from IBM quarter-to-quarter and if look at the delta in the gross margin percentage is between the average that we achieved and IBM you get about a half percentage point. So, that’s what I’m expecting to see if all things are equal, basically the only transaction to influence things I expect things to fall by about half a point.

Operator

Your next question comes from Troy Jensen - Piper Jaffray.

Troy Jensen - Piper Jaffray

Steve, over the past two to three quarters outside of the October quarter you guys talked about an abnormal amount about one year service in maintenance extensions. Just curious to know if you think that you guys can get a nice tail wind maybe better than typical seasonality over the next few quarters as those services and extensions comes back for renewals.

Steven Gomo

I think that is somewhat a function that the economy and somewhat a functions of customers’ mindsets with respect to where they are in terms of their own budget etc. And I think that as the economy stabilizes, that we think we are starting to see today, we are not seeing quite as many of those one year extension as we were.

In fact, this quarter, they actually declined slightly and we are seeing more or the normal three-year contracts as the point of sale. So, we are not back to where we were two years ago type of thing before the economy tanked, but we are clearly off the low points that we have seen with respect to the mixes of one-year contract.

Operator

Your next question comes from Katie Huberty - Morgan Stanley.

Katie Huberty - Morgan Stanley

Steve, the accrued compensation on the balance sheet jumped more than typical this quarter. Is that just a function of the upside you saw on the top-line and wouldn’t that have been a offsetting headwind on gross margins that potentially alleviates going forward?

Steven Gomo

Well, you are right about the increase of the accrued compensation on the balance sheet. Actually that is the result of what we call our incentive compensation plan, which is actually been on our operating profit dollar performance; and the fact that we exceeded our internal expectation, our external target by so much means that we accrued a lot more incented compensation for the vast majority of our non-commissioned employee.

Also, included on that line, a positive increase, was an increase in commissions as well due to the sheer volume of our business. So, in the second half, we are actually resetting our targets for operating profit commensurate with what we have just done with our guidance. And so, it’s going to be more difficult or let’s say this, we have set a higher bar for overachievement. So we are not expecting nearly as much overachievement in the second half of the year, we will have to see things play out.

Operator

Your next question comes from Ittai Kidron - Oppenheimer.

Ittai Kidron - Oppenheimer

Steve I wanted to hopefully can get some more color from you on the V-Series. Is there any way for you to give us some color on how much of the revenue this quarter and in the previous quarter was generated from sales into a prior V-Series installment. So just that we get a better sense of how much is that V-Series really contributing to current performance on your product line.

Steven Gomo

Well, I think there’s a couple of factors there. It depends on why the customer buys the V-Series. In many cases, the V-Series is an entry point to a new account that allows people to use our data management technology and our storage efficiency technology without ripping out all the stuff that they already have which may have usable life left in it.

Now, one of the things that mitigate V-Series growth, and V-Series overall is probably less than 5% of our revenue, so, I don’t know if that’s enough to answer your question or a little more than that but less than 10% of our revenue.

What mitigate to get to the V-series growth is for the customers that use that as an entry point when the time comes for them you come to the usable end of the life of the infrastructure behind it we think to replace that with NetApp gear. So the V-series business actually convergent to conventional system sales.

So, what’s interesting thing about V-series is that it’s basically a new account generator for us and the mature account actually move into other category simply because they move along.

And in fact, one of those big SAN opportunity that we talked about was in fact the largest V-series customer that actually converted to NetApp and by full assistance from us and they no longer buy the SAN back ends from other players.

So, I say that the V-series is one of the key vehicles for opening up new accounts, and I think we think about it in more on those terms rather than ongoing contribute to our revenue stream.

Thomas Georgens

Just keep in mind why the V-series is so structurally difficult. Remember the V-series is still without disc. So, it’s basically just the computer head and the software, which gives us the rich configuration that I was talking about earlier.

Operator

Your next questioning comes form Ben Reitzes - Barclays Capital.

Ben Reitzes - Barclays Capital

Could you talk a little bit more about your guidance for the January quarter in particular, what is going on with public sequentially? You mentioned that you didn’t expect the surge to continue. So can you talk about how much that decline sequentially as well as the Europe phenomenon if you could describe that sequentially in a little bit more detail and then what needs to fill the void sequentially to hit your guidance, that would be great. Thanks a lot.

Steven Gomo

Okay, there’s a number of moving parts there. One of them clearly is the federal season reaches its peak of euphoria in September at the end of the government fiscal year. So, clearly this is the biggest federal quarter of the year or the biggest public sector quarter of the year. And as we go forward we lose some of that. So, I don’t really want to quantify that with any detail. But we basically lose some of that.

What we will see in the fourth quarter is we will see IBM very, very fourth quarter centricity and let’s seem IBM December which would take them up in the mix. And Q3 also traditionally is a very-very strong quarter for us in Europe. Now, they just had a very-very strong quarter.

So, as I would see that we should see a significant Q3 decline in federal, just like we see every year. We should see strength in Europe because that’s usually our strongest quarter and we should see some strength in IBM. Those are kind of the key moving parts for us.

Operator

Your next question comes from Bill Fearnly - FTN Equity Capital.

Bill Fearnly - FTN Equity Capital

Tom in the past you have commented about the number of deals above a million dollars in the quarter. Is there any additional color in the number of larger deals which verticals and if you see a sustainable improvement in larger deal flow here for the next couple of quarters or it’s just the improvement in the overall market?

Thomas Georgens

No doubt that we actually had a number larger deals this quarter. So certainly deal size, whether it be over $10 million, we had some in this quarter, we haven’t had any of those in over a year. $5 to $6 million is up, $2 to $6 million is up, pretty much every single category of deals over a million dollars has been up. So clearly deal size is improving.

I think that would be an indicator that customers are moving away from just satisfying incremental demand for short-term covering of their need. I think they are moving more towards tech refreshes and broader build out of new infrastructures particularly as they look towards their internal cloud.

So, as you can well imagine large deal sizes they tend to be lumpy, they tend to be hard to predict, they tend to be the ones that are going to get pushed out in time because they get a lot of scrutiny up and down the approval chain.

So there is no doubt that a lot more of those came to fruition. So we think about implicit measures of the health of the overall industry, it’s a fact that more and more of those deals are coming up the other end. That would be two things. One of them is that budget are certainly not what they once were. Budgets are a little bit more firm than they once were.

It also tells me that people are thinking and starting to implement new data center architectures and new tech refreshes as opposed to just satisfying incremental demand with bare bone systems.

Operator

Your next question comes from Paul Mansky - Canaccord Adams.

Paul Mansky - Canaccord Adams

Maybe trying to bundle a couple questions into one, building on some of the gross margins and revenue expectations, and you provided a lot of explanation but I didn’t really hear much about components availability and we’ve been hearing quite a bit about it on our end. Maybe could you address how you feel about availability of components particularly those higher capacity disk drives?

Steven Gomo

Yes there is no doubt that availability is becoming something that we’re spending more time on. It’s no doubt tighter now than it’s been. The first statement is I think within the range of guidance that we gave I don’t believe that component available is going to be a threat to that.

So, I would just start with that. What’s interesting about the supply chain is we’ve actually seen a lot of capacity come offline in the last couple of years, and a lot of sub-suppliers to our suppliers, cable, sheet metals, connectors, things like that, a lot of suppliers have gone out of business. And as a result as demand starts to pick up, we are seeing a fair amount of reluctance in the supply chain of companies that are doubting whether this is going to be a broad based recovery or not.

So, I think your observation about the supply chain is definitely true. I don’t believe it’s going to be an issue for us in terms of any of the guidance that we have given. But it’s something that we are watching more closely than we did six to nine months ago.

I think one thing that does help companies like NetApp on offset quarters is that we aren’t competing for capacities or not contract manufacturers of a party. At the same time, some of the larger companies are they are traditional quarterly boundaries.

So I think that helps us a little bit. But bottom line answer to your question is supply line is definitely tightening, not just disk drives but in a lot of areas bankruptcy of major suppliers has been a factor, but I don’t believe it’s going to be a threat to the guidance we gave.

Operator

Your next question comes from Bill Shope - Credit Suisse.

Bill Shope - Credit Suisse

Can you comment on backlog trans exiting in this quarter versus historical averages. I understand you don’t usually give any quantitative measures here, but at least qualitatively was it above or below normal.

Steven Gomo

Bill we really don’t talk about backlog here, we don’t think it’s - not much of a backlog could be cancelled at any time type of thing. But it’s suffice to say we are just very please with our backlog position right now, and it’s all been factored into the guidance.

Bill Shope - Credit Suisse

Okay, could I guess a change that to pipelines. I mean how do you see the pipeline right now. I am assuming it’s improved pretty substantially from the prior quarter.

Steven Gomo

Yes, the pipeline, our pipeline looks very good and the good is that the growth rates have improved. So, we feel that the predictability of the pipeline is much better than it was certainly six month ago. Again, all we know about the pipeline, and all we know about our backlog has been factored into the guidance we gave you.

Operator

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

Brent Bracelin - Pacific Crest Securities

I guess, a question for you Tom. The SAN only kind of stepped up here this quarter, a little surprising. My question is what’s changed, how sustainable is the success in SAN only. Are you seeing increasing win rates there, is it driven by the new hardware upgrades or OS upgrades or really just by more of the economy picking up and large enterprise picking up, anymore color on the momentum there and how sustainable that is would be helpful?

Thomas Georgens

Well, I think it’s, you know, obviously marginally divide the overall market size. But I think in terms of win rates in market share, I know I think it’s sustainable, I also think it’s one of our key objective. If you look at the overall storage industry and you look at specifically at the SAN space. I think that’s one area particularly in midrange then where the pace of innovation by the major vendors has been to slow it.

So, when I look at products from the major players, you know, who they are, I actually think that those are the weakest offering from the storage industry and the ones that we need to be attacking most aggressively. You know when I look at this tech refresh cycle, I presume that my competitors have also got old equipment sitting out there as well.

When you look at it, that equipments 3, 4, 5 years old, the architectures that people have in mind gone forward particularly on the around the Virtualized Data Centers and internal cloud basically sever virtualization intensive environment. Those are very different than the environments that they had in mind when they bought that equipment 3, 4, 5 years ago. When that comes up for tech refresh and most of them have seen very very little innovation, particularly in terms of its relevance in virtualized server environment, I think that’s, that’s our strength is in that environment.

So, I think intercepting that tech refresh, particularly around mid range SAN is a very very core focus of ours. So, you know, I am not going to predict what the markets going to do on terms of our continued success. I am actually very bullish on our opportunity and I expect that you see similar deals like this in the future.

Operator

Your next question comes from Rajesh Ghai - ThinkEquity.

Rajesh Ghai - ThinkEquity

Tom you mentioned that you are seeing growing tractions for NFS and Virtual Disc Server deployments; to a couple of questions there; amongst your customers, how many have moved from SAN’s to an NFS based deployment and what percentage of these first time adopters are all these customers are first time adopters of server virtualization?

Tom Georgens

I don’t have any numbers on how many have transitioned, but there was a time when the VMware business was 90% SAN; and now based on our system reported staff which is basically the systems that we have in the field which is our entire full base, is that the entire full base has kind of moved to about whatever the number I quoted roughly 50-50, moving less I think 40%. That would tell me that a fair number of them have moved from SAN to NAS or are running both at the same time, maybe SAN for their original deployment and NAS on their newer deployment.

Where we really see the payoff is in the very very large account and you know many of the accounts that VMware promotes that their success stories are actually running NetApp on NFS. The other thing is NFS was not available in the initial releases of VMware and it is now and I think that the education process both with our customer base, with our sales force, and with the VMware sales force has moved in that direction.

So, I think the data management flexibility, the reconfiguration, the data mobility, all other things are just fundamentally enabled by NFS and are fundamentally enabled just for the stand. So I want to be real clear the customer want SAN we could win there. The value of proposition for your offering your comes integration stored efficiency are just as integration and storage efficiency are just as viable as SAN is they are now. I just think that the NAS architecture generate a degree of flexibility independent on that app a customer definitely consider.

Operator

Your next question comes from Chris Whitmore - Deutsche Bank.

Chris Whitmore – Deutsche Bank

A question for Steven around the deferred revenue and cash flow margins; can you provide any colors to number 1, when you expect deferred revenue to grow on the cash flow statement, and secondly what’s the outlook for the cash flow margins going forward may be in the quarter or for the year, any change to review there. Thanks a lot.

Steven Gomo

Okay Chris. So when I expect to see it growing on the cash flow statement. Well the deferred is a what you’re referring to then is a increase in the deferred liability on the balance sheet. What we just saw on the past quarter about $7 million, I am not expecting to see large increases in the balance sheet deferred liability until we get our bookings growing in more than 10% year-over-year, and revenues would be growing roughly 10% year over also and as you know we’re roughly just under zero right now. So slightly negative in products.

So I think it’s going to be several quarters before you start to see feasible growth and deferred revenues on the balance sheet. As far as the impact on cash flow that’s I think that we’re going to be range that I gave you at the analyst day. Certainly my anticipation for next quarter and I am not going out beyond that right now.

Yes the 32-day BSO is a remarkable achievement by the company and tribute to our collections team. I also believe that BSO starts with customer satisfaction but nonetheless that’s a very low number and a day at BSO is $10 million in cash.

Operator

Your next question comes from Jayson Noland - Robert Baird.

Jayson Noland - Robert Baird

At this time just a question a follow-up with Cisco. What kind of attach have you seen to Cisco’s UCS platform so far and is it fair to think that going forward your expectations there are just moderated I guess given BCE.

Thomas Georgens

No, not moderated at all. I said it before is that I think an EMC is firmly entranced to count. That is really the target of this relationship and by definition those one are NetApp account.

Once you get out of those I consider Cisco fair game partner just like everybody else and we tend to partners with them aggressively and compete against EMC and time will tell in terms of stories that are out there but I can personally speak of where are the numbers very-very significant UCS deal that are Cisco partnering directly with NetApp and no EMC involvement at all.

In coming times we can talk about them, but I think in the short run, yes Cisco has gone with the leverage EMC’s market presence. Well EMC does not have a market presence the whole world knows what EMC is but customers have currently chosen not to buy EMC and I don’t think the VCE is going to change their mind.

Operator

Your next question comes from Richard Gardner - Citigroup.

Richard Gardner -- Citigroup

Thomas I was just hoping that you could summarize some of the key metrics on new account penetration during the quarter, and the progress that you are making against your storage goals?

Steven Gomo

Okay. So I don’t have those data points, I do know that new account accusation was actually up this quarter over the last quarter which was expected with a sequential growth.

So I don’t think we are on track I don’t think many thing report you to positively or negatively on that dimension but still there remains a focus something that we fully trying to do and now we have our own channels but also IBM’s doubled our due account acquisition last year through our activities with them So expect that to continue, we expect to have a good quarter with them as they close their fiscal year.

Operator

Your final question comes from Glenn Hanus - Needham & Company.

Glenn Hanus - Needham & Company

May I just talk a little more about the Fujitsu relationship, what if they really been reselling to date and where and how significant is this new announcements in expanding that relationship and any specifics you can provide?

Steven Gomo

Yes okay. So Fujitsu announcement is something that we were working out for quite some time and you follow the Fujitsu story, Fujitsu, Siemens and recapitalize the company and that kind of slowed things down a bit, but then they renewed in earnest with the new leadership and basically we are trying to is put now that Fujitsu owned that entity they are looking to drive a unified storage strategy across Japan and all of Fujitsu.

So they have got some internally developed products, they have got partnership with NetApp which is quite significant, I think we have talked about them in the past, we have to quantify them but I think we would say this bigger than the IBM relationship which is a fact, and so they are important partner for us. And they also have other partners that are competitors to us but they also do business with. Not on a significant scale.

I think going forward what we have agreed to do is that we have jointly billed a storage portfolio that unifies a number of their technologies, their storage management and some of other core technologies that we have and basically build a single product portfolio for Fujitsu that based on a combination their technologies and our technologies.

The Fujitsu is multi hundred million dollar partner of ours and I think that this represent a very-very interesting relationship for us going forward and it gives them an opportunity to stream-line their storage story and allows them to have a single story world wide around storage I suppose there is some reseller relationship they have today.

Operator

This concludes the Q-and-A portion of today’s call. I would now like to turn the call back over to management for closing r remarks.

Tara Dhillon

Thank you for joining us today everyone. I would just like to close by letting you know that our target at third quarter earning release date is February 17, 2010. We look forward to updating you then and thanks for your time today. Good bye.

Operator

Thank you for participation in today’s conference this concludes the presentation you may now disconnect. Good day.

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Source: NetApp Inc. F2Q10 (Qtr End 30/10/09) Earnings Call Transcript
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