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Executives

Tara Dillon – Senior Director Investor Relations

Thomas Georgans – President, Chief Executive Officer

Steve Gomo – Chief Financial Officer

Analysts

Brian Marshall – Broadpoint AmTech

David Bailey – Goldman Sachs

Wamsi Mohan – Bank of America/Merrill Lynch

Benjamin Reitzes – Barclays Capital

Kaushik Roy – Wedbush Securities

Aaron Rakers – Stifel Nicolaus

Keith Bachman – BMO Capital Markets

Kevin Hunt – Hapoalim Securities

Bill Shope – Credit Suisse

Chris Whitmore – Deutsche Bank

Brent Bracelin – Pacific Crest Securities

Jayson Nolan – Robert W. Baird

Doug Ireland – JMP Securities

Richard Gardner – Citigroup

Mark Moskowitz – J.P. Morgan

Eric Martinuzzi – Craig-Hallum

Kathryn Huberty – Morgan Stanley

Alex Kurtz – Merriman & Co.

Glenn Hanus – Needham & Company

Rajesh Ghai – Thinkequity

Amit Daryanani – RBC Capital Markets

Kevin Shea – MKM Partners

NetApp, Inc. (NTAP) F3Q10 Earnings Call February 17, 2010 5:30 PM ET

Operator

Welcome to the NetApp Q3 fiscal year 2010 earnings conference call. (Operator Instructions) I would like to turn the call over to your host for today, Tara Dillon – Senior Director of Investor Relations.

Tara Dillon

Good afternoon everyone. Thank you for joining us. With me on today’s call are Tom Georgans, our CEO and our CFO, Steve Gomo. This call is being webcast live and will be available for replay on our website at netapp.com along with the earnings release, the supplemental commentary, our financial tables and the non-GAAP to GAAP reconciliation.

As we indicated on our February 4 press release, this quarter we implemented a new format for our quarterly results announcements. Concurrent with the press release we are now publishing and distributing supplemental commentary which contains the metrics and some of the analysis we have previously provided on our live call.

Our goal is to provide the investment community with additional time to review and analyze all of our results, allowing for a more thoughtful interactive dialogue during the Q&A. This live call will focus on strategic commentary and outlook from our CEO and CFO and allow for a little longer Q&A period. We will be interested in hearing our feedback on this new approach.

As a reminder, during today’s call we will make forward-looking statements and projections including our financial outlook which involve risk and uncertainty. Actual results may differ materially from our statements and projections. Factors that could cause actual results to differ from our projections are detailed in our accompanying press release which we have filed on an 8-K with the SEC as well as our 10-K and 10-Q reports also on file with the SEC and available on our website, all of which are incorporated by reference in today’s discussion.

These factors include among others, our quarterly operating results may fluctuate for a number of reasons, some of which are beyond our control. All numbers mentioned today are GAAP unless stated otherwise. To see the reconciling items between non-GAAP and GAAP, refer to the table available in our press release, our supplemental commentary and on our website.

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

Steve Gomo

Thanks Tara. Good afternoon everyone. Now that you’ve had a chance to read our written commentary, I’d like to take a few minutes to discuss our perspective on these results. We are extremely pleased with the breadth of our success this quarter and all of the records set across the various geo's, products, revenue and earnings. While Tom will delve further into these, I’ll talk about the impact of our performance as it relates to our business model and the implications for the future.

NetApp significantly outpaced both the market and the competition and we are forecasting Q4 sequential growth at about 6% to 9%. These sequential growth numbers translate into about 22% to 25% year over year organic growth in revenue, a figure that our competitors are nowhere near achieving in their storage businesses.

On top of that, this implies our year over year product revenue growth will be greater than 30%, a growth number that is remarkable in any environment, especially for a company of scale. While we significantly outpaced our revenue forecast, our non-GAAP gross margin expressed as a percent of revenue was almost exactly where we expected it to be.

Moreover, we passed along some cost savings to our customers in order to stimulate growth and share gains just as we said we would.

It’s worth noting that our 64% plus gross margins were achieved in a quarter where we had a significant jump in the mix of low end units. A robust low end does not materially impact our gross margin. In fact, because it carries far less disc, the low end actually has very similar margins to our high end systems which typically pull more software but also have far more disc.

The key point is that with the unified architecture and a single operating system across all of our product lines, we are relatively indifferent to the changes in the mix of our platform. With the mix of deferred revenue in the P&L remaining strong, non-GAAP gross margins should continue at a similarly healthy level next quarter.

Our non-GAAP operating expenses were above plan, although it was due to greater than expected variable compensation related to our expense and operating income performance. While you should expect us to continue to drive toward a 16% annual operating income target, Q4 is likely to be higher than that as it takes time to ramp investments targeted at additional share capture.

I would like to call your attention to this quarter’s 10% year over year growth in deferred revenue on the balance sheet. It is not surprising that this occurred in the quarter when products started to show year over year growth again.

Deferred elements result mostly from attachment to product sales with some additional contribution from renewals by the installed base. Over the long haul, product revenue growth drives the deferred revenue liability.

I’d also like to reiterate that we expect our free cash flow as a percent of revenue to return to our targeted range of 17% to 22% next quarter as accounts receivables level off. It is worth noting that the average for Q3 and Q3 combined is 20.3% right in the middle of our targeted range with the quarterly variation due to fluctuation in accounts receivable.

The bottom line is that our business model is thriving and should be relatively stable going forward. We are excited about the market opportunities unfolding in front of us and proud of the team for capitalizing on them so effectively.

At this point, I’ll turn the call over to Tom.

Thomas Georgans

Thank you Steve. The NetApp team demonstrated remarkable execution this quarter. We produced record revenues, record numbers of systems shipped, record profits, record EPS as well as producing double digit year on year growth and guiding to over 20% revenue growth for next quarter, all of this in an improving but hardly robust IT spending environment.

I’m especially pleased with the breadth of our progress. We saw year over year bookings growth in every major geography, momentum in both our channel and our direct businesses, tremendous performance from our operations team in the face of consistent supply constraints, and our 17% year over year product revenue growth is far better than any of the other major storage vendors. NetApp clearly gained significant share this quarter.

Delivering storage efficiency, the key business application is the primary driver of this demand. The NetApp value proposition offers customers the ability to accomplish their objective with lower cost and improving their business performance at the same time.

With NetApp, customers can deploy their next generation virtualized shared infrastructure architectures with greater confidence, reduced implementation time and lower CapEx and administrative costs than our competitors.

The transition from siloed application specific infrastructures to a broad homogeneous infrastructure shared by multiple applications generally referred to as an internal cloud, offer compelling advantages in terms of cost, rapid application deployment and administrative efficiency. It is rare that I meet with an IT executive where we do not discuss this at length.

In addition, the age of their existing infrastructure prolonged by reduced investment during the downturn is creating a sense of urgency to deploy their next generation data center and will likely represent a significant portion of IT hardware spending in the immediate term. In fact, many of these projects have moved beyond the talking stage and into implementation and are contributing to the results we announced today.

NetApp technology is particularly well positioned for this new architecture as evidenced by our recent success. And as many customers move in this direction over the next couple of years, it represents a major opportunity to gain share and outgrow the market.

As we highlighted at our analyst day in October, diversifying our pathways to market has been a top priority for the company and this quarter we are beginning to see demonstrable results from these investments. Our new customer acquisition across all segments was very strong. In fact, this was the second highest quarter ever of new customer additions.

Of particular note, was the performance in the mid size enterprise for MSE space. We simplified our order process, repositioned our low end products, created solution bundles targeted at this space and we made it even easier for our channel partners to do business with us. As a result, we saw remarkable growth in our channel business.

Our distribution partners together combined for a record 28% of revenue which drove a tremendous increase in shipments of our low end systems. Along with the strength at the low end, our high end units were up significantly and contributed the highest percentage of our revenue in over a year.

A number of factors drove this including a return to spending from some of our larger customers, infrastructure build outs by certain cloud service providers and our newly created performance bundles.

These bundles tightly integrate flash memory next to the CPU in the form of a performance acceleration module or PAM, enabling significant improvement in performance. In addition, this performance boost frequently eliminates the need for fiber channel drive in favor of lower cost, denser serial ATA drives, thereby simultaneously improving performance, increasing density, reducing power requirements and lowering costs.

The PAM card is a big part of our strategy to seamlessly deploy flash technology in our offerings more pervasively than our major competitors. In just the second quarter of availability, the PAM is already attached to 10% of supported systems shipped.

It’s been a long time since I discussed operations on this call, but this was a remarkable quarter for that team. On the last earnings call, we indicated that supply constraints were a definite challenge, but they were not a threat to our guidance. The problems remained all quarter, yet the operations team still managed to achieve more than 50% sequential increase in systems shipped while maintaining inventory terms at near record levels.

Going forward, we do expect some supply constraints to persist in Q4, particularly in semi-conductors, but we do not expect them to be as acute as last quarter and we have once again factored them into our guidance.

Our partner relationships continue to deepen and produce results. Quarterly revenue form our IBM OEM relationship was at a record high. Early in Q3, we announced the expansion of our Fijitsu relationship and we recently announced the Cisco VMware NetApp collaboration.

The jointly developed products from this collaboration is a unique solution to one of the most compelling needs in virtualized infrastructures, a need for secure multi-tenancy. This provides the industry’s first end to end solution to enable customers to run multiple applications on a shared infrastructure with predictable performance and data security.

Our newly expanded strategic alliance with Microsoft deepens our product collaboration and technical integration and will extend joint sales and marketing activity to customers worldwide. We are beginning to see a greater proliferation of Hyper-V installations in the market and our strong relationship with Microsoft will further our traction in virtualized environments of all types.

While virtualization and its enablement of shared infrastructure is a key component of our growth strategy, the impact of our storage efficiency and the industry’s most mature unified storage offerings also resonate in environments running general business applications, engineering applications and traditional cloud services. In the past quarter we saw success on all of these fronts in customers both large and small.

There is no doubt we are seeing momentum in the business and we have resumed investing in key areas to drive growth. In prior quarters I indicated that outside of variable compensation, we are holding controllable spending flat until we return to our 16% operating income target.

That return came sooner than expected last quarter, and resumed this quarter. Now that we are back on the model, and with the undeniable opportunity ahead, we are choosing to reinvest in the business and do not anticipate generating leverage much beyond 16% annual in the intermediate term.

This has been the strategy that has served NetApp well throughout its history and it is even more appropriate today as we endeavor to be a growth company of scale.

To summarize, while we have need for improvement in several areas, the company is still executing very well on many fronts. Our product portfolio has never been more reliable or more relevant to the major trends underway in IT. Our channel breadth has never been greater across multiple geographies, storage 5000 and MSC, direct and indirect and system integrators and cloud service providers.

Our industry alliance activity is creating meaningful solutions for our customers through our recent announcements with Cisco, Fujitsu, Microsoft and VMware. We are more committed than ever to the strategy we described at our analyst day in terms of the emergence of the virtualized data center and the leverage of various types of channel and technology partners.

The intervening period also confirms our belief that an aging infrastructure is creating time urgency for customers to act. Intercepting the technology refresh of legacy products that cannot match our value proposition in the new data center reality, represents an immediate market opportunity of which we are just beginning to see the results.

At this point I will open up the floor to questions. Although we have more time for Q&A with our new call format, given the number of people in the queue, we still ask you to limit yourself to one question so that we may address everyone during our allotted time.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Brian Marshall – Broadpoint AmTech.

Brian Marshall – Broadpoint AmTech

A question with regards to OpEx as a percent of total revenues, can you talk about if you can get to 45% of OpEx as a percent of total revenues and what the time frame is to get to that point?

Thomas Georgans

The first thing we’d like to do before we answer any questions is acknowledge HP who was gracious enough to start their call a half hour early to allow us to go ahead today on the same day as they did, and also allowed probably most of you to join the call and most of the investors listening as well, so we really appreciate it, and thank you to HP.

With respect to the 45% question, we can get to 45% of expenses as a percent of revenue very quickly if we wanted to. But in doing so, the question one would have to ask is if we’re foregoing opportunities to invest to increase our growth going forward. And there lies the trade off that we have to make and we have to make all the time.

So I think our goal remains to achieve a 16% operating margin over the long haul and we’ll manage between operating expenses and gross margin along the way. There will be periods of time when we’re a little higher. There will be periods of time when we’re a little lower. But over the long haul, right now our goal remains 16%.

Brian Marshall – Broadpoint AmTech

So suffice to say pretty soon here in the near term you’re going to see OpEx grow faster than revenues on a sequential basis.

Thomas Georgans

We’ll see. We haven’t drawn that conclusion yet.

Operator

Your next question comes from David Bailey – Goldman Sachs.

David Bailey – Goldman Sachs

Head count was up almost 70 people this quarter. How should we think about that trend as we move through the year?

Steve Gomo

We’re not forecasting out beyond the next quarter. I do think we’re probably going to see on the order to 150 to 200 people joining us next quarter. Some of that is going to be from some new college hires that really grab coming out. Some are going to be engineering and a few sales people.

As I think Tom noted in his portion earlier on the conference call today, we are starting to invest in the business and certainly engineering and sales remain two of the focal areas.

Operator

Your next question comes from Wamsi Mohan – Bank of America/Merrill Lynch.

Wamsi Mohan – Bank of America/Merrill Lynch

There was significant revenue upside in the quarter relative to your guidance. Can you help us with which areas you saw particular strength relative to your original expectations? You also commented that there were product availability issues throughout the quarter. How much revenue do you think was left on the table because of that?

Thomas Georgans

In general I’d say strength was pretty strong across the board. I think what was particularly notable was the dramatic rise in the entry level systems and I think that a lot of programs that we put in place in the channel, I think we’ve extended our reach and I think we’ve moved deeper into that particular sector.

It’s been something we’ve been working on for awhile. It’s actually something that we’ve been having progress on, but in the last two quarters, we’ve seen quite a big run up. So I think that the strength of the MSC has really been an important part of this as well.

Interesting thing is as you see the numbers, the high end was also strong and I think that’s been a return of some of our larger customers. And we talked a little bit about the performance of acceleration modules on the prepared text, but I also see some of our big service providers see systems moving into that category as well.

So what is interesting about this is that we saw significant strength on the very low end and the very high end which I think would speak to the breadth of the business.

As far as supply constraints, clearly that kept us entertained all quarter, suffice to say. In terms of leaving revenue on the dock, I think we worked very, very hard at trying to understand which revenue we could ship and which revenue we couldn’t ship and expediting things. I don’t know if I really want to speculate as to how much revenue we really left behind.

Clearly it was running from the last quarter to this quarter so there’s a bunch of moving parts there, but I wouldn’t suspect that was a component either on the plus side or the minus side of the numbers we posted.

Operator

Your next question comes from Benjamin Reitzes – Barclays Capital.

Benjamin Reitzes – Barclays Capital

With regard to margins, could you talk a little bit about the 16%? It sounds like it’s going to be higher than 16% for the fourth quarter. And I assume by your commentary that by 1Q you want to go back down and then stay there for the next fiscal year, and I just wanted to see if that’s what you meant by your commentary. And then Steve if you could just clarify what gross margin levels go into that, that would be great.

Thomas Georgans

I think the operating margin target is more of an annual number, so I think we’ll see some variability quarter to quarter as we go through it. I think frankly, the over achievement on revenue has been, I wouldn’t go so far as to say a surprise to us, but I think we certainly weren’t baking that into our operating expense plans as we went along.

So I think there will be a little bit of lag until we catch up to the business a little bit and I think as a result, that will flow through in the form of increased operating margins. We certainly saw that this quarter. But I think in the long run, our objective is to invest in the business.

First of all, the momentum on many fronts has obviously got us excited and I think that there is plenty of avenues for us to invest very, very proactively in order to generate some growth here. So I don’t think this is the time for us to be cautious. So I think we want to address the investment in the business.

Obviously we don’t want to be wasteful and reckless so we need to be careful about it, and some of those investments have a lead time. I would be really clear that we’re not going to be perfectly 16% every quarter. I think you will see some seasonality in our results. And beyond that, with variability on the top line either above or below our expectation, you’ll also see some variability on the bottom line. But right now I think our investment stream is still catching up to the revenue growth.

Steve Gomo

I think that’s a fair characterization. Also the gross margins that support that kind of position in the fourth quarter, I don’t see a lot of change from the third quarter margins levels either on a product basis or on a overall company wide basis. I think we’re going to see pretty steady gross margins in the fourth quarter.

Operator

Your next question comes from Kaushik Roy – Wedbush Securities.

Kaushik Roy – Wedbush Securities

Can you comment on the linearity in the quarter and some of the specific verticals where you saw strength?

Thomas Georgans

Linearity in the quarter pretty much had two dimensions to it. The booking linearity was actually pretty solid and this tends to be a more linear quarter than most because of December being the end of the fiscal year for a lot of our partners and a lot of our customers, and especially IBM. On the other hand, the revenue linearity because of the supply constraints is probably a bit more back end loaded than the bookings would indicate.

Overall, I’d say that the public sector continues to be strong and I’d say that other industries up and down. Tech was strong. Financials, obviously we went through quite a trough there. I think they’ve come back to some degree. And within each of the industries there are winners and losers, so I wouldn’t say that one industry is outpacing the others. I think we’ve got the top end companies in each of the industries appear to be reasonably active.

Steve Gomo

To add another commentary to that, the supply constraints that we’ve talked about here tended to clear up toward the back half of January. We didn’t come completely out of the constraint scenario, but a lot of the constraints were alleviated with about two or three weeks to go.

Operator

Your next question comes from Aaron Rakers – Stifel Nicolaus.

Aaron Rakers – Stifel Nicolaus

One of the things that I look at in terms of your gross margin structure on the product side is, I think you obviously talked about the low end business, but one of the things I don’t know that you really discussed was the continued ramp that we’re seeing in the V series product and that obviously has a very low disc content to it. So it might be helpful just to understand what that gross margin trend looks like, why we should maybe not think that that continues to be a positive driver, any kind of framework of how meaningful V series is either as a percentage of revenue or total product revenue.

Thomas Georgans

I think the way to think about V series is less as an economic engine and more as an opportunity for us to enter new accounts. So one of the things that happens with V series is that we’ll frequently enter with a V series and then as time goes on and customers get familiar with it and their existing infrastructure behind it ages, it will get replaced with traditional FAS systems.

So in some ways, the V series business is somewhat self cannibalizing. So the way we see V series is it’s a relative percentage of overall revenue because the disc attachment as you indicated is smaller, but it’s an enormous tool to enter new accounts because people, if they’re intrigues with the NetApp value proposition and they can see the value that we can bring in, it allows us to allow customers to start using our technology without step one being replacing everything that they have.

So I have V series adoption as a, a measure of people’s interpretation of the difference between the value proposition of the NetApp software portfolio versus that of the infrastructures that they typically have in place, primarily SAN. And more importantly, it’s an opportunity for us to get into new accounts, and that’s primarily as we see V series as opposed to something that’s going to fundamentally change our business model.

Aaron Rakers – Stifel Nicolaus

Is it fair to say that carries a pretty meaningfully above product gross margin relative to your overall business? Is it is a high 70% gross margin versus what you just reported?

Thomas Georgans

It’s a high gross margin product and definitely higher than the norm. On the other hand, as a percentage of total revenue, it’s not a big number. So I wouldn’t be heavily modeling on gross margin. I think it’s more important and indicative of our ability to penetrate new accounts.

Operator

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

Keith Bachman – BMO Capital Markets

I wanted to go to product trends if I could and see if we could understand a little bit more about why Unified ticked up as a percent of total and more importantly, versus SAN, and more importantly what does that suggest about mix and/or new client penetration.

Thomas Georgans

That’s kind of a tough one. I guess there’s a couple things that I would say. I think we’ve been making that point that as customers seek to build more of a homogeneous infrastructure that can run multiple applications, typically those applications have the need for multiple access methods, both file and block.

As a result, as we see more of this virtualized shared infrastructure roll out, then I see more and more customers that are interested in products that can run both at the same time. The other thing is, it gives them an option that if it’s NAS today, it could be SAN tomorrow or vice versa and I think that’s a factor as well.

The other thing that is a little bit different is I think that all along the Unified component is a little bit higher. A customer may buy that app because he can do both SAN and NAS, but they may actually buy certain boxes for SAN and certain boxes for NAS because that’s the way they’re segregated in their installation. However, the Unified storage is the reason why they bought, because it gives them flexibility.

So I would expect to still see some volatility in the Unified number but I think in the long run, if customers want to build a big homogeneous storage infrastructure on multiple applications, the ability to be multi-protocol is going to be an essential requirement and I think single protocol products are going to become essentially obsolete over time.

Keith Bachman – BMO Capital Markets

Does it suggest if it is Unified it’s weighted towards the 3000 line or 6000 line at the expense of the 2000 so that’s positive for mix? That’s what I was trying to understand.

Thomas Georgans

I think on the Unified storage it’s both. So on the high end you might think about business applications or running Oracle but on the low end simply be able to do Windows file services and Microsoft exchange at the same time, would typically generate a multi-protocol system, probably and SF&B and even fiber channel.

So I think from that regard, I wouldn’t rule out the high end versus low end type of a thing. In fact, you might actually see, I would venture to guess that you would see it in both cases.

Operator

Your next question comes from Kevin Hunt – Hapoalim Securities.

Kevin Hunt – Hapoalim Securities

I wonder if you could clarify your comment on investing in the business. It looks like in the quarter you had down R&D expense on a pro forma basis. Is that one area that you’ll invest? You did have a pretty good product margin in the quarter. Is that something you’ll continue to re-invest on a pricing front like you suggested last quarter?

Thomas Georgans

I think we’re going to invest in some things that we believe are going to generate growth and I think it will primarily be field activities, product development activities and service and support activities. Those are the categories of our head count.

I’d say what we’ve been doing all along is we’ve been relatively constrained from a spending perspective as we tried to climb back to our operating margin target and what we have seen in terms of the actual results printed is the impact of the over achievement on operating margin and growth. That’s basically driving a lot of incentive compensation.

And that’s been a big part of our growth, and it remains that way this quarter. Clearly next year, we’ll go back to more of a base line and some of that will go away and the true growth of the business will be more evident in the numbers.

But right now, we’ve had a pretty big run up in operating expense last quarter and this quarter and even buried into our forecast for next quarter, but most of that is in the form of incentive compensation and not really that much of it just yet in the form of increased investment.

We released some spending a few months back. We released more and we’re being more aggressive going forward. So I think you’ll see some of that kick in in Q4 and then more of it in Q1, but Q1 will also see the roll back of the incentive.

Operator

Your next question comes from Bill Shope – Credit Suisse.

Bill Shope – Credit Suisse

I have a follow up on the prior V series question. Can you give us some color on the conversion rate you are seeing with V series customers right now to full NetApp systems and have you seen a material increase in that rate particularly as the economy started to recover and if you have seen an increase, are there any specific verticals where you’re starting to see this conversion become more common?

Thomas Georgans

On the vertical question no. In fact, there was a long time where we had one particular V series customer that was a substantial amount of the V series revenue and they’ve actually converted over to full systems at this point. So in terms of the V series growth numbers, they need to overcome these things from quarter to quarter.

In fact they had their biggest single customer go away. Obviously a tremendous benefit for NetApp. So for us the numbers have continued to keep increasing and the rate of new ones coming in are offsetting the ones going away, but I don’t have a data point on how many of them actually convert, but it’s a substantial number.

There are some customers, even some big customers that have standardized on V series and other people’s back end, but that is not very common. Most customers enter this model with the intention of converting over time.

Operator

Your next question comes from Chris Whitmore – Deutsche Bank.

Chris Whitmore – Deutsche Bank

I wanted to follow up a question around passing cost savings onto customers. Specifically I was wondering if that translated into a higher win rate in the quarter versus competition and to what extend are component shortages impacting your pricing strategy going forward.

Thomas Georgans

On the question on passing it back to customers, I’d say that we didn’t just say sales for go out and discount like mad. I think we did a few things. One of the them was specific channel programs around certain resellers to stimulate business and I think we saw that in the performance of our distribution partners in particular. So that was clearly using above the line on gross margin dollars to stimulate sales without changing our sales behavior at all.

And then clearly there are some accounts that we felt that price elasticity would open up doors for us where they previously wouldn’t have. We basically approved selected deals where we went aggressively and strategically.

So we worked really hard in the past three quarters to get discipline around discounting and I think it’s shown in the results but we weren’t going to give that up overnight. So for the most part we tried to keep that discipline in place and focus our use of our gross margin dollars really on very, very specific targeted accounts and targeted programs for our resellers.

As far parts go, I would say it’s had relatively small impact on pricing. Where it will come into play and really haven’t seen it that much just yet, at least with most of the components, is if our downstream pricing from our suppliers now becomes problematic because of the shortages, then clearly that would create some pressure on us to hold that back from our customers.

However, I think that worst of that, at least for most of the commodities is past, so I think if that was going to happen it would have already happened. But I wouldn’t try to imply the gross margin we saw sequentially had to do with parts. Most of that was mix, IMB component and the strategic choice on our part that I talked about on the last call as an effort to use that very high gross margin to drive growth.

Operator

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

Brent Bracelin – Pacific Crest Securities

I had a question on the sustainability of the rebound here. Still on top of product cycle, second highest number in your customer adds in the quarter. Your outlook suggests that you’re going to return to 30% product growth. How much of the success that you’re seeing would you attribute to share gains from new products versus share gains from new channel partners versus a change in the enterprise spending patterns, improving budget dollars that kind of gives you confidence in the outlook here not only in the quarter but as you enter next fiscal year?

Thomas Georgans

I think that in terms of the overall storage market as a whole, we just put up 15% numbers. HP reported down. IBM was up a little. EMC was down and those are improved numbers for all of them. Hitachi is down. So I wouldn’t claim that this market is by any means robust.

I think that it has clearly improved over the last six months were all of those guys were down double digits. But nonetheless I’d say that it’s not like it’s a roaring success. So I don’t think that we’re expecting a double digit growth rate in this industry to propel our growth going forward so pretty much several things at play.

I think within the context of IT spending, I think storage is going to get a disproportionate amount of the incremental spending by virtue of it being a consumable. I think that virtualization is fundamentally changing the way people think about the data centers of the future and I think that these data center build outs as their equipment ages, is becoming a top priority and that’s going to compete for IT dollars.

So I think our growth opportunity here is basically winning or participating in the segments of the IT that are actually going to get investment even if the overall IT market doesn’t grow. So I don’t think that we need to get significant IT more storage growth for us to grow.

I think we’ll dramatically outgrow the market. I do expect it to rebound. I think we do have some concerns about if we’re going to see another let down, is this going to be a w or not. But on the other hand, the business has momentum and as some point you have to believe, and I think that we don’t want to look back a couple of years from now and say, you know what, we were poised. We were perfectly positioned with the products. We were perfectly positioned with the channel. We passed up an opportunity to invest.

So I think we need to take some courage, go with the momentum of the business, make some investment choices and try to take share when we believe things are in our favor.

Operator

Your next question comes from Jayson Nolan – Robert W. Baird.

Jayson Nolan – Robert W. Baird

A question on AMIA, you were up sequentially on a really tough comp. What are you seeing there and what are your expectations going forward from here in the guidance?

Thomas Georgans

The AMIA growth was actually muted a little bit from what it could have been. The supply constraints while it did not impact our overall business, did impact various geographies and I think Europe was one of the two geographies that was impacted by it. And that just has to do with the mix of customer, the terms of the trade if you will with respect to the orders that we’re shipping against, that ability to get the right parts to the right geography.

So I think that Europe’s revenue tends to be a little bit understated from what it could have been had we not seen the supply constraints that we did.

Steve Gomo

I think going forward you’re going to see a rebound revenue growth wise in both Europe and Asia Pacific particularly in the fourth quarter.

Operator

Your next question comes from Doug Ireland – JMP Securities.

Doug Ireland – JMP Securities

I was wondering if you could comment on any budget flush that happened during the quarter and how linear the quarter was.

Thomas Georgans

I would say that the budget flush was not particularly evident. I would say that I don’t believe that we got a dramatic headwind in this quarter that wasn’t going to persist because of the budget flush. Otherwise, we wouldn’t have guided the way we did.

So there’s no doubt that certain parts of the government still remains strong and I think that certain commercial customers certainly had a budget flush to some degree but I wouldn’t say it was like what we’ve seen in the past.

Probably the biggest non linear component of our business would be IBM which tends to be very fourth quarter centric so clearly they were the highest percentage of our revenue. They were at the high point in terms of the year which is typical. But overall linearity I’d say is more or less what we would have expected.

Operator

Your next question comes from Richard Gardner – Citigroup.

Richard Gardner – Citigroup

You mentioned what you’re doing with the channel in terms of product bundling. Can you give us a sense of what inning we’re in there, how far along that process is, what your channel partners are telling you about that, how what you’re doing compares with what your competitors are doing in the channel? In other words, how unique is this? And how should we think about the margin profile in the channel as the business scales up more?

Thomas Georgans

This going after the channel has been a recurring theme on this call and if I go back a year and a half to two years ago, certainly you had competitors of mine talking about strength in the commercial space which in a lot of ways is synonymous with the channel and we’ve been going after that.

If you look at the volumes of our low end products, we went from 2000 a quarter to 4000 a quarter so obviously a much bigger number this quarter. I guess there’s one side of me that says that we have not completely tapped that market. Certainly we haven’t seen a leveling off. If anything, it seems that either the investments we made, the channel progress we took, perhaps some of the alienation created by some of our competitors has opened up the door.

So I still think we’re early on in this. There’s nothing that would indicate to me that we’re out of ideas or out of channel. The other thing is, most of our dialogue here is about the U.S. I think there’s creativity that we could apply internationally as well in getting some more channel partner leverage over there as well.

Operator

Your next question comes from Mark Moskowitz – J.P. Morgan.

Mark Moskowitz – J.P. Morgan

I want to come back to the mix in terms of the low end. I hear how you’re not concerned about the margin impact but I wanted to see if you could help us understand in terms of some of the other puts and takes with respect to the low end. Is this a function of competitive shift in the market that’s forcing this or is it a function of the channel or could it be a combination also of maybe a refresh as the industry standard is driving lower in the patch to storage.

Thomas Georgans

I guess that could be. If we did nothing and the numbers suddenly materialized then I’d say perhaps there’s some external impact. But what we did in the quarter was we introduced a new product and we pushed our existing low end product further down in the market. So I think our product positioning has changed.

Now it is possible that several refresh has also taken storage refresh with it and maybe our channel partners are connecting those two dots that we are not. That’s certainly a possibility. Certainly we’ve seen server business.

We also try to make ourselves just plain easier to do business with so not only have we done bundles, we’ve reduced the amount of software SKU’s. We’ve got a lot more bundling in with the base unit at fewer options just to make the whole thing easier so the process of flowing through. We did some things so that they don’t have to come to us for pricing.

There’s a whole bunch of things that we did to try to make this easier and in the channel, I think if there’s one lesson that we’ve learned, and perhaps the company knew it but I didn’t, is that product is one component but the process and the pricing and the positioning and the competitive behavior also matter quite a bit as well.

Operator

Your next question comes from Eric Martinuzzi – Craig-Hallum.

Eric Martinuzzi – Craig-Hallum

The public sector strength, it sounds like those trends persists. I was wondering if you could address that by geography and then if those geographies if there is a shift in your guidance.

Thomas Georgans

Most of the public sector is still Federal for us although interestingly enough, the public sector market is actually bigger than the Federal market, so therefore we’re excited about that growth opportunity and it had a big year over year growth, but nonetheless our historical emphasis has been Federal as opposed to state and local and higher ed.

We formed a whole new division. We put that into the public sector component and that’s coming on really, really strong but it’s a smaller number. So right now most of our public sector numbers that we’re posting is really Federal related.

But nonetheless, state, local and higher ed has good momentum. It’s a good market that we’ve truly not participated in very deeply in the past. It’s something that we’re going to go after aggressively.

So obviously with all the components to it, the ramps in the states, and some of the Federal programs that have got state components and the race to the top, all of these things are components of participating at that level.

That’s a big investment we took, one of our most senior people to run that and we put in into our public sector business. But right now, I’d say most of the conclusions you should draw about that business should really pertain to Federal.

Eric Martinuzzi – Craig-Hallum

And that momentum from Q3 continues through Q4?

Thomas Georgans

Yes, I think on a relative year over year basis, Q2 buying season obviously is the big lump in the year so Q2 is usually the big hitter for them and then Q3 is the big drop off and then Q4 is a little bit bigger and then it drops off again. So I think year over year the comparisons are just fine, but there’s no doubt there’s a sequential drop off as you’d expect with the seasonality of that business.

Operator

Your next question comes from Kathryn Huberty – Morgan Stanley.

Kathryn Huberty – Morgan Stanley

How would characterize your visibility in general right now and then more specifically do you have a view yet as to whether revenues could trend better than normal in the typically slower summer months as large enterprise spending continues to come back and you’re able to ship to full demand without the same component constraints?

Thomas Georgans

I wish I could say I had that kind of visibility. I would say external affects, the dollar, the overall economy, are we going to see another leg down. So those types of things I can’t predict so I don’t want to overlay that on my guidance, and that’s why I really only guided for one quarter.

However, what I do feel strongly about and the things I can control are my competitive position, the breadth of my channel, and those I feel really good at. So as far as guidance in terms of how strong we believe that we will be able to maintain our competitive position, I feel good about that certainly into the summer and beyond.

But the overall economic environment, I’m a little bit reluctant to do that. We’re really only one month into 2010 and we’ll see how people are really going to respond here. But overall, I expect our close rates to be more normal. Probably more important than that is that we’re participating in more deals than we ever have in the past and unless the economy ticks down or we have some blow up with exchange rates, I would expect the momentum to continue. But I’m not in a position to do macro economic forecasting.

Operator

Your next question comes from Alex Kurtz – Merriman & Co.

Alex Kurtz – Merriman & Co.

You were talking about making investments in field activities and obviously that’s going to lead to OpEx growth but what specifically, what vertical, what customer segment are you going to be spending your incremental dollars on growing field presence?

Thomas Georgans

Historically our field activities have not been vertically oriented. However, I’d say Telco and service providers is a high priority for us and clearly there’s a lot of secular dollars are going to flow to health care and that’s probably, to the extent that we’re going to go after verticals, it would probably be those two.

But some of the investment is going to be geo based as well as we expend our coverage both in our successful geo’s and also a lot of ego’s where we’re just really getting off the ground.

Operator

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

Glenn Hanus – Needham & Company

In terms of sort of a tech thing, EMC’s been talking up their fast auto which is kind of phase one now with a more important product I guess later this year. Could you give us you competitive view of that and what NetApps is doing in that regard?

Thomas Georgans

I think there is a couple of components. Specifically to EMC, FAS is a collection of things not a specific capability, so FAS Symetrix is different from what FAS is on a Clarion is different from what FAS is differed on a Solaro which is different on a, or what have you.

FAS is kind of an umbrella name for a bunch of point technologies that are different on every platform. But first and foremost whatever NetApp does, it’s going to consistent across all of the SAN and NAS high end and low end.

Second of all, frankly I think the entire concept of cheering is dying and I probably don’t want to go into a long speech on that but at the end of the day, the simple fact of the matter is, cheering is a way to manage migration of data between fiber channel based system and serial ATA based systems.

And with the advent of Flash, and we talked about our performance acceleration module, basically these systems are going to go to large amount of Flash which are going to be dynamic with serial ATA behind them and the whole concept of have tiered storage is going to go away.

Operator

Your next question comes from Rajesh Ghai – Thinkequity.

Rajesh Ghai – Thinkequity

[inaudible] up pretty significantly quarter on quarter. I think it was up 35% quarter on quarter and how do you expect this to trend over the next few quarters and once you’re at the low end are you gaining share over there and who are you gaining share from or it is a question of customers adopting storage for the first time?

Thomas Georgans

It would probably be share and I’ll come back to the question on margins. I think with the growth rate of 15% year over year and forecasting 20% year over year, we absolutely positively have to be gaining share, particularly with product growth rate actually even higher than that which is not true of my competitors where their product growth rate is generally lower than their aggregate growth rate.

But I think we are clearly gaining share and on analysts day I talked about our objective to gain a point of share this year. I think we did more than that this quarter and if next quarter plays out the way we say, I think it will do that as well.

As far as the margin position, I think Steve talked about the mix and as far as the channel is concerned, the channel margins are not substantially different that our large customer margin, so I think the channel mix is not a big margin play.

It will trend down a little bit next quarter. It may. I think we’re not actually forecasting that as part of our marketing calculation, but the number was up quite a bit and there are a number of factors to that. There may have been backlog from the prior quarter so I would probably expect it to come down a little bit but I think that the strength of those two partners and the investments that we’re making in them and some of their partners downstream, that’s going to persist.

So I would expect them to be higher than they were in the past even if it does dip down a little bit from this quarter.

Your question has to do with does you margin structure change as opposed to channel shift between MFV and enterprise market, whatever the case there, high end, low end product the answer is no. There is not going to be a material shift because of that.

If customers at the high end or low end choose to configure products differently or order richer configurations, obviously that could have an impact. But channel shifts in and of themselves shift between our high end and low end offerings, all things being equal are not going to make a material mark on our gross margins.

Operator

Your next question comes from Amit Daryanani – RBC Capital Markets.

Amit Daryanani – RBC Capital Markets

Just a question on you balance sheet. You have about $3.2 billion of cash on hand. Could you talk about uses of cash, acquisitions, stock buy back or actually looking at stock is around $32 for you.

Thomas Georgans

We have about $3.2 billion of cash as you note. Right now we have no plans for a stock repurchase, certainly we’re not announcing anything today. I wouldn’t rule them out in the future by any means. Our objective is still to offset the dilution associated with the option grant with repurchases.

That said, if you look at where we are versus our history, we’re in pretty good shape right now. So as it stands right now, we’re still basically planning to augment our cash balance, particularly our U.S. cash balance to make sure we have plenty of dry powder in case there is an M&A opportunity that comes along that we choose to pursue.

As far as the convert is concerned, yes, the base bond convert at $32 and some odd cents, but remember we had a cost overlay on top of that which takes us up effectively to $41 or $42 convert point. So to be fair we lost about 20% of that cost spread when Lehman went under.

But if the stock goes to $42 I think everybody is going to be happy. That’s our view of it right now.

Operator

Your next question comes from Kevin Shea – MKM Partners.

Kevin Shea – MKM Partners

I’m wondering if the virtual environment is driving more storage demand and just curious if you can give some insight into how much of your business is driven by VMware or VMware related and as far as your technological competitive advantage there, has that changed at all with regards to EMC or other competitors.

Thomas Georgans

Virtualization in general, not just VMware and also virtualization including best virtualization desktop, as well as virtual server are all key areas of focus for us. The competitive advantage that we bring to that space is first of all, I think we recognize it as a trend and made the appropriate development adjustments earlier than anybody else and I think we got the market center.

I also think it exposed, or I should say unveiled a lot of the other technologies that we had in a very positive way. NetApp is still really the only player that does primary D duplication and our D duplication technology in the context of VMware environments is very, very effective.

In fact we run a campaign that on new accounts we’ll guarantee that we can do it in half the space. We have provisional technology called cloning, or flex cloning. It will actually create a copy of the data without actually replicating any of the physical space.

But if you provision virtual desktops to a larger provision, we’ve done demos where we provisioned 5,000 virtual desktops, consumed no additional space and did the whole thing in five minutes.

Then we’ve got other technologies as well including tight integration. So I think the value proposition there is obviously economic. It’s ease of management. It’s reduced space, reduced power. It’s all of those things. I think the economic story is very, very strong. I think that’s what we’ve gone out with.

The technology duplication and the thin provisioning and the flex cloning is also important in other environments as well so I don’t want to make this only about the VMware. But if we look at last year, virtualization was the primary application. We won a new account this year with VM ware. I don’t know if you want to call it an application, an environment is up there with all the traditional environments, oracle and things like that.

So I don’t want to give you the impression that’s half our business but clearly we went from nothing five years ago to now one of the dominant environments in which we sell but it’s also an area that’s growing very, very rapidly for us and growing very rapidly for the industry and a key focus for customers.

So it keeps our story top in mind. In the VMware world, we’re not a server vendor and we don’t own VMware. So for a customer to choose VMware, they need to choose NetApps to run VMware. They need a good reason and I think our value proposition has demonstrated that and VMware has recognized that. Our partnership with them is outstanding particularly at the field level where it really matters.

All in all I think our value proposition is good there and I think VMware has moved less around pure server utilization and now virtualization is enabling what’s ultimately coming with what w call shared infrastructure on cloud computing now that applications are decoupled from hardware. And that creates another whole set of requirements that I think NetApp is particularly well suited for us.

And that was our announcement with VMware and Cisco was that secure multi-tenancy and if you’re going to share an infrastructure, how do you guarantee performance and how do you guarantee date security. And ourselves, Cisco and VMware collaborated on a solution to go after that problem.

So all in all, the virtualization trend I consider to be very positive. And it’s not only VMware, and it’s not only server virtualization. I wouldn’t rule out Microsoft by any means and desktop virtualization is starting to come into its own as well.

I think at this point we’re at the end of our time and I think we’ll wrap up. I’d like to thank everybody for joining us. Once again I’d like to reiterate my thanks for HP who allowed us to not overlap our meeting so we can both get to communicate with our investor base and I’d like to thank you all for your time and your interest in NetApp. Take care.

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Source: NetApp, Inc. F3Q10 (Qtr End 12/31/09) Earnings Call Transcript
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