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NetApp Inc. (NASDAQ:NTAP)

F1Q2011 Earnings Call Transcript

August 18, 2010 4:00 pm ET

Executives

Tara Dhillon – VP, IR

Steve Gomo – EVP & CFO

Tom Georgens – President & CEO

Analysts

Keith Bachman – Bank of Montreal

Jayson Noland – Robert W. Baird

Richard Gardner – Citigroup

Aaron Rakers – Stifel Nicolaus

Brian Marshall – Gleacher & Company

Louis Miscioscia – Collins Stewart

Amit Daryanani – RBC Capital Markets

Ben Reitzes – Barclays Capital

Jason Ader – William Blair

Katy Huberty – Morgan Stanley

Chris Whitmore – Deutsche Bank

Mark Moskowitz – JPMorgan

Brent Bracelin – Pacific Crest Securities

Jason Maynard – Wells Fargo

Brian Freed – Morgan Keegan

Kevin Hunt – Hapoalim Securities

Alex Kurtz – Merriman & Co.

Paul Mansky – Canaccord

Operator

Good day, ladies and gentlemen, and welcome to the NetApp first quarter fiscal year 2011 earnings conference call. My name is Crystal, and I will be your operator for today. At this time, all lines are in listen-only mode. Later, we will conduct a question-and-answer session. (Operator instructions) As a reminder, today’s conference is being recorded for replay purposes.

I would now like to turn the conference over to Ms. Tara Dhillon, Vice President, Investor Relations. Please proceed.

Tara Dhillon

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

Concurrent with today’s press release, the supplemental commentary we published contains many of the metrics and analysis we’ve previously provided during our live call. Our goal is to provide additional time for review of the data prior to beginning the call. This allows us to focus on more strategic commentary and perspectives from our CEO and CFO as well as a longer Q&A period.

As a reminder, during today’s call we’ll make forward-looking statements and projections, including our financial outlook, our expectations regarding future market share, and our beliefs regarding the benefits that our customers will realize from using our products, all of which involve risk and uncertainty.

Actual results may differ materially from our statements or 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 Web site, all of which are incorporated by reference into today’s discussion.

These factors include among others that our quarterly operating results may fluctuate for a number of reasons; that competition may increase in our target markets and that our results may be adversely affected by general economic and market conditions, some of which are beyond our control. All numbers mentioned are GAAP unless stated otherwise. To see the reconciling items between non-GAAP and GAAP, refer to the table in our press release, our supplemental commentary, and our Web site.

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

Steve Gomo

Thanks, Tara. Good afternoon everyone. The NetApp team produced the strongest Q1 in our history with non-GAAP operating margins well above our target and with revenue near the high end of our targeted range despite a seven-tenths percentage point sequential currency headwind.

The strength of our business is apparent with revenue growing nicely, robust gross margins, and strong cash performance. For the second quarter in a row NetApp generated product revenue growth of over 50% and despite the decline from Q4, product margins remained strong relative to our historical levels. The rapid growth in product revenues combined with strong product gross margins is a very good indicator of our current competitive position in the market and is very consistent with our market share gain.

The 51% product revenue growth is also a leading indicator for the strength of our business over time because of the maintenance streams that are attached to our product sales. The same product growth eventually drives the growth of the deferred revenue elements on our P&L.

While the overall gross margin remained strong this quarter, non-GAAP product gross margins did decline by just over a point and a half from Q4 level. This was due to the foreign exchange impact of a weaker euro, sales of less originally configured systems and some volume effects on our manufacturing operations.

On the other hand, non-GAAP service gross margin was up by more than 3.5 points as support contract revenues continued to grow faster than support cost. Our non-GAAP operating expenses declined 4% from Q4 as the abnormally high levels of variable and incentive compensation associated with FY’10’s outperformance were reset with the start of the new fiscal year.

That said, expense levels will rise in Q2 as we realize the full quarter effect of the hiring we did in Q1 along with the impact of our annual merit increase, which went into effect at the beginning of Q2. We also plan to continue hiring primarily sales and engineering resources, albeit at a more moderate pace.

Turning to the balance sheet, I would like to point out that our cash and investments increased by nearly $200 million in Q1 despite the cash payment for the Bycast acquisition and the record payout of variable compensation.

The big contributors to the cash balance were the high level of net profit, the reduction in our receivables balance highlighted by our 30-day DSO and an unusually high level of employee stock purchases and stock option exercises.

The combination of stock option exercises and employee stock purchases added $140 million of U.S. cash to the balance sheet this quarter. Those stock option exercises did have the negative results of increasing our share count by approximately 4 million more shares than expected. We don’t expect this level of additional dilution going forward.

In terms of free cash flow, Q1 ended at 12% of revenues, below our annul target of 17% to 22%. As we noted on our last earnings call, this was anticipated due to the seasonal outflow of cash associated with the payout of record variable compensation resulting from the Company’s outperformance in FY’10.

We are still committed to our annual target free cash flow range. Looking forward, the mid-point of our target revenue range of two to six percentage points sequential growth for Q2 implies our third consecutive quarter of 30% or more year-over-year growth.

At the midpoint, it implies year-over-year product revenue growth of over 40%. Of course, we are taking into account the current economic uncertainty that remains in the market, but we were not expecting an economic tailwind in Q1 and we’re certainly not expecting it in Q2. In up markets or down markets, we believe NetApp will take share.

The strength of our overall non-GAAP gross margin is expected to continue in Q2. This, combined with the high rate of revenue growth is a primary driver of the continued outperformance of our non-GAAP operating margin. With expenses increasing in Q2, we expect operating margins to be in the range of about 18% to 18.5%. Also, without the renewal of the federal R&D tax credit, our tax rate is expected to remain at 16.3% going forward.

To summarize, we expect continued momentum in our business, particularly relative to the competition. While we continue to invest in sales and R&D, we expect the combination of strong revenue growth and solid gross margins will keep our operating margin higher than our long-term target, though probably lower that this quarter’s level.

So at this point, I’ll the call over to Tom for his perspective. Tom?

Tom Georgens

Thanks, Steve, and good afternoon. I’m very proud of the results that NetApp team delivered again this quarter. Despite an unclear economic backdrop, NetApp produced the best Q1 in our history, traditionally our most challenging quarter of the year, and we began our fiscal year 2011 with significant momentum.

In fact, at the midpoint of our target revenue range for Q2, we will have posted 30% overall growth and over 40% product revenue growth for three consecutive quarters. Our focus is on gaining share and our results indicate that we are achieving clear customer preference as IT organizations transform their data centers.

Last quarter we highlighted a metric we have been using internally to measure our progress in the market, the concept of a two-year compare. Looking at this quarter’s revenue compared to the same quarter two years ago eliminates a distortion of weak compares and more accurately represents our sustained growth rate.

Looking beyond our performance to the industry at large, on this metric all of our major competitors range from down double-digits to up only slightly. For each of those already reporting this quarter’s earnings there was actually a decline in their two-year growth rate from last quarter’s compare.

NetApp’s growth in this period was 31%, an increase of six points of growth over a same two-year compare last quarter. This relative outperformance, probably our largest since the dotcom bubble burst, is convincing evidence that NetApp is indeed gaining share. As of last quarter the performance was well balanced across all geographies with each one growing in excess of 30%. Despite overall strength, we did see some areas of weakness in EMEA. We spoke on the last call about our caution regarding the macro environment, and we are pleased with the reported results despite some headwinds.

We remain similarly cautious looking into the upcoming quarter. However, our confidence and our competitive position remain unchanged and we intend to gain share independent of macro factors beyond our control.

We have spoken at length about our demonstrated success in virtualized server environments and that continues. As customers transform their data centers to the virtualized model, a new set of decision criteria emerges. NetApp recognized this several years back and has been the innovation leader in bringing unique solutions to the market.

Among them are technology we co-developed with Cisco and VMware to enable security and data privacy in a shared infrastructure environment, the realization of the full promise of virtualization by enabling application mobility, and tightly integrating this functionality with management tools customers are already using. All of this is built on a platform of integrated storage efficiency technologies that allows our customers deploy with 50% less physical storage than our competition.

We are also seeing good balance in our workload penetration beyond server virtualization. Although somewhat related, desktop virtualization is becoming more common and we have customers that have virtualized tens of thousands of desktops and mobile devices. This is a workload class where our win rate is exceptionally high. Beyond these, we are also seeing strength in more conventional workloads including database, file services, technical computing, and Microsoft application.

The economic slowdown has deferred investments and tech refreshes are long overdue in many of these area. Our value proposition around efficiency, flexibility, and complexity reduction is clearly resonating with new customers and having proven ourselves with existing customers, they are now inviting us to participate in applications and much larger deals that we would not have been considered in the past.

Our partner ecosystem remains a key component of our success. From a go-to-market perspective, our indirect business remains robust and our distribution partners remain at or near record percentages in our overall revenue mix. Our OEM partners, Fujitsu and IBM, are going with IBM up a point in the mix over Q4.

We continue to achieve design-ins with key systems integrators around the world as we become more integrated into the solutions and practice areas they offer their customers. We also continue our joint development and sales activities with our alliance partners, most notably VMware, Cisco, and Microsoft.

Overall, our go-to-market strategy has never been as balanced as it is today, between our direct sales, indirect sales, and alliance relationships. I would contend that we have better channel diversity than any competitor and in areas such U.S. Federal and Germany, where we have achieved sufficient scale and concentration, we have established number one market share positions despite lower sales investment levels.

Internal operations remains focused and disciplined. The manufacturing team has increased unit shipments nearly 80% from a year ago and we had worldwide component shortages yet still returned lead times and inventories to their typical levels.

Our DSO performance of 30 days is indicative not only of our outstanding collection efforts, but a reflection of our invoice linearity and strong customer satisfaction and partner relationships. In addition, our product quality has never been better.

In fact, a recent survey by Storage magazine ranked NetApp Number One in enterprise array quality. But we still have operational improvements to make on many fronts and some areas as yet unaddressed, our initiatives have made exceptional progress in our key components of our financial results.

Once again, we posted a quarter that outperformed our historic 16% operating margin. This is primarily a result of the highest sustained gross margins in the history of the Company and 30% revenue growth as opposed to any sudden change in philosophy regarding spending.

While we are aggressively driving efficiency and productivity enhancing activities, investment in strategic areas of the business remains robust as evidenced by the headcount growth of over 600 people last quarter.

We are firmly committed to taking full advantage of the market share gain opportunity in front of us. The combination of deferred tech refreshes creating impeding demand and the data center transformation enabled by virtualization is creating an urgent and undeniable shift in customer preference towards NetApp solutions.

Capitalizing on this transition remains our top priority and we are pursuing it with levels of investments that are aggressive, but within our ability to effectively manage. Should our revenue and gross margins remain robust, operating margins will continue to remain above our historic levels. If revenue slows, we will reevaluate our market opportunity and adjust our expense levels accordingly.

Our accelerated return to our target operating margin levels last year should alleviate any doubt about our ability to manage expenses when necessary. However, right now we are clearly wining in the market and our investment priorities remain unchanged from last quarter.

I would like to close by thanking the now 9,000 employees of NetApp. The team maintained its focus despite the challenges of high growth, supply line shortages, corporate efficiency initiatives and unsteady macroeconomic indicators to produce the best first quarter in our history.

On prior calls, we have been cautious about the microenvironment that remains unchanged. Our response is the focus on taking market share. Regardless of the economic backdrop, we fully expect to continue to gain share as customers turn to NetApp to enable the modernization of their IT infrastructure.

At this point, I’ll open up the floor to questions, reminding you to please limit yourself to one so we may address as many people as possible during our allotted time. Operator?

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Keith Bachman with Bank of Montreal. Please proceed.

Keith Bachman – Bank of Montreal

Hi, thank you very much. Steve, I wanted just to get some color on the gross margin on how you think the trends are there. You called out services, which clearly was pretty good this quarter, but if you could take down a little bit on the drivers, particularly as we look out to the October and January quarters. How should we be thinking about the current level of gross margins including the potential impacts of product mix that may unfold?

Steve Gomo

Keith, let me start by giving you a quick bridge from the fourth quarter to the first quarter and explain in a little bit more detail why our product [ph] margins are up. There is really two big items there; both are about nine-tenths of a point. The total drop is 1.7. Now, the first item there is the net impact of foreign currency. This is the foreign currency impact offset by our hedge, mostly what was associated with the euro. So that was nine-tenths of a point. Product configuration was the second big item that was also nine-tenths of a point, and this includes things like software mix and richness of the hardware configurations, some discounting, etc.

So those two items right there explain most of it. Everything else tended to wash. There was a slight unfavorable volume impact, but that was offset by some other favorable manufacturing transactions. As we move forward, I would expect product gross margins to stay kind of in the range it has been in, maybe right where it is today, maybe slightly higher as we look out into next quarter and then hovering in a one point to two point deviation of where we are. So I think we’re in pretty good shape. I don’t see anything on the horizon that’s going to significantly change our product gross margins over the next couple of quarters.

Keith Bachman – Bank of Montreal

Okay, thank you, Steve.

Operator

Our next question comes from the line of Jayson Noland with Robert W. Baird. Please proceed.

Jayson Noland – Robert W. Baird

Thank you. It’ll be a question on your traction in Web 2.0. Have you seen increasing wins there? I guess could you talk about just your success here given multi-tenancy and everything else?

Tom Georgens

Well, Web 2.0 covers a lot of ground. Clearly, some of the largest service providers in the world, some of the largest consumer brands that you’re well aware of, that you use everyday are big consumers of NetApp technology. In fact, depends on where you want to go with Web 2.0, but if you’re talking about consumer services, whether you’re talking about handheld devices, and business services attached to that, I think we’re pretty well positioned in those particular markets and I would suggest that we clearly have a dominant share in those particular categories.

As far as broader infrastructure, is if you’re referring to Google and things like that, they clearly have a homegrown infrastructure that at this point is off-limits at least in terms of their search business to companies like NetApp and other commercial players. Overall, I think in the Web 2.0. space, if you tick off the big brand names that are buying commercial products, I think you’ll find that NetApp is extraordinarily well positioned. Obviously, you can add Yahoo! to that mix as well.

Jayson Noland – Robert W. Baird

Thanks, Tom.

Operator

Our next question comes from the line of Richard Gardner with Citigroup. Please proceed.

Richard Gardner – Citigroup

Great, thank you. Steve and Tom, I was hoping that you could talk a little bit about linearity throughout the quarter. I know that there was a reference to that in your prepared remarks, but can you talk about whether you saw the same type of pause mid-quarter around the European situation that Cisco talked about on its and how orders basically trended throughout the quarter?

Tom Georgens

Let me talk about linearity, which is an invoice linearity phenomenon and also drives our receivables. So, our invoice linearity, which to some extent is a reflection of the orders we’re seeing, was remarkably linear during the quarter. In fact, the last five weeks was exactly what a five-week would result in if you calculated the math. So, there is no question that that linearity helped us with respect to managing our receivables as we were able to collect a lot during the quarter.

As far as orders were concerned, I didn’t denote any significant linearity deviations in the quarter. It was a typical first quarter from my standpoint. Even peeling back a layer and looking down into the regions, I didn’t see anything that was significant, save the currency effects of Europe, which I think everybody experienced. Aside from that I didn’t see anything.

Steve Gomo

The one thing I’d add to that is, first of all, to be perfectly honest I wouldn’t want to underestimate our week-by-week intra-quarter analysis of dynamics of a business getting weak and getting back again. I think we don’t quite have that granularity of the business. We clearly have a run rate business, but the weak lumpiness is really driven by big deals.

Tom Georgens

The one thing I would say about Europe is clearly there’s a lot of headlines around Europe. While we turned in a remarkably strong revenue quarter in Europe, we did see some areas of weakness. For one, we hear a lot about southern Europe. For us that’s a small market. So the impact on us I think is pretty modest. We are certainly seeing talk of austerity on behalf of the European governments and probably the place where we saw that was in the U.K. U.K. is a meaningful market for us, and a slowdown there clearly has some impact on us. Southern Europe is a place where we have no market share.

Frankly, my response is, if you have no market share, the macroeconomics don’t really matter that much. I think we have opportunity to win business there independent of the macro. So all in all, I think in the aggregate we had a good EMEA quarter, and I think we were strengthened by areas we had been previously weak, but nonetheless, we do see in the overall landscape, particularly in the government spending side, some changes particularly in the U.K.

Richard Gardner – Citigroup

Thank you.

Operator

Our next question comes from the line of Aaron Rakers with Stifel Nicolaus. Please proceed.

Aaron Rakers – Stifel Nicolaus

Yes, thanks, thanks for taking the question. The question is on the inventory side. Looks like you guys had a pretty solid management of inventory this last quarter, down about 20% sequentially. Steve, I think last quarter, you had alluded to the fact that some of the shipments got reversed and put back onto your finished goods line. You actually made the comment that you’d carry a similar level of inventory exiting this quarter as you did last quarter. I kind of read that as somewhat of a pipeline coming into this quarter, so the question is help me understand the inventory decline and whether that actually did play out where you are carrying a similar level of inventory as you had alluded to in the commentary last quarter?

Steve Gomo

I guess, simply put, I think from that dynamic; I think that came to pass. I think the inventory picture, we went through a period of relatively significant supply shortages across the board, and we were doing a lot of things to protect ourselves. We were running into obviously piece-parts and cheap metal in semiconductors, so we did a lot of longtime purchases and a lot of hedging against potential demand mixes, so we wouldn’t get caught short.

I think in the end, certainly our performance wouldn’t indicate that we left much material on the dock or much revenue on the dock because of supply line issues, but the price we paid I think was a buildup in inventory to protect ourselves. As we see the supply line constraints relaxing to some degree then we need to protect ourselves with longer term procurements and longer term protection, and inventory goes down and I think that’s a big think we saw in the inventory number rather than any broad manipulation or any timing of finished goods.

Aaron Rakers – Stifel Nicolaus

Thank you.

Operator

Our next question comes from the line of Brian Marshall with Gleacher & Company. Please proceed.

Brian Marshall – Gleacher & Company

Great. Thanks, guys and nice quarter. I just wonder if you can talk a little bit about your assumptions for the October revenue guidance, about 2% to 6% sequential and what you are baking in for specifically EMEA, perhaps U.S. Federal and the indirect channel.

Steve Gomo

So we don’t typically disclose all of our geographical projections or whatnot. Suffice it to say that if there was a serious problem in any significant area like Europe or like one of our major verticals, we wouldn’t be able to make these kinds of projections.

Brian Marshall – Gleacher & Company

Thank you.

Operator

Our next question comes from the line of Louis Miscioscia with Collins Stewart. Please proceed.

Louis Miscioscia – Collins Stewart

Yes. Gave us very good color about what’s happening in the U.K. with the government austerity programs here, just maybe going back to John Chambers’ comments about his customers in general starting to get very cautious or not giving a lot of visibility in those spending trends, obviously, your guidance implies that things seemed pretty decent for NetApp. Maybe if you can just go in a little bit deeper into what CIOs or CFOs are telling you about what they expect to do for the rest of the year?

Tom Georgens

So I think it’s a couple of things. One of which is that our view of the market is through our customer base and our prospects in our channels. So I can report what we see there. What we see there is, as I described it, I would say that the overall climate in majority of the geographies is largely unchanged. I talked about specifically where we saw weakness and I think you would be correct to imply that the other areas that I did not call out, we’ve not seen any change, certainly not through the context that we deal with, which clearly, represents our installed base in our prospect list. Now, clearly FX is a problem and there will be some volatility associated with that, that’s hard to predict.

Now, on the broader question about CIOs and are they slowing down, I can’t say that I see that. I will say that we will get up in the morning and we’ll all read the headlines, and most days they are not as good. What I have been saying on the last few calls is that business levels are better than the headlines would indicate and it’s been that way for long time now. So I don’t know whether that’s the function of our value proposition or who we do business with or the channels that we’ve developed, but I think that’s helping us.

The other thing is our momentum in a relatively slow growth market, clearly, really has helped us attract other channel partners who also want to help distribute our products. So I think that’s expanded our coverage a bit. But all in all, I would say while the headlines are not pretty, I am not seeing that translate into CIO behavior. In fact, if I had a more detail summary of CIO discussions. CIO discussion are much more high level than that and that is what they are effectively seeing is that they are under tremendous pressure by the CIOs to basically support the business requirements of the company. People want to do acquisitions, they want to be flexible, they want to make changes in pricing, they want to make changes in strategy and frequently IT is the long pole in the tent. Likewise, I think competitive pressures are putting pressure on IT budgets and I think IT budgets are under a lot of pressure.

So the combination of meeting the flexibility of the business along with the inefficiency and reducing that making IT more cost effective, that’s the pressure that people are seeing, and if you layer on top of that kind of a slowdown that’s been extended, IT infrastructures are aging. They have been aging inefficient infrastructure. They need to move to a new model. They are under tremendous pressure to support the ability and the business philosophy that’s in front of them. That’s primarily the dialog I have with CIOs. They may be told some day that their budgets have been cutback, but right now they are responding to the pressures of the business.

Louis Miscioscia – Collins Stewart

Okay, thank you. Good quarter.

Operator

Our next question comes from the line of Amit Daryanani with RBC Capital Markets. Please proceed.

Amit Daryanani – RBC Capital Markets

Yes, thanks. Just had a question on operating margins. Nice to see margins ramp up to, I think, 18.8% this quarter, you guys are talking about 18.3% for next one. How should we think about your comments, I think, from the last call that basically was around 17.5% margin target for fiscal ‘11? That would basically imply margins will go to 16.5% range for the back half of fiscal ‘11, is that kind of what you guys are expecting right now?

Steve Gomo

Well, I think we want to do this one quarter at a time. The simple fact of the matter is as long as gross margin are strong and revenue growth is strong that’s going to create a pretty big umbrella. We are spending aggressively underneath that, but nonetheless we are still producing ever increasing operating margin.

So as long as the revenue growth remains robust and remains strong, we continue to guide yet another quarter of 30 plus percent growth, then there is really no way for these operating margins to go down. I think we are spending aggressively. We believe in this opportunity. We’re certainly not pulling back. But I think there is a limit to which we can do prudently and do effectively.

So at the end of the day as gross margins stay high and revenue growth stays high, the operating margins are going to stay high, and each time we keep forecasting a 30% growth quarter then I think that we are just going to push out the downward pressure on the operating margin. So for now, there might be a little bit of moment. We just had our biggest hiring quarter of all time. We’ll absorb that for a full quarter of expense.

But overall, it’s the fundamental strength and the robustness of the top line in the gross margin that’s creating this. There is no other philosophic change here. As long as that stays strong and I think you are going to see gross margins in this range.

Amit Daryanani – RBC Capital Markets

I guess just to clarify, you definitely do not…

Steve Gomo

I got to cut you off at one question, I’m sorry.

Amit Daryanani – RBC Capital Markets

All right.

Operator

Our next question comes from the line of Ben Reitzes with Barclays Capital. Please proceed.

Ben Reitzes – Barclays Capital

Yes, thanks. Can you comment on two things? I noticed in the release it says V-Series was down 38% I believe sequentially, and your petabyte shipped in the Fibre Channel were down. There were many really good numbers. Those were two that stood out that were going in the direction. I wanted to know why those were down, and what that means, if anything.

Tom Georgens

Well, I think V-Series has got a couple of moving parts. First of all, (inaudible) was up 40% something year-over-year, if I remember the number. So I think that obviously big deals will move around, there will be some lumpiness, but in terms of the overall trend, it’s unmistakably positive. I don’t think we’re fretting over it at this point. The other question on Fibre Channels being shipped is, it’s kind of an interesting dynamic. Its overall petabytes were up significantly, despite the fact that it’s a seasonally down quarter. I think there’s a couple things at play. First of all, a lot of the Fibre Channel demand or enterprise demand is going to move towards SAS, so the SAS was up significantly. So we kind of put SAS and Fibre Channel in the enterprise class drive space.

And then more broadly, I think there’s another idea at play, and the other thing that I think is at play is that we’re starting to see with the advent of the high attach rates of our flash memory, we’re starting to see flash as a cash in excess of 20% of the eligible systems. The rationale there is if you can have big enough cash, you could soak up a lot of random I/O workload. That’s really the only reasons why Fibre Channels rise. So we’re seeing capacities grow up, shifting from Fibre Channel to ATA, thereby eliminating a tier of storage making the systems easier to manage and it’s being driven by flash, so I think all of that’s a good thing.

Overall, I think you need to think about mix as mostly SAS plus Fibre Channel in terms of the enterprise drive space. At the end of the day, I think flash is going to diminish the use of enterprise drives in these types of systems, simply because of its ability to soak up the I/Os per second and obviously the semiconductor is a lot faster than the rotating media, and storage is primarily going to be used for permanent storage without a performance requirement on it it’s going to go Serial ATA. That’s a trend that I think we are leading. I think our flash attach rate is by far the highest of the major vendors, and I think we’re leading this and basically it drives the level of simplification and eliminates tier of storage in a tremendous number of environments.

Ben Reitzes – Barclays Capital

All right. Thanks.

Operator

Our next question comes from the line of Jason Ader with William Blair.

Jason Ader – William Blair

Yes, thanks. I have two very quick questions. So it’s really about the size of one. Number one service margins, where do you see those going, Steve? They were very high this quarter. And then also the G&A line, that was a down pretty substantially. Where should we see that going?

Steve Gomo

So, service margins are probably I think in a pretty high range right now, and I don’t expect to see them expand a whole lot from here in the next few quarters. I think that you should see it hover right around where it is. It may even step back slightly a point or two. So I think we are kind of at the range right now. I think we are kind of in a range that we’re going to operate in within the next couple of quarters.

With respect to looking forward at the G&A line, we did have a big step down from the fourth quarter. A lot of that had to do with the incentive comp, etcetera, and then we have a lot of concentration in that particular line, but I am looking forward to it. Inching up slightly low single digits and I’ll take it quarter at a time, so I am only going to go a quarter out there.

Jason Ader – William Blair

So Jason, you asked two questions, so we’ll give two answers. On the professional services side, component of service, part of the movement of that I think has been by design. I think we said on this all before, I certainly said publicly of our intention on professional services.

The focus of our activity is on customers that insist on getting professional services directly from NetApp and likewise significant projects that only NetApp can execute on. A substantial amount of the general territory professional service activity we spent a good part of the last two years training up our partners and transferring that business to them. So that’s a lower gross margin mix for us, but attractive business to them.

We find ourselves getting partners that are well-trained in our products and we find ourselves competing with them less for business that they care about. So part of the professional services move is or part of the overall service margin move, is a result of a conscious effort on our part to rethink our professional services strategy, the one that’s more focused on high-value engagements and also more compatible with our channel partners.

Jason Ader – William Blair

Thank you.

Operator

Our next question comes from the line of Katy Huberty with Morgan Stanley. Please proceed.

Katy Huberty – Morgan Stanley

Thanks. Good afternoon. Another segment where the headlines have been negative is the U.S public sector, but your results were incredibly strong whether you look at them sequentially or year-on-year, and you’ve got a number of peers like Brocade and IBM blaming federal for some weakness. What do you think is going on in your business versus the rest of the market? Do you think we’re seeing a year-end federal budget flush and is it sustainable?

Tom Georgens

Well, it’s certainly the federal season and so we’re pushing up on the end of that fiscal year of course. I certainly don’t want to comment on other people’s commentary, but our view of the market and our view of the momentum and our customer base is still very positive. So, at this point, I certainly read the headlines, I certainly read the commentary. Some of that consolidation is around customers that we have. So some of that is actually good for us.

So, all in all, at this point, while I read the headlines and we certainly have the appropriate caution and we probably inspect the results and question the field at a higher rate than we normally do, the overall actual realized business level appears they’ll still be very, very strong. So at this point I’m not signaling any weakness in that territory.

Tara Dhillon

Next question, please.

Operator

Our next question comes from the line of Chris Whitmore with Deutsche Bank. Please proceed.

Chris Whitmore – Deutsche Bank

Thanks very much. Wanted to ask about the relative weakness in the mid-range versus the high end and the low end. Is that a reflection of any changing dynamics within your business? Or perhaps you can comment on new customer acquisitions, would that help drive the strength at the low end?

Steve Gomo

There is a fair amount of quarter-to-quarter volatility. I think that the fact that in this particular quarter, I mean as we go through the year we seem to do all the permutations. This one is the one where the low end or high are successful. I think there is a bunch of dynamics at play. I think the low end is probably the one with the most dynamics and that is the channel play, the strength of our channel partners, the emergence of some new channel partners that has taken us in that direction is probably indicative of our penetration to the mid-sized enterprise, which was very strong in this quarter. I think the low end is probably an element of just greater and greater and greater channel penetration as a company.

I think as far as the rest of the products, I don’t necessarily think of the rest of the products in terms of entry, mid-range and high end. I just kind of think of this small, medium-sized and big and customers have different requirements. So I’ll not read anything into it. I think the mid-range is still 50% of the business. But all in all, I think rather than skewing all to the bottom or all to the top, the fact that the top and the bottom probably tells me there probably isn’t much going on in the market.

Tara Dhillon

Next question.

Operator

Our next question comes from the line of Mark Moskowitz with JPMorgan. Please proceed.

Mark Moskowitz – JPMorgan

Thank you. Good afternoon. Tom, I want to come back to your earlier prepared remarks regarding NetApp’s ability to penetrate both new and existing customers in workloads or applications, maybe historically you’re not given the opportunity to. So can you talk about is this being driven by one, NetApp’s own sales efforts or just because of the partnerships with Cisco or Microsoft and VMware they are helping out? And then the core there is, these type of inflation, are they higher margin kind of higher recurring revenue streams longer term once established?

Tom Georgens

So I think that there is a bunch of components there. I previously told people that kind of the anatomy of a NetApp sales call is that we’re going through an account and the story we tell is very different than what the competitors tell. Typically, the response to that is, we’ll escalate if you can do that, but I am not so sure I believe you, and our response to that is, well give us a project to prove ourselves. And then we insinuate ourselves and we grow. That’s how NetApp grew, post dot.com bubble to obviously the great recession, we actually had very, very high growth rates without a lot of new customer acquisition, and most of it came through that model. Now that insinuate ourselves in and then approve ourselves to more and more and more applications.

I think that what we’re trying to do over the last couple of years, certainly since the beginning of the slowdown on financials is really go after expanding our installed base and doing new customer acquisitions, that’s why it’s such as big high priority for us. A lot of the storage 5000 analysis came out of our searching for just how concentrated we were. So I think a couple of things happened.

First of all, as we enter new accounts, one thing that is happening is we’re entering accounts with bigger and bigger deals and there is no doubt that our alliance partners are helping us. Just the combined creditability is greater than either one of us alone, there is no doubt about that. So I think we are bit more credible. I think we have a bit more crisper value proposition and we are also aligned with some partners. So the amount of first time transactions with new customers that are much larger is actually much higher than it has ever been.

But I think, more broadly, even the other customers that we enter on a more ‘can you prove yourself point of view’, I think we are opening that up. So we may enter on file services or VMware and then bid on Oracle database or bid on SAP or bid on other types of things. In terms of the margin profile, it’s probably safe to assume that first time transactions with new accounts because typically they involve unseating somebody else who is an incumbent. Those tend to be more challenging from a margin perspective.

Clearly, once you have proven yourself and customers realize your value and they are willing to factor that value into the pricing discussion, things like being willing to accept less physical storage from NetApp than a comparable bid from a competition because they have already realized and they have proven the benefits of deduplication. Those things do help us. So it’s probably safe to assume that repeat purchases at new accounts are probably better margin deals than brand new breaking into new accounts.

Operator

Our next question comes from the line of Brent Bracelin with Pacific Crest Securities. Please proceed.

Brent Bracelin – Pacific Crest Securities

Hi, thanks for taking my question. Tom, I wanted to go back and try to put things in a perspective. If I go back to the 2004-2007 timeframe, NetApp was able to sustain I think 30% plus grow through share gains, you were hiring I think 200 to 500 employees a quarter, margins were in that 15% to 17% kind of range. I guess part A, do you see NetApp entering another two, three year sustainable share gain cycle? b), is NetApp at the scale, where you can sustain share gains and 18% op margins going forward or as we model the next couple years out, think about the balance between kind of that long-term target of 16% and the 18% where you are at today?

Tom Georgens

Okay, so all of you are trying to outsmart me with these two part questions. Just a few things on what’s different between when we used to be growing 30% as opposed to when we’re growing 30% now. I think one thing that’s different from a business model perspective is that our gross margins are four points higher now than they were then. I think that’s clearly driving the operating margin. So, part of that is a reflection of that we’ve got higher margin stuff coming off the balance sheet, which is certainly contributing to the higher gross margin. The flip side, however, is the stuff coming off the balance sheet was put on a long time ago when we weren’t growing at 30%. So ironically, despite our high growth the stuff coming off the balance sheet has actually been slowing us down and our product growth rate has actually been higher.

So I think as time goes on when the ins is coming in at a high growth rate than the outs, then we will start to see the deferred coming off the balance sheet grow faster. In the near-term that’s actually an impediment to our growth, but we’ve been able to overpower it by just simply outstanding product growth. I think as time goes on, one thing that you need to factor in between that period and this period is what is the total aggregate growth rate of the industry, and the aggregate growth rate of the industry is flat to negative. It’s hard to maintain 30% growth. It takes a lot of share gains to do it.

On the other hand if it returns back to those numbers, I think on our Analyst Day, we basically did just a brief analysis of the industry that basically said that if we can gain simply a share point per year and you assume the IDC estimates for next five years and that’s 15% to 20% product growth rate right there and this year we’re clearly going to gain well more than a share point, and you can debate whether it’s going to sustainable, whether IDC is right, or all those other types of things. Right now our focus is on gaining share and if we are gaining a point to a point and half per year then I think we’re going to be one of the few companies of our size that’s growing at a high rate. Whether it’s 30% or 20% is really going to be a function of what the overall growth rate of the aggregate industry is and I’m probably not prepared to predict that.

Operator

Our next question comes from the line of Jason Maynard with Wells Fargo. Please proceed.

Jason Maynard – Wells Fargo

Hi, good afternoon. Maybe just a follow-up on the share gain commentary. When you look at the virtualization market, are you seeing any dynamics playing out where your partnership is with Microsoft and the work you’re doing on the desktop side tying into some of the server virtualization deployments?

Tom Georgens

No, I think that they clearly play in if we have won the server virtualization deployment, because it allows us obviously an easy entrée to have this next conversation. If it’s an account where we do not have a presence, so we are on the outside looking in, and clearly that’s a bit more challenging of a scenario.

On the desktop virtualization side, the value proposition is pretty compelling. The zero-space copies allows you to do desktop virtualization storage for cheaper than what the raw drive would be on your laptop and that’s a pretty powerful story and there’s been some really public comments by some of our partners in that domain about how cheaply we can do that and how compelling that is. I think that’s why our win rate is very high.

Nine out of the 10 largest banks at Wall Street have selected us for virtual desktop. I think there is no doubt that virtualization in general is a very, very strategic trend in the data center. If you were connected to that and you are a provider to that that’s what’s enabling them to modernize, that’s what’s enabling them to build a big homogeneous infrastructure capable of running multiple apps simultaneously. That’s how they drive out costs. That’s how they are extending flexibility. That is the core of the modernization that’s going on.

So if you are connected to that, then you are party to all the other dialogue that’s going on in the business. So if win an server virtualization, now we’re in the door, we’re credible, we’re enabling the more strategic initiatives they have underway, and it opens up the door to talk about some of these other applications that they may have in place.

Operator

Our next question comes from the line of Brian Freed with Morgan Keegan. Please proceed.

Brian Freed – Morgan Keegan

Good afternoon. Thanks for taking my question. Real quick, if you look out at the market and your goals for driving future growth, can you talk about the market opportunities that you think will be the primary drivers? You’ve mentioned virtualization, virtual desktop, you guys acquired Bycast, and so you fairly see the Grid Medical Archive, and then you get the scale-out NAS product that you’re working forward with. Can you talk a little bit about of those three, do you see any of those as standout those areas that would drive particular growth or market share gains going forward should you successfully execute?

Steve Gomo

I think there is a timeframe associated with all of them. When you’ve seen data that would say that somewhere between 60% and 80% of all storage is going to be deployed in these virtualized infrastructures, so it’s pretty clear that we have to win there. Because if we don’t, there isn’t enough rest of the market to satisfy our growth aspiration.

On top of that, I think that there’s plenty of opportunity to continue to innovate in that particular space. That said, I think, overtime, there are clearly other storage consuming spaces that are going to emerge that are different workload types. I think, certainly the healthcare vertical, but more broadly the idea of very, very, very large numbers of object, whether they be video objects or email objects or whatever, medical images, you name it.

So I think the bulk storage of large numbers of objects that can be effectively managed is an important one, and that’s really what drove us down the Bycast route, is they built a very, very powerful vertical in the medical side, but I think there is also applications for that in a lot of other places, including Web2.0, media. There are a number of government things that we’re pursuing, pharmaceuticals you name it. So I think that the management are very, very, very large objects.

If you look at accounts like ours, like Yahoo! and other ones that I can’t mention, we’re talking about people that have got billions and trillions of things to manage. It’s going to take sophisticated things to do that. But I think at the core business applications that virtualize is a key one, database is unquestionably a key one. So business applications I think in the near term is still the biggest storage opportunity. But going forward, whether it’d be the consumer cloud, whether it’d be the enterprise cloud, likewise large archiving applications of tremendous amounts of data, I think those are all significant tools of data going forward and we want to participate in that.

Brian Freed – Morgan Keegan

Thank you.

Operator

Our next question comes from the line of Kevin Hunt with Hapoalim Securities. Please proceed.

Kevin Hunt – Hapoalim Securities

Hi, thank you. I just want to follow up on the OpEx question that someone was asking earlier. You’re talking that your total OpEx was down roughly $20 million or so sequentially, yet you hired more people this quarter than you did in the last year, and I think I just in the entire history of the Company actually in a quarter. So just wondering if you could kind of talk about those two effects, were those sorts of late in the quarter hires or kick in fully in the future or is the sort of higher bar on performance incentive comp more than offset that?

Steve Gomo

Basically, the hiring was pretty much linear throughout the quarter. So it wasn’t backend loaded necessarily. There wasn’t anything unusual about the timing of the hires. I think the biggest phenomena here and you can see the impact on the balance sheet as well, it’s a fact that we had all this compensation that we had accrued for our incentive compensation program for the employees, in fact, it was record for the Company, and the fact that basically that flowed out and we went back to a normal accrual rate based on the standard program that we have was the big difference.

So we come off of fourth quarter when the ICP was being accrued at an accelerated rate back to a standard quarter when it’s substantially less than that rate. Now, we see what it’s like going forward. So that’s the biggest single effect. Now, obviously, that gets neutralized or the clock gets reset, if you will, only one time at the beginning of the fiscal year. So going forward, now we’ll just continue to build up the accrual as we go. Although to be perfectly honest, our intention is to outperform and build up that (inaudible) yet again.

The other thing I would add is that in that 640 number, this is also a new college grad season and it was also the Bycast acquisition. So those two times combined is about 200. Bycast was early in the quarter and a new college grads pretty much started in mid-May and spread out, so they are probably a little skewed towards the beginning as well.

Operator

Our next question comes from the line of Alex Kurtz with Merriman & Co. Please proceed.

Alex Kurtz – Merriman & Co.

Yes, thanks for taking the question. Tom, can you just talk about your view of 3PAR acquisition at Diego by Dell, a), what does that mean for your relationship with Dell? How does it make you guys think about M&A going forward?

Tom Georgens

So, I think as far as our relationship with Dell, that’s passive. I mean they are our competitor, and we certainly sell into Dell environments. So I don’t think we have much relationship to jeopardize. I mean it’s not bad, but they are just a normal competitor. I think obviously the relationship question applies more directly to EMC, and I think we can debate is it bad or is it very bad, but suffice it to say it is probably not good for the relationship with EMC.

Alex Kurtz – Merriman & Co.

That is more like, with couple of other smaller vendors out there, sort of tuck-in acquisitions you guys are still thinking about in the specific area of the storage environment? So you guys are still thinking about just generating cash and keeping on the balance sheet for now?

Tom Georgens

No. I think that the transaction probably doesn’t change our thinking in any meaningful way. I think that the business being bought out probably was not a surprise to anybody. Probably the price indicates there is probably more than one person interested in just the 3PAR for extracting that value. I think Dell is a lot easier to bundle the Ecologic with the server business than it is with 3PAR. I think Dell will certainly open up a lot more doors that they couldn’t open on their own. But 3PAR, as a technology still got to win (inaudible) against all the normal competitors and that’s probably going to be a little bit more exposed storage sale than Ecologic was.

As far as our thinking, we’re always looking for tuck-ins. Certainly, nothing about this changed our tuck-in belief. As far as larger transactions, I think that if the time is right and the price is right and the affinities are there, I’d say that our thinking on acquisitions is there has to be something that has some affinity to what we do, has to be something that either our sales force can sell, or something that by virtue of having it in the portfolio we can move more of our existing product. So I’m not looking for just similar assets just to be a holding company, I don’t think that’s worked for anyone in our space. On the other hand, we’re always interested, both large and small on things that have got affinity for our core business that we can leverage. I think that Dell, 3PAR deal probably doesn’t change the timing of that any.

Alex Kurtz – Merriman & Co.

All right, thanks.

Operator

We will take our last question from Paul Mansky with Canaccord. Please proceed.

Paul Mansky – Canaccord

Thanks for squeezing me in. Your primary competitor has been broadcasting a series of product introductions expected over the next few quarters here. I know that you obviously refreshed your lower end a little less than a year ago. Should we be thinking about a mid or high-end refresh soon? If so, does that have any bearing on mid-range performance on the quarter?

Tom Georgens

I don’t think so. There’s no doubt that the hardware releases have more of an impact on our business than software releases, but it’s not like we’re going to have something next week for people to buy. So I don’t think that that was a big factor. I think we’re all in this normal horse race of upgrading our platforms, so I think you will continue to see new platforms from NetApp, and you’ll see you platforms from all of competitors. At the end of the day, I think, the platforms matter but the software matters more, and I think the software differential is really what’s driving our performance right now, and I don’t think that that gap is going to get close.

Operator

This concludes our question-and-answer session. I would now like to turn the conference back to Ms. Tara Dhillon. Please proceed.

Tara Dhillon

Thank you for joining us today, everyone. We will be projecting to announce our earnings in November and our coming Analyst Day will be in March 22 of 2011. We hope you’ll join us then. Thank you.

Operator

Ladies and gentlemen, that concludes today’s conference. Thank you for your participation. You may now disconnect and have a great day.

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