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NetApp (NASDAQ:NTAP)

F3Q11 Earnings Call

February 16, 2011 5:00 pm ET

Executives

Thomas Georgens - Chief Executive Officer, President, Principal Operating Officer and Director

Steve Gomo - Chief Financial Officer, Principal Accounting Officer and Executive Vice President of Finance

Tara Dhillon - Senior Director of Investor Relations

Analysts

Louis Miscioscia - Collins Stewart LLC

Brian Marshall - Gleacher & Company, Inc.

Maynard Um - UBS Investment Bank

Keith Bachman - BMO Capital Markets U.S.

Benjamin Reitzes - Barclays Capital

Richard Gardner - Citigroup Inc

Amit Daryanani - RBC Capital Markets, LLC

Aaron Rakers - Stifel, Nicolaus & Co., Inc.

Jayson Noland - Robert W. Baird & Co. Incorporated

Shebly Seyrafi - Capstone Investments

Kaushik Roy - Wedbush Securities Inc.

Eric Martinuzzi - Craig-Hallum Capital Group LLC

Chris Whitmore - Deutsche Bank AG

Kathryn Huberty - Morgan Stanley

Mark Moskowitz - JP Morgan Chase & Co

Alex Kurtz - Merriman Curhan Ford & Co.

William Fearnley - Janney Montgomery Scott LLC

Jason Ader - William Blair & Company L.L.C.

Jason Maynard - Wells Fargo Securities, LLC

Bill Shope - Goldman Sachs Group Inc.

Operator

Welcome to the NetApp's Third Quarter Fiscal Year 2011 Conference Call. My name is Monica and I'll be your operator for today's call. [Operator Instructions] I will now turn the call over to Tara Dhillon, Vice President, Investor Relations. Ms. Dhillon, you may begin.

Tara Dhillon

Good afternoon, everyone. Thank you for joining us today. With me on today's call are our CEO, Tom Georgens; 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 earnings release, the supplemental commentary, our financial tables and the non-GAAP to GAAP reconciliation. As a reminder, during today's call, we will make forward-looking statements on projections, including our financial outlook for Q4, our expectations regarding our future market share and the benefits of our recent product introduction, as well as our expectations regarding future hiring, all of 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 into today's discussion. These factors include, among others, customer demand for our products and services including our recently announced new product introductions, our ability to compete effectively and general economic and market conditions. All numbers mentioned today 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 on our website.

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

Steve Gomo

Thanks, Tara. Good afternoon, everyone. Continuing the trend of recent quarters, NetApp generated very strong business results in Q3, driven primarily by our successful new product launch in November.

Total revenue grew by 25% and product revenue grew by 32% year-over-year. Our total non-GAAP gross margins remain quite strong at 65.5%, demonstrating the competitive strength of our products and non-GAAP operating margins continued new record highs.

Non-GAAP net income grew 46% year-over-year and made a large contribution to free cash flow, which registered a robust 23% of revenue. This quarter, we experienced the fastest uptake of a new product line in our history. Customers converted over to the new FAS3200 platform at a far faster rate than we had projected, significantly exceeding our expectations for the mix between the new and the previous FAS3000 product line. As a result, we are experiencing some material constraints, which we believe delayed the shipment of approximately $10 million to $15 million of revenue.

We have increased our forecast with suppliers several times over the past few months and we are managing the situation closely. Given the steep ramp in demand, certain materials may remain supply constrained in Q4. Despite this operational challenge, product revenue growth was still above 30%.

We are very pleased with our overall growth margins, which ended up slightly stronger than expected. Non-GAAP product gross margins behaved as we have anticipated, finishing just slightly above 60%. The timing of cost reduction and price reduction that we discussed last quarter is now back in balance. Non-GAAP service gross margins finished about one percentage point stronger than anticipated as support renewals were a bit higher than expected.

Non-GAAP operating expenses increased 3% sequentially from Q2 as lower marketing and administrative expenses partially offset the salaries associated with increased headcount and increased variable compensation. We added 415 net new people in Q3 and expect to continue hiring, primarily sales and engineering resources, at slightly higher levels this next quarter.

Cash generation was another highlight this quarter. Despite a slight increase in accounts receivable, DSOs, our strong net profit combined with a large uptick in the growth of deferred revenue on the balance sheet yielded $364 million in cash from operations and $297 million in free cash flow.

As I mentioned earlier, free cash flow finished at a very solid 23% of revenue. This was the primary contributor to the $374 million sequential increase in our cash and investments balance. Cash and investments now stand at $4.8 billion.

Our diluted share count increased 14.5 million shares sequentially to 406 million shares, roughly in line with what we had projected on last quarter's earnings call. The increase was driven primarily by the impact of a higher average quarterly stock price and the accounting for our convertible notes and warrants.

With an average closing price of $54.77 in Q3, approximately 4.5 million additional shares are included in the diluted share count to account for the impact of the notes and another 5.5 million additional shares were added to account for the warrants sold as part of the original transaction. You may recall that 80% of the convertible notes are hedged while the warrants were not hedged. If we were to adjust the share count to reflect the bond hedge, then the non-GAAP EPS would have been $0.02 higher. You will find a table on our website which shows the impact on diluted share count for a range of stock prices.

Looking forward, our target revenue range for Q4 is $1.38 billion plus or minus 2%, which implies approximately 7% to 11% sequential growth and 15% to 20% year-over-year growth. The current uncertainty regarding our materials constraints has been reflected in this guidance.

Non-GAAP gross margins are expected to moderate in Q4 to a range around 65%. We anticipate that non-GAAP operating margins will be in the range around 18.2%. Diluted share count will likely continue to be significantly impacted by the accounting for convertible notes and warrants. We expect the diluted share count to be roughly 414 million shares in Q4, which includes 18 million shares from the convertible debt and 12 million shares from the warrants.

Recall that the favorable impact of the note hedges is not included as an offset, bringing our earnings per share estimates to approximately $0.49 to $0.53 per share. Since we cannot accurately predict what the average stock price will be for the full quarter, the diluted share count was calculated using the $58.22 average share price from the first 10 business days of this quarter.

If we were to adjust the share count for the convertible bond hedge, that would add $0.02 to the EPS guidance. Despite the renewal of the federal R&D tax credit, our non-GAAP tax rate is expected to remain at 16.3% in Q4, primarily due to a greater concentration of profits in our U.S. geography.

While on this topic of future guidance, I wanted to make sure that you are aware that consistent with our SEC disclosures, NetApp is required to adopt a new additional accounting standard for revenue recognition for FY12. We will adopt in either Q4 FY11 or Q1 FY12 depending upon the timing of our implementation of systems, tools and processes. Irrespective of the timing, we do not expect any fundamental changes to our business model as a result of this adoption.

To summarize, we are pleased with the strong demand for our products. We continue to demonstrate compelling differentiation in the market and our competitive position is as strong as it has ever been, evidenced by the continued strength in our gross margins. We will continue to prudently invest in growing our business while at the same time generating strong free cash flow.

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

Thomas Georgens

Thanks, Steve, and good afternoon, everyone. I remain pleased with our financial results and our continued momentum in the marketplace.

As data centers move toward a shared virtualized infrastructure, NetApp's innovation leadership is enabling compelling business outcomes for our customers and is propelling our growth. Our recent product announcements further enhanced our competitive position and led to the fastest uptake of new platforms in our company's history.

Unfortunately, after solid execution by marketing sales and engineering, we significantly exceeded our forecast and sold out of the new products. While disappointing in the near term, we remain optimistic as demand is very strong, our margins are evidence of our competitive strength and we continue to generate significant amounts of cash while simultaneously investing aggressively.

For the last year, we've been using a two-year compare metric to measure our progress both internally and externally. These are comparisons to the same quarter two years ago to reduce the overstatement of growth due to weak quarterly compares post-Lehman Monday. We believe it gives a more accurate depiction of true momentum in the market.

While likely the last time we will use this metric, the gap between our growth rate and that of the Storage business of our nearest of the four largest competitors is nearly 30%, the greatest separation we have seen since we have started doing this analysis. This is also inclusive of all of their acquisitions in the intervening periods.

The result is that NetApp has gained more market share in this interval than at any time in our history.

Last month, NetApp was honored to be named number five on Fortune Magazine's 2011 list of the 100 Best Companies to Work For. We improved two positions from last year and it was our third consecutive year in the top 10. It is a tribute to the NetApp culture and the commitment of the total NetApp team.

While the recognition is satisfying, our objective is very pragmatic. NetApp has always stressed that our culture is a long-term strategic advantage, and this process enables to measure ourselves against the very best and identify opportunities for improvement. Our belief is that if the employees are happy, they will demonstrate maximum commitment. And if our employees are happy, our customers can tell.

A few comments are more awarding that when a customer says, it simply feels different doing business with NetApp. Our recent product launch further strengthened our position as the platform of choice for the next-generation IT infrastructure.

IT departments today face tremendous pressure to decrease costs while at the same time increasing their enablement of business objectives. As a result, they are changing how they are architecting their infrastructure in order to achieve greater flexibility and efficiency. This means moving away from application-specific hardware silos to a shared infrastructure enabled by server virtualization which can run many applications at once.

NetApp has been a clear innovation leader in virtualized environments, producing solutions at a far more efficient, flexible, automated and secure, all with far less complexity and a smaller footprint than those of the competition. The announcements we recently made extend our capabilities in each of these dimensions, and we see nothing from our competition today that comes close to providing a storage efficiency and cost savings that we bring to IT infrastructures of the future.

In addition to products, the diversification of our channels has been a key driver to our growth and an essential part of our strategy. At this point, our channel diversification and channel relationships are the best they have ever been and among the best of any IT company.

Revenue from our distribution partners, Arrow and Avnet, was up 34% year-over-year and our OEM partners, Fujitsu and IBM, are both expanding with IBM growing double digits year-over-year to a new record. Our newer channel initiatives around service providers and systems integrators continue to broaden our reach as evidenced by the Accenture announcement we made this week.

An additional element of our strategy has been to deepen our technology integration in our go-to-market activities with other best-of-breed innovators in the industry. We certainly see the major server vendors offering turnkey solutions including services, their proprietary hardware stocks and support.

Our approach is to partner with other industry leaders to create more highly integrated, technologically superior offerings with a common support infrastructure and enabled by systems integrators and channel partners.

Publicly announced solutions include our secure multi-tenancy and FlexPod offerings in partnership with Cisco and VMware. We are also a top tier provider in the Microsoft private cloud program, and we have numerous solution offerings with our OEM partners. Our recent announcement with Accenture will further enable those offerings.

Looking at our business from a geographical breakdown, the results of EMEA and U.S. Public Sector are notable. U.S. Public Sector grew 8% after nearly 60% growth last quarter and EMEA grew 35% after only growing about 15% last quarter.

In the case of EMEA, despite macro headwinds in certain countries, our own execution in Q2 could have been better, and we made good progress this quarter. Nonetheless, the big variation in quarterly performance of these geos is overstated due to timing of certain large shipments rather than any sudden major shift in positive or negative momentum. Averaging the last two quarters will be more indicative of our performance.

APAC and the Americas, excluding U.S. Public Sector, were both solid. As NetApp went through the economic downturn, we made many hard decisions to reprioritize our product lines, seizing some activities and investing more heavily in others. And those hard choices have yielded the outcomes you are seeing today.

We have continued to invest heavily over the past nine to 12 months while making similar prioritization choices and those investments positioned us well for the future. Despite any number of intermediate term macroeconomic concerns, as long as we continue to gain share and outgrow the market, we intend to continue to spend aggressively to make the most of our opportunity.

We are clearly winning in the market more broadly than we ever have in the past, and we intend to take maximum advantage of this competitive position we have created. Should our revenue growth and gross margins remain robust, operating margins will remain above our historic levels.

In closing, I would like to sincerely thank the nearly 10,000 employees of NetApp and all of our partners and customers for their dedication and support. The team executed the largest product launch in our history and at the same time grew product revenue 32% over a strong compare last year. Our market share gains are evident and our competitive position has never been more distinct.

We look forward to spending time with you at our product-focused Analyst Day in March to help you gain a deeper understanding of our value proposition and the scope of our competitive differentiation. At this point, I will open up the floor to questions, reminding you to please limit yourself to one so we may address as many folks as possible during our allotted time. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Aaron Rakers of Stifel, Nicolaus.

Aaron Rakers - Stifel, Nicolaus & Co., Inc.

If we can dive a little bit deeper into the component constraints, you guys had referenced to $10 million to $15 million, was that across both the mid-range and the high-end products? And then also as it relates to the company's guidance, what are you assuming as far as that constraint continuing in the current quarter?

Thomas Georgens

Well, for the most part the constraints are more severe on the midsize product. And actually more particular than that is -- and to put it in perspective, I mean we've introduced products before, but this one actually had 4x the take-up rate of any of our previous products. So clearly, the ramp is pretty steep. And the other thing that's a little bit different about the 3000 family here is they also have this thing called an I/O expansion module, which allows you to put more connectivity in. And the demand for that was much higher than we forecasted as well, and in fact, that ended up being the limiting factor. And probably in retrospect, the lesson learned here is that people were looking to build with the higher performance systems that we introduced, they were looking to build bigger systems. And the other thing is that those slots where the flash cards go in included demand for our flash cards is very, very high. In fact, the attach rate of flash on these class of machines are actually 10 points higher than they were on the previous class. So, overall in terms of constraints, it's primarily in the I/O expansion module, certain semiconductor components along the way. But at the end of the day, demand is really strong, so it's kind of a bright side at the end of this. But nonetheless, it's primarily and then particularly that dimension, I wouldn't call out any individual part, but the simple fact of the matter is we ended up shipping thousands of these units, so we ended up at 4x the demand that we expected. As we go into the next quarter, our guidance currently reflects the fact that we've not resolved these problems yet. We're working on them. We think we have approaches that will resolve them, but it did cause us to take some consideration here with respect to whether or not we get all the parts we want whatever the case. We also can't estimate the mixes correctly. We want to make sure that if there was this huge mix shift, that one way or the other, more modules, for instance, of come on -- OM modules, we can handle that. So the bottom line here is we tended to be a little more conservative with our guidance because we have not solved all of the mix and the material stuff yet.

Operator

Our next question comes from Maynard Um of UBS.

Maynard Um - UBS Investment Bank

Can you just clarify, did you guide the upmargins to 18.2% because if I take the midpoint of your guidance just to get to the midpoint of your EPS implies upmargins of sub-18%. So if you could just talk about the drivers there, were there any one-time compensation next quarter or other items that are in there?

Steve Gomo

Yes, the guidance at the midpoint, we expect to be at about 18.2% and if you -- as you go to the extremes of the ranges we gave you, you're going to have a range around operating margin as well. No secrets here. We showed you that gross margin is anticipated to come down slightly from the 65.5% level we just reported in Q3. And OpEx is up a little bit in the fourth quarter as is typical on our fourth quarters and we're reflecting that as well.

Operator

Our next question comes from Brian Marshall of Gleacher & Company.

Brian Marshall - Gleacher & Company, Inc.

Question with regards to the M&A strategy. I mean obviously, your arrays are doing quite well, $5 billion. But if you look -- some of your competitors are expanding in the big data, et cetera, and there are some other opportunities out there in security software and other ancillary markets. And so I just wanted to get an update on what the thought process is with regards to kind of TAM expansion outside of the product category as it stands today?

Thomas Georgens

Well, I guess, first to start before we think about that is as I think about just where we are with our existing business. So if I look at the market share at least the way we calculate it in the markets that we participate in is for all of our growth and for all of our momentum, we're still 15% or so market share. And so I still think there's plenty of opportunity. So in a $15 billion market and if you believe IDC growing at 7% or 8% per year, that's a pretty big opportunity. We're number one or number two in market share and probably four out of the 20 largest deals, including our awareness seems to be better than where it is today. So those will sound like daunting tasks, but what it tells me first and foremost is that A, that there is no limit to our ability to double our business just in the business we're in; and second, the fact that we gained two points of market share as I measured it, just in the last 12 months, tells me that market share is gainable in this segment. So first and foremost, I think our fundamental core business is very, very healthy and our aspiration is double the size of our business right in the space we're in. When I think about acquisitions, there's really two components that I think about. Number one is there needs to be affinity. Affinity meaning something that our salesforce can sell or something that by virtue of having in our portfolio, we can move more of our existing products. I think if there's one thing that this industry has shown is that buying up of dissimilar assets with no leverage and no affinity, don't yield any shareholder value. And I think there's some pretty high profile cases in this market, of very, very good assets that are not great stocks. The other thing that I think is key to our strategy as well is that we don't want a lot of overlap. We don't want to pursue a product that may give us marginal incremental market, but end up has substantial overlap with what we do and we spend the next several years of our core team and this new product basically spending money, replicating each other's features and basically building Noah's Ark to of everything. So at the end of the day, I think the affinity and the lack of overlap are things that are key to us. So certainly, if you think about Data Domain in our past, Data Domain was a backup product. It was targeted at target market. It clearly had affinity and it didn't have overlap. On the other hand, I think there are some other properties that changed hands recently that had tremendous overlap with what we are doing, and therefore, we were not interested. That's how we see it. But right now, I feel no pressure to do applications or acquisitions to generate near-term growth, nor do I believe that we're out of headroom in our current market. But that said, I do believe that there are adjacencies that are very, very attractive that I think are high growth, and I think that will be part of our acquisition strategy going forward. So I expect that we will be acquisitive, but I feel no pressure to do it in the near term. And likewise, certainly don't want to signal any lack of conviction about our core business.

Operator

Next question comes from Scott Craig of Bank of America.

Scott Craig

I was wondering if one of you guys could go over the small systems growth that look like it had came off a little bit this quarter? Is that from some competitive pressures with new products coming out and sort of how you see those segments rolling out over through the guidance?

Steve Gomo

I wouldn't say there was anything special in that category, well if I can find the exact numbers, but I wouldn't say that there was anything notable either competitive or otherwise. The business was up double digits and the units were up more than that. So I still consider that to be an important part of our business. I know in midsize enterprise, I believe we've added over 1,500 new accounts this year and a lot of it is driven in that segment. Our Arrow and Avnet business, which moves a lot of that product has been very, very strong. And the other big mover of the entry-level products is actually Public Sector. And while the Public Sector business shipments don't look that impressive, that business is actually quite healthy for us. And I think that we also refreshed the midrange business as well and may have drawn a little bit of demand particularly from the larger of the smaller machines into a more modern unit. So that probably had some impact on the number as well. But fundamentally, I don't see any change in dynamics there that I have any concern about.

Operator

Our next question comes from Shebly Seyrafi of Capstone Investments.

Shebly Seyrafi - Capstone Investments

Can you talk about the current lead times for the midrange? I'm hearing things like possibly six weeks. Do you think that the supply constraints will be resolved at least by the fiscal Q1 quarter and might that drive better-than-seasonal growth during that quarter because of this?

Thomas Georgens

Yes, I'm not going to confirm that the six weeks, I think that at some point in time some of the products run allocation and some customers may have gotten delivery in six weeks. Obviously, we're working like mad to try and close this gap. I mean frankly, from my personal perspective, it's disappointing to be having this conversation because other than that, we've put up another very, very solid quarter as a company would have been the top of our range and over the top on EPS. But in general here, I think the question is will the mix shift again and will it shift even more aggressively towards the new products. And I think we're certainly planning as if it is. We've never been a company that optimized ourselves around our inventory position. So I think we’re willing to take material risks to cover uncertainty. But at the end of the day, there's only so much capacity downstream. So my hope and my expectation is that, that we'll get this cleared up this quarter. But at this point, I think that there is still 10 weeks to go or more and things can happen.

Operator

Our next question comes from Bill Shope of Goldman Sachs.

Bill Shope - Goldman Sachs Group Inc.

Can you give us a little more clarification what your comments were around the U.S. Public Sector, I just want to make sure I understand. So you mentioned obviously there is a big fall-off from the growth rate this quarter versus last quarter. And I think you'd said there are some large deals that distorted this sort of comparison. Should we take that to mean that there are really no incremental signs of spending constraints from your customers here? And how should we think about the steady-state trends here given those distortions you said?

Thomas Georgens

Well, I think, the 60% number last quarter was an outlier, likewise the 8% this quarter. So what happens is we really track the business based on bookings and we see that everyday and then revenue could either lag by product availability or big shipments or revenue recognition, so a lot of big things move the needle there. So neither the euphoria of the 60%, nor the despair of the 8% I think accurately represent the business. And to answer the direct question, certainly the quarters that we've just been through, I've seen basically no change in the posture of the U.S. Public Sector business. And in fact, I wish all of our businesses were performing as well as that one is.

Operator

Next question comes from Ben Reitzes of Barclays Capital.

Benjamin Reitzes - Barclays Capital

Just bigger picture, I mean you have some things here moving around with your $10 million to $15 million of constraints and maybe it's even bigger. But what is your view of the market right now? You typically have said you can quote 2x to 3x the market. IDC conservatively is at 7.5%. I think that there is upside to that number. And has anything happened that would change your view of your ability to grow of that 2x to 3x and what about your prospects as we head out the long term?

Thomas Georgens

Yes, I think as far as 2.5x to 3x, even the guidance still is in that range. And the other thing about the 7.5% is that 7.5% will be an average, but we'll probably never see any 7.5% here. We'll see 3s and 15s as we go forward, so it will be very lumpy. So the way we think about the business in light of the fact that the market, I expect to be lumpy, is we think almost exclusively in terms of market share because market share, a point of share is a point of share whether the market is up or down and we tend to continue to gain share. But if you do the math, a point of market share on the market this size growing at this rate; a point of share alone is roughly 15% growth. And this past year, we gained two points a share. So from that perspective, I think the mathematics of us growing at the rates that you talked about I think are still very, very much achievable. Clearly as we get bigger, it becomes more and more challenging but certainly, I mean we've been big all year. We've still been growing by the last trailing 12 months growth rates, probably in the vicinity of 30%. So the business is robust, it's certainly there. I mean if I look at the geographical landscape, we talked about U.S. Public Sector and there's lots of speculation about what may happen, but there's been lots of speculation and the business is still strong, certainly stronger than anybody else's in the Storage business. When I look at Europe, Southern Europe is still a challenging environment, but that's not really material to our business. In fact, our growth there, I tell the team with no market share, the macro doesn't matter. U.K. is a concern because of the government austerity and I met with the CIOs of a number of agencies of the U.K. Ministry when I was over there just a couple of weeks ago and clearly, they are seeing constraint. But the German economy is remarkably strong and they are remarkably confident. And Asia-Pacific hasn't been historically a strong area for us, but actually we've seen very, very good growth and I'm very pleased with the progress we're making there. And that frankly needs to be a bigger percentage of our business going forward. I mean the U.S. I think I feel better about our execution in that market than I do about the market at large. So all in all, I'd say what's going on would leave me to believe that 7.5% is probably a viable estimate going forward. And I feel good about our competitive position.

Operator

Our next question comes from Amit Daryanani of RBC Capital Markets.

Amit Daryanani - RBC Capital Markets, LLC

Guys, I Just have a question going back to this $10 million to $15 million revenue hold from component shortages. I guess what's the risk that you think you could get bigger in the April quarter? And are these shortages more because you just can't get the components or the components are really long lead times and we just inaccurately guess how much we needed?

Thomas Georgens

Well, I think a few things happened because if it gets bigger, I'm not going to alarm anybody and say otherwise, but I could, I suppose. All that's factored into our guidance in terms of what we think the various risk factors are one way or the other. But some parts are fabricated like sheet metal and cables and stuff and some parts are off-the-shelf. So when you consume off-the-shelf and worldwide distribution, then eventually you're exposed to the manufacturers' leadtimes. And likewise, we've been working on this for a while, so some of that lead time has been worked down, but we're still working through the issues. Clearly, when you look at the grand scheme of things, new product introductions are always tricky, but we came out with really not much engineering trauma and these products came out, like I said we built thousands of these, it's not like we can't build them and ship them. We just can't get enough parts to build enough of them. And I think we'll still have on some of the products -- certainly some of the products are back to normal lead times, but some of them aren't and we need to continue to work on that issue.

Amit Daryanani - RBC Capital Markets, LLC

To the best you can see, when do you think these issues get resolved? Is it by the July quarter?

Thomas Georgens

I clearly want to get this cleared off as this fiscal year ends. I think we have a plan to close it based on various different mix scenarios, but if the mix scenario changes dramatically yet again, there could still be some unknowns. And I wish I knew the answer and in 90 days, we'll all know the answer. But I think at this point, we're looking at the data we have and we're expediting as hard as we can. We're certainly taking a fair amount of material risks or at least near-term inventory risks or similarly burn it off. But I can't tell you with full confidence that we're going to clear this up, but I can tell you with full confidence that we're working on it night and day. And I can tell you that we've made -- the bounce we put around the guidance reflect reasonable assumptions about mix and change, et cetera. So we've tried to reflect everything we know in the guidance.

Operator

Our next question comes from Katy Huberty of Morgan Stanley.

Kathryn Huberty - Morgan Stanley

Tom, curious if you have any thoughts on EMC's aspirations to sell more product through your channel and specifically, do you feel like you have to go head-to-head with them at that $9,000 to $10,000 price point? Or you just have mature software offerings and you'll let them deal with that low-end market?

Thomas Georgens

Well, first of all, I appreciate you calling it our channel. I think, certainly, if I was in their shoes, certainly I would go after our channel partners as a pinch point on NetApp. On the other hand, there's a lot that goes into partner relationships. And I think that we're going to participate in the segments where we currently play and I think we've got very, very strong relationships there. And certainly, I wouldn't seed any ground functionality, but even in addition to the functionality, there is program, there is relationships, there's longevity, there is trust, there's a whole set of factors that go into building channel loyalty. So certainly, I expect EMC to continue to assault us on all fronts like they've been doing for the last year. And I think it's up to us to compete and I think we'll compete based on compatible channel strategies. I think we'll compete based on product features. We'll compete on our ability to make our channel partners more profitable. So yes, I expect nothing less than EMC to come out very aggressively with their new products just like they have with everything else that they've got. But I really don't see anything happening here that's going to fundamentally tilt the balance in this business. If there was one irony in the product releases that there was a heavy dose in the press, I'll talk about EMC closing the gap with NetApp. And on one hand, we can debate the merits of that statement where they're really closing the gap and where there is a whole category of features they haven't even begun to address. But I think the real key component there is that NetApp has become the innovation yardstick by which EMC is measured, and I think at least that part we felt good about.

Operator

Our next question comes from Alex Kurtz of Merriman Capital.

Alex Kurtz - Merriman Curhan Ford & Co.

A lot consolidation that data analytics is based over the last, call it, two quarters. I know you guys announced partnership with ParAccel last year. Do you feel like the space that you need to be more involved in from the acquisition perspective? Or do you feel like there's just enough core storage opportunity in share that that's more of a TAM for larger companies to go chase?

Thomas Georgens

Well, I think for us to be in the data analytics space, I think that's probably in the category of affinity. I'm not quite sure. I think that there are more attractive adjacent markets for us to pursue. And in addition, I think that doesn't mean that there's more TAM elsewhere we're not interested in that. I think partnership opportunities in that space is still very attractive to NetApp. And at this point it's going to be the way we're going to go after that business as opposed to actually being in the analytics business on ourselves.

Operator

Our next question comes from Lou Miscioscia of Collins Stewart.

Louis Miscioscia - Collins Stewart LLC

Maybe you can talk about the component environment. Dell saw some nice margin upside, realized that there's only minimum amount of overlap, but obviously you do have DRAM and hard disk drives. And it looks like obviously your product gross margin was down a bit quarter-to-quarter, I guess I would have thought maybe it would have ticked up, just what you're seeing there, what do you expect going forward?

Thomas Georgens

So we had anticipated our product margins were going to be down. In fact, I think we guided you that way. Remember our second quarter benefited from a timing difference between cost reductions and price reductions. We straightened all that out this quarter. We had rich configuration mix last quarter. We saw that we were back to normal this quarter. So the fact that the product gross margins are down was anticipated. And in fact, I would argue that we're slightly ahead of where we expected to be and that's why our gross margin is a little higher than what we had told you. With respect to the components environment out there, our operations people tell me that it's kind of, generally speaking, there are not a huge amount of supply constraints, but there are key components that are under constraint. And unfortunately, we have a couple of those in our products and when mix is shift in a manner that hits those particular components, it just gets exacerbated at the system level. So at the end of the day, I think that there are some spot shortages out there. They're not widespread across a whole variety of different components, but there are a few that are unfortunately in constraint right now. I think overall in terms of the pricing environment, the key commodities that are interesting to us clearly disk drives. And I think the disk drive supply chain has got multiple suppliers, and they all appear to be relatively healthy in terms of being able to meet our needs. So I think that, that gives us some multiple choice options. Clearly, DRAM and the other one is flash. About a year ago, we made a very, very significant inventory commitment around flash to guarantee supply, which is now completely burned through. We're on advancing when we thought it would be and we're going to move forward with that as well. So all in all, I think the pure commodities are probably -- we probably are seeing some ability to exert a little bit of pricing leverage but not a lot. And the issue that we have with our product is in suddenly some part is in short supply. What really is, is that we suddenly have tremendous demand for a part. And we either need to find them throughout the supply chain or try and convince them to rest on their way from somebody else or in some cases actually have them fabricated by the original manufacturer.

Louis Miscioscia - Collins Stewart LLC

And then looking out to the April quarter, pretty much still a decent benefit or it's sort of moderating?

Thomas Georgens

That's hard to tell, particularly with these commodity parts, flash and DRAMs and disk drives, pricing changes on a weekly basis, so we need to stay on top of that. But I would say that our takedowns in those areas have been good, probably a little bit better than we forecasted. But I should also add that some of those commodities are also -- our competitors see that too, so we basically use that to pass that along to our customers.

Operator

Our next question comes from Jason Maynard of Wells Fargo.

Jason Maynard - Wells Fargo Securities, LLC

I had a question for you on the FlexPod. I know there is obviously a lot of talk about EMC going after you, but I'm curious what you can talk about in terms of the FlexPod launch and how do you think that's going to play out from a competitive dynamic over the next year?

Thomas Georgens

Well, as far as FlexPod is concerned, it's just as significant relative to the full server vendors as it is specifically around EMC. I think FlexPod and Vblock are basically strategies by EMC and ourselves to really go after the value proposition of what the server vendors offer. So the server vendors offer a stack of proprietary technologies with front-end services and back-end support, and they come as effectively a one-stop shop. So the appeal of that is basically the one point of contact, but the downside of it is that none of the technology is best-in-class or state-of-the-art. So ultimately, what you're getting is you're trading off in favor of integration, but you're trading off best-of-breed, you're trading off the ability to drive lower cost and greater efficiency than your company. So recognizing that there is a power of integration that I think the players in the industry are looking to integrate with other best-of-breed providers to basically create integrated solutions that approximate the integration of those with the server vendors, and then have professional services and common support on the backend. So I think that effectively, this is the way to effectively compete and nullify the one advantage of the server vendors, yet at the same time offer best-of-breed technology. Now as far as EMC, I think clearly we've clearly taken different approaches. I think we really designed for more flexibility as opposed to fixed configurations. I think we're a bit more channel-friendly, and frankly, it's generating a tremendous amount of momentum in the market. I'm sure you guys check and see that, but those are all the engagements between VMware always been strong, the engagements between us and Cisco is accelerating and FlexPod is a culmination of the number of those activities. So all in all, good.

Operator

Our next question comes from Chris Whitmore of Deutsche Bank.

Chris Whitmore - Deutsche Bank AG

I wanted to ask about the Oracle relationship. Can you give us an update where that stands and what's that, if any of your products like Exadata create for NetApp going forward?

Thomas Georgens

So the Oracle relationship, from a go-to-market perspective as a technology partner and our engagement with customers is probably largely unchanged. Clearly, we're involved in accounts. We do projects together, so I think that continues. One of the things that stood in our way of doing some joint technology development obviously was the lawsuit that they inherited from Sun, and the resolution of that has allowed us to do more collaboration from a technical perspective, while that had been a roadblock there for a few months. So with that out of the way, we can work on more constructive things going forward. As far as Exadata, it's an interesting scenario and that is the idea of a totally integrated stack from software all the way down to storage. In some ways, it is orthogonal to the idea of building a shared virtual infrastructure that can run multiple different types of apps at the same time. And I have a lot of conversations with customers about where do you draw the line, do you basically carve off because there's no doubt that the vast majority of the applications are going to pursue the virtualization path because of the flexibility and the efficiency and the economics involved. And the question is, do they carve off one or two applications that are so important they're going to build a dedicated stack. So I think that Exadata is not a broad market product. It's really tied to the Oracle and it's really tied to only really a certain class of Oracle applications. And where the customers ultimately draw the line, does Exadata support all the Oracle apps in an enterprise or just one or two? I think time will tell. But at the end of the day, I think our strategy with Oracle is to basically engage them around Exadata rather than competing directly with it. Clearly, the space where Exadata is competing today is clearly occupied a lot more by our competitors than it is with us. So I think it gives us more of an opportunity to work collaboratively with them around the rest of the infrastructure rather than just the online transaction processing database or the data warehouse.

Operator

Next question comes from Jason Ader of William Blair.

Jason Ader - William Blair & Company L.L.C.

Guys, the last two quarters, even if we include the $10 million to $15 million mez from the demand situation this quarter, just seems like last two quarters it's gotten tougher for you to beat the top end of the guidance whereas the prior three quarters you were kind of blowing away the top end of the guidance, whereas the prior three quarters you were kind of blowing away the top end of the guidance. So just kind of wondering, we're just coming to a more normal environment in the previous three quarters before the last two quarters were just kind of pent-up demand and you underforecast significantly. Just trying to get a sense of anything, has anything changed in either the demand or the competitive environment which is causing the actual results to be kind of more top end to guidance versus above that?

Thomas Georgens

There's been no change in our approach to guidance. We give it our best shot with respect to what we think we're going to do. We give you a range and we point you towards the midpoint, and that's the point that we're kind of focused on. If things develop during the quarter that allow us to take it to the high end, we do. If it goes the other way, so be it. But we haven't changed the way we're giving guidance and I think the numbers speak for themselves in terms of the growth rates and particularly, the product in that space, which is the one I would focus on.

Steve Gomo

I mean I think it's pointless for us to gain the system. If we basically gave you guidance that we intend to come in over the top off, then effectively you'd ignore the guidance that we're giving. So there's no gaming that's going on. We're giving guidance and that is the guidance and there's no winks and nods here. We're giving a range and this is where we think we're going to be given everything we know.

Operator

Our next question comes from Richard Gardner of Citigroup.

Richard Gardner - Citigroup Inc

Tom, as a follow-up to Katy's earlier question, you said you'd be willing to engage in discussion around futures on VNX and where you think their product continues to be deficient and I'd just love to get your thoughts there.

Thomas Georgens

Well, I think first of all, from a maturity point of view, we certainly have an eight-year head start on them. And then I think more generally, I think the breadth of our software features, the breadth of our integration, the efficiency technology particularly in that segment of the market, the ability to drive economics because most at the very, very low end we talked about people with relatively small IT budgets. So to be tightly integrated with the applications they run, to be able to run it far more efficiently with our deduplication technology and the maturity improvement technology as time goes on, I think the raw factor is that that come into play. The other thing is I think that we've enabled our channel partners with our professional services strategy that our channel partners I think are far more capable of helping small customers adopt and put our technology to use than the generic channel partners. So the professional services strategy of not doing it ourselves in this segment of the market has basically raised the confidence level of our channel partners and I think that's a factor here as well. So I think from an economic perspective, from an ease of use perspective, from an integration perspective and from a risk of deployment perspective, I still think we have a superior offering.

Operator

Our next question comes from Mark Moskowitz of JPMorgan.

Mark Moskowitz - JP Morgan Chase & Co

Steve, I wanted to get a sense from you in terms of the guidance, if we should take anything from the 18.2% operating margin midpoint, does that imply any change in your indirect channel exposure because I do know you get a little better operating margin boost there to offset some of the gross margin decrement from the indirect channel, and you did have a pretty big indirect channel number this past quarters, so just wonder if you can talk about that a little more.

Steve Gomo

Sure. At the operating margin level, the channel mix almost has absolutely no effect. It can almost swing 100% one way or the other and you're going to get the same operating margin. This just reflects the fact that we expect to see some abatement in the level of gross margin which would be typical in our fourth quarter, most of that would be in the product margin area. And then typically, we tend to invest for next year. We're putting resources in place in both the field and engineering as we get ready to wrap up for next year, and those are the kind of investments that create the growth that we're seeing. So there's nothing more to it than that.

Operator

Our next question comes from Jayson Noland of Robert Baird.

Jayson Noland - Robert W. Baird & Co. Incorporated

Just to clarify, the material constraint mostly results in delayed business, not lost orders, and my question is on the high end, I think there were a couple hundred beta sites, if you guys could talk about conversion and what you're seeing at the high end and if you thought there was some pent-up demand coming out of that in November refresh?

Thomas Georgens

Well, I think as far as the high end is concerned, the high-end customers fall into the various different categories. There are some that are on the extreme end of the performance and they're going to basically adopt a new technology as soon as it's available, so clearly there's probably some pent-up demand there. But there are other customers that are running the high-end systems or the large systems in mission-critical applications, and to them, they all go through a phase of certification and testing and performance modeling and all of that. So I would say that there's a general rule that applies to all of the large systems. I think it depends on the customer set that's actually using them. Clearly, one thing that we also see is the connect rate of our flash technology in the high-end systems is extremely high. Not quite in every unit item but very, very high. So I think people are using that technology very, very effectively and I think the high-end systems help us with that as well particularly and also the latest release of the software allows us to use the cash with all of our other features and large drives and things like that. So a lot of the compatibility issues we have with cash are now gone and so it allows the deployment a little bit more broadly. So I'd say that that's really what's driving it there. Like I said, people buy large systems for high performance, they buy them for high capacity and they also buy them for large-scale mission-critical applications and all three of them have a different adoptions schedule.

Operator

Our next question comes from Keith Bachman of Bank of Montréal.

Keith Bachman - BMO Capital Markets U.S.

I had a related question to the past one and that is, Steve, if you look longer term, if you think about product mix, I want to try to understand if there is impact to gross margins. What I mean by that is you mentioned that 3200 have a lot of I/O and customers are scaling out. Does that eventually has some implication for product mix from people moving from high to low and/or does the inclusion of more flash longer term have an impact on gross margin? And related to that, Steve, is there anything on the mix side that would impact services margins from where they are now?

Steve Gomo

If you look at long term, we're not anticipating any major shift in the mix of cost of goods sold or in the mix of gross margin because of some of these new technologies that we're adding. We'll be pricing accordingly and we'll be pricing to be remaining competitive in the marketplace. So I think that our goal is to try and keep the product margins at or around 60%. And I've always said, give us a point or so for normal fluctuations, but that's pretty much where we're going to be. I think these new features allow us to grow fastest as much as they do give us some competitive margins.

Thomas Georgens

And some of our software is capacity-based in terms of its pricing so to the extent that we sell larger capacities from a software perspective, that's still going to scale largely linearly. And that too varies if you're talking about the high-end products. Some of the high-end products that are extremely capacity intensive tend not to have the rich software set, but certainly the ones that are in the mission-critical data processing or transaction processing environments, they tend to be very, very software heavy.

Keith Bachman - BMO Capital Markets U.S.

And then Steve, anything on the services side?

Steve Gomo

Nothing at this point, Keith. We talked about the new accounting convention that we're going to be adopting. That could have a minor influence but very minor. I'm not anticipating anything major long term that I think will adjust our business model accordingly.

Operator

Our next question comes from Bill Fearnley of Janney Capital Markets.

William Fearnley - Janney Montgomery Scott LLC

When you look at the vertical markets, any additional color either domestically or in EMEA that you wanted to call out for the quarter? Any particularly verticals that were stronger than you had expected? And then one other question on the backlog, is there any additional color on who got left waiting? Was there any geo effect on that as well?

Steve Gomo

From a geo perspective, just looking at the mix, probably a little bit more strength in financial services, which probably should be good news for all you guys, but other than that mostly the other ones stayed relatively constant. As far as who got shipped a lot, that's a function of a lot of things. We've got revenue recognition relative to other items that are on the PO and what gets deferred and what doesn't get deferred or what other pieces were short. Obviously, some customers in terms of their size and their history and the urgency is a factor as well. So I would say that there is probably no overt geo color, but if you look at the growth rates of the geos, clearly the shipments were not evenly distributed. And we talked about USPS being at 8% and that being grossly understated relative to their business. To be fair and honest, the EMEA number at 35% is probably overstating the activity level there and I'm sure how these got prioritized probably had some impact on those numbers as well.

Operator

Our next question comes from Kaushik Roy of Wedbush.

Kaushik Roy - Wedbush Securities Inc.

So you have definitely continuing to gain market share, but are you having to discount more than in the past? The reason I asked is because I'm looking at gross margins and I understand for January it came down, but April is seasonally a stronger quarter and your gross margins expand in April, at least because of volume. If you could give some color that would be helpful.

Steve Gomo

Sure. Kaushik, even if you look back to last year, our product margins actually declined slightly from the third quarter to the fourth quarter. We're not projecting a particularly significant decline. It's on the order of a half a percentage point, probably within our ability to call. But we're expecting that we will see the normal aggressive sales behavior that we do. There will probably be some extra discounting that we typically see in the fourth quarter. Nothing unusual and nothing is going to have a significant impact on the product gross margins.

Thomas Georgens

If I look at the numbers I think it's 2/10 versus 6/10, so I don't think it's that much different. And as Steve indicated, I think that pressure in the fourth quarter is clearly, it's obviously peak commission time. And obviously, the amount of whining and crying on our shoes that we get about doing discounts around specific accounts because particularly acute this time of the year as you can well imagine.

Operator

Our last question comes from Eric Martinuzzi of Craig-Hallum.

Eric Martinuzzi - Craig-Hallum Capital Group LLC

You had a particularly strong cash flow generation quarter a year ago in your Q4 2010. Could you give some color on your expectations for free cash flow for Q4 '11?

Steve Gomo

Yes, I think it's going to be on the order of the same type of percent of revenue that we just saw. Some of it is going to depend on that DSO number, maybe coming down a little bit from where it was in the third quarter. If that were to happen, you'll see a number that's a little bit north of the 23% we just posted. But I think modeling in the 23, 24 type of percent ranges is probably reasonable for the fourth quarter.

Operator

At this time, I would like to turn the call back over to NetApp for any closing remarks.

Tara Dhillon

Thank you, operator. We look forward to seeing all of you at our Technology Forum on March 22 in New York. Registration will open next week on February 22. We appreciate your time today. Talk to you soon.

Operator

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.

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