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NetApp (NASDAQ:NTAP)

Q2 2012 Earnings Call

November 16, 2011 5:00 pm ET

Executives

Tara Dhillon - Senior Director of Investor Relations

Steven J. Gomo - Chief Financial Officer, Principal Accounting Officer And Executive Vice President Of Finance

Thomas Georgens - Chief Executive officer, President and Director

Nicholas R. Noviello - Senior Vice President of Finance and Global Controller

Analysts

Richard Gardner - Citigroup Inc, Research Division

Brian Freed - Wunderlich Securities Inc., Research Division

Keith F. Bachman - BMO Capital Markets U.S.

Brent A. Bracelin - Pacific Crest Securities, Inc., Research Division

Kaushik Roy - Merriman Capital, Inc., Research Division

Andrew J. Nowinski - Piper Jaffray Companies, Research Division

Brian Marshall - ISI Group Inc., Research Division

Mark A Moskowitz - JP Morgan Chase & Co, Research Division

Katy Huberty - Morgan Stanley, Research Division

Maynard J. Um - UBS Investment Bank, Research Division

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

Glenn Hanus - Needham & Company, LLC, Research Division

Bill C. Shope - Goldman Sachs Group Inc., Research Division

Operator

Welcome to the NetApp Second Quarter Fiscal Year 2012 Conference Call. My name is John, and I'll be your operator for today's call. [Operator Instructions] Please note that this conference is being recorded. I will now turn the call over to Ms. Tara Dhillon. Ms. Dhillon, you may begin.

Tara Dhillon

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

As a reminder, during today's call, we will make forward-looking statements and projections, including our financial outlook for Q3 and future operating metrics, the benefits to us and the customers of new product introductions, the adequacy of our future inventory supply, our expectations regarding our future competitive position and the benefits we expect from our partnerships and strategic alliances, 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 include, among others, general macroeconomic and market conditions, particularly the continuing fiscal challenges in the U.S. and Europe; the effects of the flooding in Thailand; customer demand for our products and services, including our recently announced new product introductions; and other equally important factors, which 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 report also on file with the SEC and available on our website, all of which are incorporated by reference into today's discussion.

All numbers discussed today are GAAP unless stated otherwise. To see the reconciling items between non-GAAP and GAAP, you may refer to the table in our press release, our supplemental commentary or on our website.

In a moment, Steve will provide you with some additional color on our financial results. Nick will walk you through our guidance for Q3 of FY '12. And then Tom will walk you through his perspective on the business this quarter.

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

Steven J. Gomo

Thank you, Tara, and good afternoon, everyone. This quarter's financial performance can be characterized by its contrast. In terms of business demand, we continue to see strength across most of our business with the normal puts and takes. For instance, our European enterprise and our Asia/Pac geographies were robust and our E-Series OEM had another stellar quarter. Similarly, our volume channel businesses were very strong and our largest channel partners demonstrated solid growth, where we saw underperformance to our revenue forecast within our major account program.

Our Q2 guidance included an analysis of the business dynamics associated with these large accounts, their seasonality as well as relatively modest expectations for sequential revenue growth from them. Of the 46 accounts in the program, just 9 of the U.S. accounts produced the entire shortfall from the midpoint of our revenue guidance. Nevertheless, despite lower-than-expected revenue, with our non-GAAP operating margin and non-GAAP earnings per share, we're quite strong with non-GAAP EPS above our targeted range and at record level.

Our total OEM revenues were strong this quarter at $230 million, growing 8% sequentially from Q1. NetApp-branded revenues grew 3% sequentially, impacted primarily by softness in those 9 major accounts I just mentioned.

Software entitlements and maintenance revenue and services revenue showed a sequential decline this quarter. In the case of SEM, the revenue decline was a function of a minor perturbation in our deferred revenue schedule. For the services revenue, the sequential decline was due to a Q2 drop in professional services revenue, which tends to be lumpy. The underlying revenue growth trends for both SEM and service maintenance contracts remain intact. Moreover, our deferred revenue balance increased by $56 million sequentially and grew 25% year-over-year. We expect that the absolute revenue level will increase for both of these revenue categories next quarter.

Our non-GAAP product gross margins declined 0.6 percentage points from Q1 levels as the favorable effects of increased volume and configuration mix were more than offset by increased mix of E-Series OEM business, warranty costs and some pricing discounts. Normalizing for mix, these product margins remain within the range of our expectation.

Non-GAAP service gross margin declined 3.2 percentage points sequentially primarily as a result of a loss on a single transaction. We expect the services margin to bounce back next quarter. The underlying service maintenance contract gross margin remains very healthy.

Our non-GAAP operating expenses increased less than 1% sequentially this quarter as we maintained our discipline on expense management. Employment growth moderated during the quarter and was lower than every quarter in the past year.

The Q2 non-GAAP tax rate was also lower than forecast, finishing the quarter at 16.4% as we are now anticipating a larger mix of our FY '12 pretax earnings will come from international geographies. We expect our tax rate to return to about 17.5% next quarter, an average 17.5% for FY '12.

Our balance sheet remained strong with approximately $4.6 billion in cash and investments, down only slightly from Q1 despite the $400 million accelerated share repurchase we executed early in the quarter. Our accounts receivable, days sales outstanding was relatively steady as it increased to 38 days from the 37 days reported in Q1. Inventory turns decreased again this quarter to 14.1x.

There are several reasons for this, including a large proactive pre-buy of flash memory and a large disc drive pre-buy as the flooding in Thailand was unfolding. We believe we will have sufficient drive inventory through the end of December, but it's difficult for anyone to predict the business impact beyond that.

Cash from operations at $370 million increased 4% from the same period last year. Free cash flow finished the quarter at $277 million. Our diluted share count decreased by 29.5 million shares sequentially to about 376 million shares, primarily due to a lower average quarterly share price and to our share repurchase.

Our average quarterly closing price was down from last quarter to $38.25 per share. The accounting per share is associated with our convertible notes and warrants had a large impact, removing about 17 million shares from the diluted share count on a sequential basis, leaving about 7 million shares to account for the convertible notes.

As you may recall, 80% of the convertible notes are hedged. If we were to adjust the share count to reflect the bond hedged, then the non-GAAP EPS would have been about $0.01 higher. You can find the table on our website, which shows the impact on the diluted share count for a range of stock prices.

In a moment, I'll turn the call over to Nick to talk with you about our guidance given that he'll have responsibility for it come January. As I said last quarter, it's been a goal of mine to retire by the time I'm 60, and that milestone is all too close. December 31 will be my last day at NetApp. And therefore, this is my last earnings call. I have enjoyed working with all of you over the years, and I hope to have an opportunity to say goodbye over the next 6 weeks. In the meantime, my CFO responsibilities remain the same as Nick and I work together to facilitate a smooth leadership transition. We will be in great hands come the first of 2012.

So at this point, I'll turn the call over to Nick.

Nicholas R. Noviello

Thank you, Steve, and many thanks for your mentorship over the years. I'm sure I speak for everyone at NetApp when I say you will truly be missed.

Now looking forward, our target revenue range for Q3 is $1.52 billion to $1.61 billion, which at the midpoint implies approximately 4% sequential growth and 21% year-over-year growth. Consolidated non-GAAP gross margins are expected to finish around 60%. We expect that non-GAAP operating margins will finish around 17%. As Steve mentioned earlier, we expect our blended consolidated non-GAAP effective tax rate to be approximately 17.5% based upon a shift in distribution of our earnings to our international geographies, bringing our non-GAAP earnings per share estimate to approximately $0.56 to $0.60 per share.

Diluted share count is forecast to increase to about 380 million shares in Q3 based on our average stock price of $41.84 for the first 10 days of the quarter. This will include about 9 million shares from the convertible notes and 0.5 million shares from the warrants. Recall that the favorable impact of the note hedges is not included as an offset. If we were to adjust the share count for the convertible note hedged, that would add about $0.01 to the EPS guidance.

To summarize, our business model continued to show its underlying resiliency in the second quarter as we exceeded our operating margin and EPS targets despite some revenue softness. In fact, for the first half, we generated 23% year-over-year revenue growth at a non-GAAP operating margin of 18.5%. However, the original financial targets we laid out at our Analyst Day did not foresee the 2 substantial macroeconomic factors we find ourselves managing through today, those being the increasing economic turmoil in Europe and flooding in Thailand. These conditions make forecasting, both revenue and cost of sales going forward, far less predictable. Therefore, we cannot confidently forecast a specific range for Q4 revenue and earnings per share at this time. We will provide you with an update on our Q3 earnings call.

At this point, I'll turn the call over to Tom for his thoughts. Tom?

Thomas Georgens

Thanks, Nick, and good afternoon, everyone. As Steve indicated, the sequential decline in our major account program in a quarter where we expected seasonal growth was the biggest deviation from our forecast. While we were not anticipating sequential growth comparable to last year, we needed better performance from this group to meet our objectives. Fortunately, most of the unexpected shortfall was confined to a small number of accounts where the customer-specific dynamics can be understood. Unlike last quarter, the companies were not concentrated in any specific industry. Beyond this concentrated shortfall, the rest of the business was generally positive.

The strength in the other areas of our business is evident when looking at it from a geographical perspective. Our U.S. Commercial business grew 24% year-over-year, our Asia-Pacific business grew 55% year-over-year and our EMEA business grew 12% year-over-year in a challenging environment.

Our E-Series OEM business remains well ahead of plan with 11% sequential growth. We even saw some rebound in spending from the financial services sector. We also saw some budget flush in the U.S. Public Sector, which while up only 9% year-over-year, it was over a month on a compare and it grew 56% sequentially.

Outside of those 9 major accounts, our Enterprise business was generally strong. Our number of transactions over $1 billion was the second highest ever, increasing 17% sequentially and over 30% year-over-year, while the total net new customer account acquisition is at a 2.5-year high. The volume segments of the business around midsized enterprise and state, local and higher education were very robust and were the highest growth areas of the portfolio.

Our emphasis on pathway diversification continues to pay off as we saw record sales from our indirect channels, representing the highest ever percentage of our revenue. Our largest distribution partners, Arrow and AppNet, grew to 31% of total revenue and grew 18% year-over-year. CDW, our largest reseller in fiscal year '12, grew over 75% year-over-year.

Our alliance program continues to generate leverage as we broaden our portfolio of tightly integrated solution offerings in partnership with other best-of-breed vendors. We're in the process of conducting a global Insight event where we train thousands of technical resources, both internally and from our resellers and partners. At the event, we further enhanced our solution offerings by introducing 4 new verified architectures: Microsoft private cloud, Oracle Database, Media Content Management and FlexPod data center solutions.

FlexPod is a modular data center solution developed in conjunction with Cisco to provide partners and customers with an integrated, standardized and scalable and for structure to support a variety of workloads. Together, we offer validated designs for VMware, SharePoint, SAP, Citrix and Red Hat Linux.

FlexPod had another strong quarter, and our relationship with Cisco continues to deepen as a result. We now have over 400 FlexPod customers and a robust pipeline for future FlexPod business. On the product side, the newer 3000 and 6000 platforms both had solid quarters. Units shipped of the 3000 were up 34% year-over-year. And FAS6000 units more than doubled over last year's Q2 levels. The 2000 was down year-over-year and down slightly on a sequential basis.

We saw a decreased demand in both the channel and our large enterprises as well as a shift in business to the newer 3000 family. However, last week, we introduced newly designed 2000 class models for this segment, but our smart decisions are built on NetApp campaign. With refreshed technology, attractive price points and our latest Data ONTAP 8.1 operating system, it represents a compelling solution for each of its target segments.

Our product launch had a particular focus on the midsized enterprise and our state, local and higher education channels, where our momentum is strong and the partners are eager to introduce the new offerings to their customers. In addition to being the standard operating system on our 2000 series, Data ONTAP 8.1 is now available on our 3000 and 6000 platforms. Our 8.1 operating system is the first product in the market to marry the industry's richest portfolio of data management and storage efficiency technologies with clustering to enable unmatched scalability and nonstop operations.

Previous architectures, including both traditional approaches and newer niche implementations, have forced customers to make trade-offs amongst these features. NetApp is the only vendor to have the functionality and configurability to produce optimized solutions for the widest range of applications, including virtualization, technical computing, competent repositories and traditional business applications all from a single architecture.

Evidence on its scalability was demonstrated, while recently published compelling results from an independent SPECsfs benchmark test in which a 24-node cluster of NetApp FAS6000s running 8.1 produced 1.5 million ops per second. This is over 35% faster than the previous record, and we did it with 50% fewer discs and 80% fewer controller nodes, demonstrating a real-world configuration with far better results and far lower cost.

Our total E-Series product family continues to make a big impact as well. Our 14% sequential growth was driven by an especially strong demand from Teradata and Dell, but our other 2 major OEMs, IBM and Oracle, were up sequentially as well. We have been sufficiently clear about our commitment to this business initially in words and now in behavior that each of our major OEM partners have confirmed the expectation of an ongoing relationship and a couple of already introduced new offerings based on the E-Series technology.

The E-Series products are also key to our big data strategy in the areas of analytics and big bandwidth. For analytics, E-Series has now been designed into 3 integrated analytic appliances. We also have integrated it into our initial Hadoop solutions and partner engagements.

For big bandwidth, we are continually broadening the solution offerings to our field, enabling some high-profile full-motion video and high-performance computing wins. All in all, our business operated largely within the balance of our expectation this quarter and were not for the exception of an expectedly large slowdown in a handful of our biggest accounts. We are at least been at the midpoint of our targeted revenue range.

And we continue this ability in Europe, the persistent economic concerns in the U.S. and the associated uncertainty around federal spending, all things considered, the rest of the business was essentially in line or slightly better than we anticipated 90 days ago. Nonetheless, in response to the aggregate revenue performance, the organization once again demonstrated its ability to manage through the business model, enabling us to increase operating margins over the last quarter and produce record earnings per share.

Looking ahead, the impact of the Thailand flooding can potentially be the biggest swing factor on both our top and bottom line in the second half. The large buyer drives we did, as this was all unfolding, should sustain us through a good part of Q3 but probably not all of it. Although enterprise class drives are considered to be the least impacted, we still anticipate some amount of supply and pricing complexity. We have all heard the predictions of the industry analyst and the drive vendors themselves. Some of the information is conflicting and most of it is changing daily in regards to scope and ultimate impact.

I expect NetApp to fare better than most in this process, but it is far too early to state the exact extent this will impact our business either directly or through our OEM partners. On the other hand, our FAS business will begin to get uplift from the just reset -- refreshed 2000 series, and our partners and technical teams are coming off an invigorating symposium where they will brief on Data ONTAP 8.1 and competing using NetApp products.

I believe NetApp continues to have the best product portfolio and the best partnerships in the industry, both of which will pay off in the long run.

Before I open up the call to Q&A, I'd like to again thank Steve for more than 9 years of tremendous contributions to NetApp. I'd also like to congratulate the entire NetApp team for being ranked #3 on the World's Best Multinational Workplaces list by the Great Place to Work Institute. The culture at NetApp is one of our keys to success, and this recognition is strong validation of our commitment to creating a model company. It is this commitment that will drive us to continue to gain market share in both good and challenging times.

At this point, I'll open up the call for Q&A. As always, I'll ask that you'd be respectable of your peers on the call and limit yourself to one question, so we can try to address everyone in our allotted time today. Thank you. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Katy Huberty for Morgan Stanley.

Katy Huberty - Morgan Stanley, Research Division

You obviously did a great job in the channel as well as with signing up new accounts this quarter, but just a question on pricing because Dell last night talked about more price competition in the midrange. I wonder if there was some variability in pricing in order for you to win those deals in the midrange this quarter.

Thomas Georgens

Katy, I'd say in the channel, probably not so much. Clearly, that's a competitive business. And certainly, our largest competitor there is being aggressive in the channel and certainly is doing a number of incentives to gain market share or gain mine share. But I would say, frankly, the pricing dynamics are a lot more complicated at the large accounts because they see obviously lesser demand and the opportunity to take advantage of that. So I'd say the pricing environment is probably no different, which isn't to say that it's calm. It's just to say that it's no different. But to the extent the pricing is relevant, I'd say it's probably a little bit more on the major account side.

Operator

Our next question comes from Mark Moskowitz from JPMorgan.

Mark A Moskowitz - JP Morgan Chase & Co, Research Division

I wanted to ask you a question, Tom, regarding the overall connotation, your unexpected -- in terms of the unexpected weakness at your largest accounts, was this due to macro events, company-specific events, NetApp's inability to deliver? Is there a competitive dynamic? I guess if you can just kind of qualify or provide us some context, that'd be greatly appreciated.

Thomas Georgens

Yes, I think that there's 2 things at play here. One of them is the performance of the accounts and the other one is what was our expectation of the performance. I think there are certainly some accounts that certainly have well-known headlines that we knew going into the quarter were going to have some issues associated with them. Certainly, there was concern about the DoD and federal spending and obviously some individual accounts that we're probably are well aware of, that we knew were going to be problematic and we factored that into the forecast. I think that the other ones, we actually probably expected more of our normal Q1 to Q2 seasonality as we think about them, and that's really not what happened. And I'd also add that these were not necessarily problem accounts. These are accounts -- may have them actually on the ascendancy that shows the slowdown. So we want to indicate that we've actually had 9 more problem accounts on our major account portfolio. I think some of those are clearly in the ascendancy with NetApp, which is that we're expecting more from them this particular quarter. I think from competitive pressures, I think, certainly, pricing, clearly in a market where demand is limited and there's a lot of capacity chasing deals, customers are using that to [indiscernible]. But from a pure competitor perspective, in those 9 accounts, there's probably only one that I would say has a meaningful competitive component to it. But I think all the other ones are either macro-related or company-specific.

Operator

Our next question comes from Aaron Rakers from Stifel, Nicolaus.

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

I want to ask on -- first of all, a clarification. I heard you say 11% sequential growth on E-Series, and then I also heard you say 14% sequential, so clarifying that. And then if I look at that and I look at your organic revenue growth at roughly 6% by my math, I know you talk about gaining market share in down and up markets. How do we think about your organic growth profile? Or how are you thinking about the organic growth profile here over the next couple of quarters in that mindset of what is the market going to grow here looking out into 2012?

Thomas Georgens

Yes. I think, first of all, on the E-Series, probably, there are 2 different data points. One was E-Series OEM business and the other one was E-Series overall. So the E-Series OEM business had a more natural compare of the overall since we just really started with the branded business. That's why that number is a little bit higher. So -- and of course, those are our revenue number. I believe on the last call, I talked about a large $14 million deal that would not come to revenues this quarter, and that's clearly still true if you're wondering where the $14 million went. I think on the broader question, the real question here, as we think about the market and we think about the macro, NetApp's focus is almost exclusively on market share because that's really the true measure of our penetration. And the key component in market share or the only thing that gets actually counted in the market share, as reported by the industry analysts, is actually product revenue growth. So as we think about companies in the space with product transitions and acquisitions and I think we're dealing with a different macro environment this year than we were last year, I think, probably, might be the best way to think about that is actually thinking about sequential growth. So if I look at our sequential growth from last quarter, it was about 5.2% on the product side. So if I compare that to, say, EMC's product growth in storage on the most recent quarter, I think that number is about 1.2%. So you could say, well, it's a NetApp Q1 to Q2, and for them, it's a Q2 to Q3. But if you go back another quarter with EMC and look at the Q1 to Q2 transition to them, that's only about 2%. So in terms -- from a market share perspective, which is really a measure of product growth, NetApp actually had more sequential growth in the last 3 months and EMC's had in the last 6 months as on a percentage basis. So to the extent that we're this 1 or #2 market share players in this market, I'd have to think that our market share gains are greater than theirs.

Operator

Our next question comes from Jayson Noland from Robert W. Baird.

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Steve, good luck with the next step. A question for you or Nick, just trying to get a sense for what's in the guidance, your expectations for the 2240. Are you assuming constraints in the HDD world? And then on the major accounts, is there any push up there into this upcoming quarter?

Nicholas R. Noviello

Sure, Jayson, it's Nick. Just to give you perspective on the new products, certainly, there is pick up of new products that's built into the guidance. As we mentioned on the drive side of the fence, we talked about availability through the end of the calendar year. Certainly, it gets a little bit more complicated once you get into the New Year. So what we've built in on the guidance side is many of the positives that we talked about for this quarter continuing the new products coming in, but those overall constraints on drives from Thailand and macro being there that we have to consider when we built the guidance.

Thomas Georgens

The one other thing I'd say on the 2240 is we've seen a decline in low-end units over the past, really pretty much over the last 9 months or so. And I would say it'd be really easy for us to just say you should -- we should expect to get all those units back in all of the incremental. But the other thing to notice about our business is that the segments of the market that are most dependent upon products of that class, which is our Volume Channel business, have been the strongest part of our business. So clearly, they moved some of the demands to the newer 3000. So I would expect some of that demand to actually come back from the 3000 into the 2000. So I wouldn't -- it'd be really easy for me to say that it will all be incremental. But I think that there will be some reversed cannibalization of the 3000 just like we saw when the 3000 came out. As far as the enterprise and Department of Defense, or I'll just say U.S. Public Sector, those are big consumers of this class of product as well. And there are some attributes of this product in terms of size and compatibility with prior products, which actually will enable the product transition in our favor here that was held up with the previous generation. So I do expect not only this to impact our Channel business but I do expect that impact our enterprise and our U.S. Public Sector business as well.

Operator

Our next question comes from Bill Shope from Goldman Sachs.

Bill C. Shope - Goldman Sachs Group Inc., Research Division

I'm a little confused on the weakness in the 9 accounts. Can you help us understand? I understand that you can't lump in the weakness into one specific reason for all of them, but how are you addressing the weakness? Is there some execution issues that you're looking at? And my memory may be foggy, but this sounds somewhat similar to the shortfall you guys had in mid-2007 where you had some issues with large accounts. And I know you were able to reconcile that with basically a different approach to a broader customer base. How should we compare it to that prior hick up understanding that there was a big recession here later? And sort of how should we think about how you're addressing this weakness and preventing it from spreading frankly?

Thomas Georgens

Yes. I think if you think about it from last quarter, clearly, the federal side was a concern for us. We're wrapping up the quarter in the face of the debt-ceiling crisis, and I don't really know whether that impacted us or not. But we also -- on the last call, we talked about the U.S. Public Sector and we talked about financial services. So you can actually argue that it's actually even more concentrated than it was last quarter, so instead of spreading it might actually be contracting. And as far as the accounts are -- we need to look at every single one of them. More than clearly, it's really competitive and/or it's largely competitive, and I think we need to take that on clearly. And I don't think that's less than anybody. But I think most of the other ones, I think, most of those are accounts that are actually doing quite well from a NetApp perspective. And they took a pause. And some of them, obviously, we did some insight to see when we expect them to come back. Some of them will, some of them will pause a little bit longer based on their own company dynamics. So I think that the advantage of it having being a definable set of named accounts is that we can build and actually play in around every single one of them. As opposed to if we saw a broad weakness in the channel that would be 1,000 account problems. So I think there are things that we're going to jump onto. I'd say that most of those accounts are still relatively favorable at NetApp and we're not losing any share in them. We may or may not, depending on each individual situation as you see a rebound in them next quarter and that's what's factored into our guidance.

Bill C. Shope - Goldman Sachs Group Inc., Research Division

And the comparison to 2007, is that relevant or?

Thomas Georgens

I think 2007 was -- had a much, much greater concentration in financial services. In fact, I would argue that last quarter's dynamic was more like than 2007 than this one. And I'd also want to be really clear. It’s not like financial services came back in a big way. Certainly, they didn't have a 50-something sequential increase like our Federal business did. So but some of them did come back and some of them came back in a meaningful way. And we anticipated some of that in our guidance as well. So it's not universal. I think last quarter, we had 6 major accounts in financial services and they were all down. It was a bit more balanced this time.

Operator

Our next question comes from Brian Marshall from ISI Group.

Brian Marshall - ISI Group Inc., Research Division

If you -- I guess a little bit of confusion with respect to the -- your 9 large customers in the top 46. I mean, if that was really the shortfall and call $50 million of call, roughly $5 million per account, are we talking mostly on the 6000 series here? Because that business was up 100% year-over-year, so I'm just trying to tie those 2 together, what these guys are actually buying and then what went down?

Thomas Georgens

I wouldn't necessarily tie it to the 6000. And simply put is there's 2 things that factor in. One of them is the amount of money that they were down and the other one is the amount of seasonality -- uplift that we were expecting from Q1. So I think there's both of those that come into play. But suffice to say that if they came in as expected, we would've sold even more 3000s than 6000s and there are probably some 2000s as well. So I think that the strength of those business, I think we're heartened by the fact that the significant movements in certainly the high end and clearly that is some indication about the customers and the types of applications we're deployed in, but the 3000 was quite strong. I wouldn't roll out that we'll see some reversed cannibalization of the 3000s going to next quarter moving back to the 2000. But the 6000 remains robust and it could've been even more so, certainly, had some of these accounts come true.

Operator

Our next question comes from Glenn Hanus from Needham & Company.

Glenn Hanus - Needham & Company, LLC, Research Division

How about let's talk about the intermediate term business model. You were pretty responsive in controlling operating expenses. You mentioned a 17% operating margin this quarter. Is there sort of an intermediate target we should be thinking about? And how will you sort of manage to that target?

Nicholas R. Noviello

Yes, so, Glenn, this is Nick. Just to help you understand, on the operating expense perspective, we've taken some measures there. What you see in the 17% is the impact from Thailand though, right? So that is something that we have to build into our planning and really driving that change from what you might see on the business model side and on that 18-plus percent model that we've been in yet so far. And you'll see it actually in the gross margins that I gave you the guidance on earlier.

Thomas Georgens

Yes. The one thing I -- just from a point of view of managing the business, I think from this particular quarter, I think, once again, we proved that when we want to put some control on expense that we can snap back, to use the 2007 analogy, I think when things ought to slow down, we said we would get back on the model in the year, we were back in a quarter. The one thing that's a little bit different this time is, on the matter of Thailand, clearly, it's concern about availability of drives but there's also concern about pricing of drives. And from the point of view of managing to the P&L and managing to the business model, I think on a normal circumstance is, clearly, we would modulate operating expenses to protect the business model. But if we think that we're going to get a hit to gross margin as a result of this transaction and certainly with modeling some of that in, then that's going to be temporary in nature. I don't want whip saw the operation and modulate operating expense based on pricing of disc drives. But frankly, to the extent that the gross margin is impacted by the drive situation, that's going to flow through the bottom line on a temporary basis and the operating expense is going to be more modulated by the overall size of the opportunity that we see.

Operator

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

Keith F. Bachman - BMO Capital Markets U.S.

I have a similar question. So, Steve or Nick, just to be clear, the software margins that you expect in January, those will be in the services margins, those will both be roughly comparable to July margins? In other words, there was uplift there in services. I just want to make sure I'm clear, so that the variance, therefore, is all in the product side. That's Part A. And I have something I want to follow up with on the product side. Can you just confirm if that's accurate?

Steven J. Gomo

Yes, I think that's accurate. Keith, Steve here. You're going to see a little bounce back, as I mentioned in my narrative, in the services margin.

Keith F. Bachman - BMO Capital Markets U.S.

Right. Will it clear 60, Steve?

Steven J. Gomo

I'm sorry?

Keith F. Bachman - BMO Capital Markets U.S.

Will it clear 60?

Steven J. Gomo

It will be on the order of 60, and then there's not going to be virtually any change at all in the FCM margin. So to your point, the entire impact is in the product margin side of the house.

Keith F. Bachman - BMO Capital Markets U.S.

Okay. And is it at all, Steve, ACDs? Or is there something on mix, say, with a new product that would also negatively impact margins as we look out?

Nicholas R. Noviello

Yes, Keith, this is Nick. In the third quarter, we're going to expect to see some impact on those product margins from customer mix from OEM as we get into the third quarter and the end of the calendar year. Those things are built into the guidance and they show up on the product margin side.

Keith F. Bachman - BMO Capital Markets U.S.

Okay. So sorry, Nick, just to be clear, so that -- what I'm really trying to slice is that product margin in a number of different ways, is pricing in there as one of the variables? And then I promise I'll see the floor.

Nicholas R. Noviello

Okay. So what's in there is, certainly, Thailand is in there, right? And we're building that in. In addition to that is a customer mix and an OEM mix. Those are the big drivers that are going to be built into that and are built into the product margin guidance for the third quarter.

Thomas Georgens

But I think from the point of view of material pricing to us, particularly disc drives, that's factored in. Products' pricing to end users, that -- our expectation is that's not going to be materially different than what we saw this quarter.

Operator

Our next question comes from Kaushik Roy from Merriman Capital.

Kaushik Roy - Merriman Capital, Inc., Research Division

Tom, can you comment on the use of flash? We know you used flash cash as so SSDs. But can you comment on your offering or maybe PCIe SSDs in the servers?

Thomas Georgens

So we kind of dropped the flash out of our commentary because flash is now bundled into more and more and more of our systems. It's just becoming an integral part of these types of arrays. And the ability of flash and ATA drives in lieu of higher costs, enterprise drives, clearly drives a cost point that's very, very competitive and it's driven up adoption. So the fact that it's bundled in and not exactly tied to customer preference makes it hard to talk about flash adoption. But I would venture to guess, certainly, on the 6000 and the majority of the 3000, that's an integral part of the solution. In terms of the way we go from here, I think you'll continue to see innovation on the flash side from NetApp, both inside the array and outside the array. I don't want to preannounce any products. I don't think that -- I think through the planning horizon in the model that you guys are trying to put up for Q3, I think you should expect that flash drives are going to be substantial the way it is. As far as PCI flash products, you need to be clear on what the opportunity is there. I think for us, things that are going to represent permanent storage, we want to bring into our data management methodology, so that's clearly our interest. As far as flash-based PCI boards as a revenue opportunity on a stand-alone basis, that's not nearly as interesting to us. But as a vehicle to sell software and broaden our footprint, clearly, that's the vector that we'll be pushing.

Operator

Our next question comes from Brian Freed from Wunderlich Securities.

Brian Freed - Wunderlich Securities Inc., Research Division

A real quick question on ONTAP 8.1. First, is it currently shipping as a GA product? Or is it still in a release candidate on the FAS6000 and 3000 product family? And related to that, can you talk any about what you're seeing from a win rate perspective? Are you seeing any visible signs of improvement particularly in the scale-out NAS?

Thomas Georgens

Well, from a 2000, it's an every unit item out of the factory, so it's basically the standard operating system that we ship. For the 3000 and 6000, still obviously an option. They are shipping actually a prior version of ONTAP 8 as the default. And they can actually ship a 7.x for some of the models also. So in terms of win rates, particularly around scale-out NAS, it isn't just about 8.1, we're certainly competing with cluster node in that technology with the existing functionality of 8.x. And I think what 8.1 brings to us is not, only the performance that you saw, the new operating system on the platforms clearly is compelling. But what it also does is it reduces the trade off necessary of trading off clustering versus the premium software features. So, many of the premium software features in our standard version of ONTAP are now fully clusterable. And from that perspective, obviously, the product has much broader appeal, not just in scale-out NAS but really around traditional business applications. And we really have very, very, rich data management, which is not typical of products in traditional business applications. And then next clustering, to basically give tremendous flexibility and both scale of performance of capacity and also clustering, is a key-enabling technology, a true nonstop operation. So from our perspective, the scale-out NAS is just about one data point. The real focus of our 8.x journey is effectively to bring clustering and premium software features into the traditional business applications area, which have been relatively modest from an innovation perspective for a long period of time.

Operator

Our next question comes from Richard Gardner from Citigroup.

Richard Gardner - Citigroup Inc, Research Division

Tom, sorry to beat a dead horse, but I did want to go back to the issues in the 9 accounts. On the one hand, it sounds like it's either macro or company-specific driven, but you also suggested that some of these accounts are on the ascendancy with NetApp and have decided to put plans on hold. And it sounds like there might be maybe a situation where you're displacing a competitor, and those customers have decided to slow down their adoption of NetApp technology. So I guess what I'm really asking is how much of this really is company specific and macro and how much of it is due to competitive dynamics in these accounts?

Thomas Georgens

Yes, I also want to be clear. I want to go back to my first answer is the real dynamic here is not the overall fundamental health of those accounts, it's the performance of those accounts this quarter against our expectation of that performance this quarter that we had 90 days ago. So there are clearly some accounts that might be problematic growth accounts for company-specific reasons. And we knew that going in. And those weren't factored in. And those might be accounts that might be tough for us to drive growth in overtime whether we gain share on them or not. On the other hand, these are accounts where we had higher expectations than what they did, which isn't to say that they're broken or they're damaged and they were losing ground. So -- and some of these accounts are accounts that we've made a lot of progress. And they all did spend money. It's just a question of not as much. So I think from that perspective, I realize that's ultimately not needing to a satisfactory answer, you keep coming back to it. But I'd say that overall, the point is, is that the major accounts, in general, at being a proxy for the broader environment have certainly seen price -- certainly seen pressure, both from a pricing perspective and a demand perspective. And I think that those accounts, being large as they stop and go, have a much bigger impact on our business. So those 9 accounts had a disproportionate amount of our business relative to our expectation, which isn't to say that we're in trouble at any of them. Like I said, I think the competitive pressures are really only relevant in one. And they aren't necessarily the 9 worst accounts because, clearly, we have accounts that we know are going to be problematic and certainly sectors that are going to be problematic, but those were already factored into our forecast. So I just want to be clear that, we only know -- it's not like we only have 9 accounts that messed -- that we're not happy with. I think these accounts will be very strong for us going forward, and there'd be other accounts that are not on this list that we know are problematic, and that was factored to our guidance. And it is continued to be factored into our guidance going forward.

Operator

Our next question comes from Scott Craig from Bank of America Merrill Lynch.

Scott D. Craig

Just a clarification on the guidance. I think I heard you say that you're assuming a pick up in the major accounts, maybe just clarify that. And then secondly, if that pick up doesn't happen, Nick, what are you guys prepared to do on the OpEx line? And what can you do to sort of mitigate some of a potential revenue shortfall if we see continued slow down?

Nicholas R. Noviello

Yes, Scott, this is Nick. Just in terms of your comment on pick up in major accounts. First of all, again, we go through an account planning and build a view of where major accounts are going to go this coming quarter. Similar to what Tom has said, there wasn't a lot of growth built into last quarter. So we're not expecting a lot this coming quarter. We do a bottoms up, that's built in and that's how we've kind of come up with the guidance on those. On the OpEx side of the fence and really back to a question of operating margin, the operating margin shortfall is really reflected in the gross margin shortfall. And the gross margin shortfall is driven by the cost pressure that we believe is going to come and we're seeing a little bit of in terms of drive situation that's out there. So that's built into product gross margins, that flows through to the overall operating margin line. And I've made reference before to the OpEx as a percentage of revenue is basically flat, so the expense structure we've managed pretty well.

Thomas Georgens

Yes. I think going forward, it's kind of if we were trying to crank back an operating expense, this will be all the usual things. It would be programs. It would be hiring and things of that nature. If you look at this quarter similar to last quarter, we came in over the top on the EPS side. And clearly, the revenue didn't quite come up for a forecast in either K, so we're quite cognizant of that. So the issue that we're trying to solve here, obviously, is we're trying to drive growth as opposed to deal with operating expense. On the other hand, with some uncertainty ahead, both at macro-economically and also with the Thailand flooding, now we need to be careful about where the top line is going and, therefore, we were prudent this particular quarter. So we still hire 300-and-something people. It's not like we were sitting idlely by, but that's the balance that we need to have going forward is how do we modulate the spending in proportion to the business. But I also wanted to be clear, as I said earlier, is the impact of the Thailand flood, we expect to be temporary. And I'm not going to modulate operating expense too much on that because, a, it's going to be hard to predict, and I hate to just kind of jerk the organization around a set of data points that are changing every day.

Operator

Our next question comes from Maynard Um from UBS.

Maynard J. Um - UBS Investment Bank, Research Division

I think you more broadly addressed this issue, but I was hoping if you could be a little bit more direct. Are there any changes within your customer base around the way they're thinking about their storage architectures or their technologies? And I'm curious, just given kind of EMC's commentary that its Isilon product has been displacing what they say a NAS vendor that couldn't scale for general purpose needs. Can you just help kind of clear the air there, what you're seeing in the market from that standpoint?

Thomas Georgens

Well, I think, specifically, on the Isilon case, I mean, certainly, we see them. We see them certainly replacing a lot of Solara. We certainly see them agitating in our accounts. I think when we think about Isilon, clearly, they were targeting us before EMC bought them. And, certainly, that has not led up. It's approximately causing these accounts. Like I said, the accounts that are on the ascendancy, that suddenly stopped buying or paused for a period of time. That wasn’t an intercept of the business by a competitive activity. Certainly, if that was a threat that we're contracting to the forecast 90 days ago, things like that don't happen that quickly. As far as Isilon itself, if you look at the value points that it has around NAS performance, and the other value point has really about manageability of large content tools. From a straight performance perspective, since that’s subjectively measure, clearly the E-Series for high-performance computing, it's clearly much higher performance. Certainly, the benchmark that we just did around SPECsfs around NAS performance and NAS scalability are dramatically less hardware. So I think from a performance perspective, NetApp is more than able to hold its own. In fact, it has a compelling leadership position there. On a general question of manageability, that's kind of a tough thing to objectively benchmark. But if you look at where we're going with that, now with 8.1, the marriage of all the premium features, which don't exist in that particular product and, therefore, it makes it difficult to sell into traditional business applications. And also, kind of the merger where we're heading with the Bycast acquisition and object-oriented stuff effectively going to be bringing the functionality of both an Atmos and an Isilon together, if you will. So I feel good about our roadmap. I think, clearly, from a performance perspective, NetApp is really clearly retaking the high ground. And I think from a manageability perspective, obviously, that's a little bit harder to objectively measure, but I think you'll see much better functionality from NetApp and continued competitiveness on that front. So I guess where I see Isilon is some of the premium side of the business around performance and key scientific applications more than comfortable with our stance there. In terms of large content repository pools kind of lower value data, that's primarily a manageability plague. You'll certainly hear more from NetApp hopefully at 8.1 in the future releases. So from us, do we see them? Yes. Were they important part and parcel of the dynamics of the major accounts? Certainly, we see them, but they were not the primary cause of what we saw in -- from 90 days ago.

Operator

Our next question comes from Brent Bracelin from Pacific Crest.

Brent A. Bracelin - Pacific Crest Securities, Inc., Research Division

One quick clarification for Nick and then a question for Tom. Nick, on the gross margin, obviously, the guide down here implies close to a 350 basis point product margin decline. Should we think about the vast majority of that assumption being tied to higher drive costs and temporary in nature?

Nicholas R. Noviello

Brent, yes, 2 points there to keep in mind. And, yes, it's pretty close in terms of that sequential decline in product gross margin. The 2 points are first of all, you're going to have a product and customer mix, including the OEM and heavier OEM that happens in the calendar third quarter of every year. That's impacting part of it, and then the Thailand drives are impacting the other part of it. That makes up the basic 3-point change and decline in the product gross margins.

Brent A. Bracelin - Pacific Crest Securities, Inc., Research Division

And then, Tom, my question for you is less about the 9 major accounts and more about the direct sales as a whole, on the absolute basis, down 2 consecutive second quarters, your lowest absolute level since October of 2009. You obviously have a new software release, 8.1, the low-end refresh. Do you think we're bottoming here on the direct side? Obviously, the commentary that there's going to be a heavier OEM E-Series mix suggests maybe this isn't the bottom. What's your general sense? Is there a pipeline of new customers that could drive a rebound going forward? Help us understand the direct sales opportunities that you see now. Are we close to a bottom? Are we seeing the bottom? And what gives you confidence that you can grow that business going forward?

Thomas Georgens

Yes, the one thing that I would -- I guess the one question I would put is that don't assume that the fulfillment model for the end customers are static. So the fact that some of our big accounts may choose to go through a channel partner or go through an integrator or the systems integrators now moving more hardware through their business. So the same involvement of our sales reps might actually have a different fulfillment model, and I think that's in play here, too. The flip-side to that argument that I would also argue is don't assume that our Channel business has 0 touch from our direct sales organization. In some cases, I wish it was more independent. But our direct sales organization is actively involved in a lot of accounts. So I think our direct selling motion is clearly creating demand. And the question is, will they fulfill it directly through NetApp or they prefer to go through in a third party. In a lot of cases, that's a customer choice. So we don't actually measure demand creation by channel. So I wouldn't read into that the direct sales force numbers are necessarily indicative of the lower direct sales force productivity.

Brent A. Bracelin - Pacific Crest Securities, Inc., Research Division

Okay. That's fair enough. We'll discount the overall direct sales force business, but it's hard to discount the branded business that's slowing down overall. So I guess, do you feel like 8.1 can help drive your acceleration branded overall?

Thomas Georgens

I think, clearly -- I think 8.1 is a -- and the entire 8.x family is really revolutionary when it comes to storage for data center environment, the ability to bring true clustering and this premium feature set, I think, will help. Obviously, the 2000 will help as well. Clearly, it's not uncommon for us to see pickups in demand. Certainly, the last product release was remarkably successful in terms of conversion of customer demand. So I expect the 2000 to pick up as well. So from an overall branded business, like I said, I think the other thing that you need to put in context is just what you believe about the macro environment. So I think the year-over-year growth numbers are all interesting, but I think we're dealing with a different macro environment. Obviously, NetApp has got other elements of the portfolio now that we can rely upon for growth. And I think if you go back to a sequential number, I think the NetApp sequential product performance is actually pretty darn good this quarter, the 9 accounts or the major account in general notwithstanding. I think 5% sequential growth, and even despite everything else that's going on 4% sequential growth from here. If we sustain that for the next couple of years, that would -- or I should say, if we can sustain that though a difficult period, I think that would be pretty good for us and I think we'll certainly be in a share gaining position.

Operator

Our last question comes from Andrew Nowinski from Piper Jaffray.

Andrew J. Nowinski - Piper Jaffray Companies, Research Division

Could you just comment on why you saw a similar slowdown in the fed sector in the month of October that Dell called out last night? And then looking into the next 12 months aside from the obvious looming budget cuts, do you anticipate any headwinds or new headwinds from competitive perspective now that EMC has qualified VNX and is now on more GSA list?

Thomas Georgens

On the federal side, I mean, clearly, that's been very, very successful for us. We're #1 market share position. Obviously, a lot of speculation in that particular business. I think all things considered over an extended period of time, a lot of other companies that talk about weakness in that area while a NetApp business continue with momentum. So that's a strong sequential growth in that business last quarter. We had growth year-over-year. So with all the headlines, I think we have to be pretty pleased with the overall performance. Did I say that -- would I say that October would slow down? I don't think -- first of all, I wouldn't over play our granularity in that regard. One thing that happens in October is a lot -- we see a lot of systems integrator business that they actually win before the fiscal year end and takes a little while to roll through to us. But I wouldn't say that we saw anything in October that made us any more or less pessimistic than what we saw in September when the deals were actually closing.

Steven J. Gomo

I would add -- this is Steve. I'd just add, as far as the past quarter is concerned, remember that in the Fed business also, we have contracts that are in existence today. We own the contracts, and what we're seeing, I think a little bit in the slowdown, there's not as many POS as perhaps people had anticipated we will receive. I think it's tied more to the fiscal situation in the United States than it is to anything else.

Thomas Georgens

Yes, I think on the question of VNX, in general, the VNX has not been -- the VNX itself has not been that much of a change in the dynamic in many accounts. The VNXe in terms of EMC's channel incentives is something that we've seen more of. Certainly, if you look at the performance of our volume segments, clearly, that's been the strongest part of our portfolio. So I don't think they've slowed us down much. But nonetheless, I'd say that VNXe is something that we see particularly because of that channel push. And I think that's been something that's generated a more discussion within NetApp and actually the VNX itself. I think the VNX itself is -- I think has been inflicting more pain on Dell than it has been put -- inflicting on NetApp.

Operator

We have run out of time for questions. I will now turn the call back over to management for closing remarks.

Thomas Georgens

Thank you, operator. Just one last thing before we wrap up is I wanted to bring up that we are quite aware of a number of press articles about NetApp products being deployed in Syria by our systems integrator named Aria. And the one thing I wanted to be very, very clear about this is I want to assure the people on the call, our customers, our partners, our employees, that we absolutely do not support the sale of NetApp equipment to Syria. I'm not here to suggest that we found a legal way to achieve an objective to sell product to a banned country. We have no intention of doing that, and we are just as disturbed as this product is in a banned country as anybody else. The other thing is that NetApp produces storage products. We don't produce the applications that are being talked about in this particular article. And our products have been deployed in this solution and in a very generic way, and that NetApp does not produce this application or participated in its development at all.

And the last thing I probably want to point out is that NetApp has proactively reached out to the government, and we've offered a full assistance in reviewing the matter, sharing any information that we have about the situation and ultimately get to the facts. At this point, we don't know even whether the story is true or acting as if it were and taking all the appropriate precautions. So I can assure you that this is a situation that we did not actively seek out. We did not choose to sell to the Syrian government. We did not deal with the Syrian government and we're not looking a way to circumvent U.S. law to sell to the Syrian government. We have no interest in providing product to a banned country. I just wanted to make sure that was clear.

So with that, I would like to thank you for your time today and your interest in NetApp, and we'll see you all in 90 days.

Operator

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

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