Sun Microsystems F1Q08 (Qtr End 9/30/2007) Earnings Call Transcript

Nov. 5.07 | About: Sun Microsystems (JAVA)

Sun Microsystems Inc. (JAVA)

F1Q08 Earnings Call

November 5, 2007 4:30 pm ET

Executives

Bret Schaefer - IR

Jonathan Schwartz - President & CEO

Mike Lehman - CFO

Analysts

Benjamin Reitzes - UBS

Katy Huberty - Morgan Stanley

Toni Sacconaghi - SanfordBernstein

David Bailey - Goldman Sachs

Richard Gardner - Citigroup

Brent Bracelin - Pacific Crest Securities

Bill Shope – JP Morgan

Keith Bachman - Bank of Montreal

Kevin Hunt - Thomas Weisel Partners

Harry Blount - Lehman Brothers

Louis Miscioscia - Cowen

Operator

I would like to welcome everyone to the Sun Microsystems'fiscal year 2008 first quarter results conference call. (Operator Instructions) I would now like to turn the meeting over toMr. Bret Schaefer, Vice President of Investor Relations for Sun Microsystems.

Bret Schaefer

Good afternoon. Thank you for joining the Sun Microsystemsquarterly conference call. I'm Bret Schaefer. With me today is JonathanSchwartz, Sun's CEO; and Michael Lehman, Sun's Chief Financial Officer andExecutive Vice President of Corporate Resources.

The purpose of today's call is to discuss the results ofSun's fiscal year 2008 first quarter, which ended on September 30, 2007. During the last hour, wepublished a copy of the operations analysis datasheet with nine quarters offinancial and operations information, including the quarter completed on September 30, 2007.

If have you not received the announcement or the detailedfinancial datasheet for any reason or you wish to hear the replay of thisconference call, you may log on to our website Sun.com/investors. We've postedslides you can view on the web which accompany our prepared remarks. These slidesmay be viewed at the same URL, Sun.com/investors. After the prepared remarks ofour call today, we will devote the remaining time to Q&A.

During the course of this conference call, we'll be makingforward projections and other forward-looking statements regarding expectedfinancial future results and business opportunities. Our actual future resultsmay be very different from our current expectations. We encourage you to readthe 10-Ks and 10-Qs that we file periodically with the SEC.

These documents contain a discussion of the risks facing ourbusiness including factors that could cause these forward-looking statementsnot to come true. We do not currently intend to update these forward-lookingstatements.

In addition, during the course of the conference call, wemay describe certain non-GAAP financial measures which should be considered inaddition to, and not in lieu of, comparable GAAP financial measures. Pleaserefer to the operations analysis posted on our website at Sun.com/investors forthe most directly comparable GAAP financial measure and related reconciliation.

Now, let's go to the financials. Sun's total revenues forthe first quarter of fiscal 2008 were $3.219 billion, an increase ofapproximately 1% as compared with the $3.189 billion in revenue reported forthe fiscal fourth quarter of 2007.

Total gross margin was 48.5% of revenue, an increase of 5 pointsover the gross margin for the first quarter of fiscal 2007. Total R&D andSG&A expenses were $1.385 billion, a decrease of $46 million year over year.

In the first quarter of fiscal 2008 we reported a $54million tax provision. GAAP net income for the first quarter of fiscal year2008 was $89 million or diluted earnings per share of $0.03 as compared with anet loss of $56 million or a net loss of $0.02 per share for the first quarterof fiscal 2007.

Q1's products revenues totaled $1.98 billion, an increase of1.1% year over year. Within products revenues, computer systems productsrevenue was $1.475 billion, an increase of 0.5% year over year. Storageproducts revenue was $505 million, an increase of 2.9 % year over year.

Q1 services revenue totaled $1.239 billion, up 0.7% year overyear. Within services revenue, support services revenue was $979 million, down0.8% year over year. Revenue from professional services and educationalservices totaled $260 million, an increase of 7% year over year. We ended thequarter with a cash and marketable debt securities balance of $5.193 billionand generated positive cash flow from operations of $574 million in Q1.

During Q1 '08 we repurchased 244.6 million shares, whichequates to approximately $1.25 billion. Shares were repurchased at an averageprice of $5.11. There is currently $1.55 billion remaining of the $3 billionshare repurchase program we announced in Q4 '07.

With that I'll turn it over to John.

Jonathan Schwartz

Thanks, Brett and hello, everyone. I'd like to start bythanking our team and our partner community for continued progress in all keyaspects of our business, turning in our fourth straight quarter of profit. Wecontinued to focus on both operational discipline and execution during thefirst quarter and most notably delivered another improvement in our grossmargins to a seven-year high of 48.5%, so customers are clearly seeing value inwhat we're delivering.

Overallin Q1, we saw strength in high end enterprise systems and infrastructuresoftware, and we stabilized our storage business. Geographically, we continueto see strong performance in EMEA and Asia Pacific, and most notably in India and China. The U.S. was down year over year,however the U.S. did show strength in both thefinancial services and government verticals.

Allthis being said, Q1 was seasonally challenging as expected, and top line growthis still an area of focus. We shared some exciting announcements duringthe quarter that are key to bolstering future revenue growth, includingstrategic partnership announcements with Microsoft around virtualization andthe Solaris platform, Google around Star Office and with IBM announcing aSolaris OEM agreement. We're also seeing virtualization, energy efficiency,storage and archival capacity and security in the announcement of the new foursocket quad-core Intel and AMD-based servers powered by Solaris, Linux andWindows as driving incremental demand.

Clearly we're bullish about our longer term prospects asevidenced by our aggressive share repurchase in Q1 totaling approximately, asBrett, said $1.25 billion or approximately 245 million shares. I'd like now towalk through some of the business highlights for the quarter and end with a fewcomments on focus areas for FY08.

In microelectronics, we entered the commercial siliconmarket with the introduction of our UltraSPARC T2, the world's fastestcommodity microprocessor and the industry's first volume processor with eightcores and eight threads per core. We've been praised by industry analysts asbeing a year ahead in the commodity chip market and believe that the T2 willfurther the growth of the Niagara and Solaris ecosystems for Sun.

In software and services, Solaris reached nearly 11 millionlicenses in Q1, with over 2 million sockets under commercial license. InAugust, we announced that IBM would become an OEM of the open source Solaris 10operating system and they announced they would resell it on their X86 orX-series servers.

Identity management continued its strong growth with largedeployments within the U.S.federal government and in addition, our consumer platform business, comprisedof embedded Java, continued its success as the Java platform is built into moredevices globally, now at 5.5 billion before what Google announced today.

Within services, our professional and educational servicesdivision showed its strongest revenue growth of 7% and strong marginperformance, punctuating the contribution of Solaris to higher value-addprofessional services in conjunction with our systems offerings.

As I've said before, we have an objective at Sun to achievegreater transparency in reporting the performance of all of our businesssegments. With a 25 year history of thinking and operating as a highlyintegrated systems company, this effort is challenging. Regarding software andbreaking out software-specific performance numbers, we're committed to clearlydefining and articulating the size and the characteristics of our software andsoftware services business so that investors can have greater insight intothese strategic assets. We take this effort very seriously and will continue tokeep you apprised as we make progress towards this disclosure.

Moving on to our systems business, we announced thecombination of the storage and systems groups under the leadership of JohnFowler to best capitalize on our R&D resources and to drive increasedproduct integration with Solaris at the core. We continue to see growth in bothour chip multithreading, as well as Intel and AMD-based businesses in Q1, andhave particular strength in our OPL line developed with Fujitsu.

To maximize market reach, Sun will continue to offercompelling and differentiated enterprise-class systems using multiplemicroprocessor platforms that set new standards in eco-efficiency.

During the quarter we also introduced our first quad-coreIntel Xeon processor systems, offering world class performance, unmatcheddensity and expandability in an advanced energy efficient design. We previewedthe first and only four socket 2U quad-core system on the market for the IntelXeon 7300 series platform and also expanded our storage virtualization portfoliowith the introduction of the StorageTek 9985 enterprise storage. For theremainder of FY '08 we expect to be shipping new Intel, AMD and UltraSPARCsystems along with expanding our storage and archival systems offering.

The product line line-up and innovation pipeline has neverbeen stronger. With gross margin at 48.5%, we continue to deliver real valueand innovation to the marketplace. Solaris is continually proving it'scompetitiveness in a rapidly consolidating operating system market and thestrength in our enterprise high end server certainly shows the value of SPARCand Solaris across all platforms on the market today.

To close, I want to be clear that top line growth isabsolutely our number one priority for FY08. We will continue to driveoperational discipline across the business and to maintain our laser focus ondelivering value and differentiation across the entire pipeline of ourorganization.

With that said, I'd like to pass it over to my officemateand our Chief Financial Officer, Mike Lehman.

Mike Lehman

Thanks, Jonathan. Ourresults in Q1 indicate that we are making continued progress towards ourlonger-term financial objectives. On a year-over-year basis we have improvedour gross margins, lowered our R&D and SG&A expenses and reported GAAPnet income for the fourth successive quarter, even with $113 millionrestructuring charge. We generated $574 million in cash from operations duringQ1, the highest level in a first quarter since 2001.

We have achieved all that in what is typically a seasonallychallenging quarter and this quarter was no exception. While we have more workto do in terms of reinvigorating the top line growth rate, Q1 makes a strongstatement that we are on the right track.

There are a few things relative to the quarter’s performancethat I want to be sure you understand. From a geography perspective, Q1 lookedmuch like the past couple of quarters. We experienced revenue growth ofapproximately 5% in EMEA, which reflects some currency benefit. We experiencedrevenue growth of approximately 6% in Asia Pacific, despite a continueddecrease in revenues in Japan.We experienced revenue growth of approximately 4% in the International Americasand experienced a decrease in U.S.revenues of approximately 4%.

While imprecise, we estimate that net revenues werefavorably impacted by approximately 1% to 2% in Q1, based on exchange ratemovements. This was partially offset by a higher level of operating expenses.We estimate that the overall net impact of exchange rate movements on thebottom line in Q1 was approximately $0.01 per share.

It is worth noting that in the U.S.we worked with our major channel partners and decreased the levels of inventoryin the channel by around $20 million in Q1. Overall, channel inventory levelshad been reduced by more than $100 million in the past five quarters. Whilethis has a negative impact on current year revenues, this helps us improveprofitability over time.

As we have talked about for the last year, we have madeplans to move to a sellout inventory model in fiscal '08. The move will occurin the current quarter, Q2, for the U.S.and for Asia Pacific. We anticipate the move will negatively impact revenue byapproximately $100 million to $150 million in this quarter. The move to sellout will occur for EMEA in the second half of fiscal '08 and will represent anadditional $40 million to $60 million in channel inventory reversal. We haveconsidered the impact of these actions in the full-year financial guidance thatwe have provided.

Back to the demand picture in Q1 and most of you are awarethat during Q1 and early Q2, we announced a number of new systems productsincluding Niagara 2 as well as certain new Intel-basedplatforms. We believe there is now more certainty in the market relative to thefiscal '08 product road map. That is always a good thing.

In terms of deferred revenue in Q1, products deferred wereup approximately 18% year over year and overall deferred were up approximately14% year over year. Gross margin was once again the highlight of the firstquarter's results; at 48.5% this was above our internal estimates. Productgross margins were 48%, up 0.6% sequentially and up 5.3 points on ayear-over-year basis in Q1. I would estimate that about $25 million to $35million of the product gross margin improvement was above our expectations.

We also experienced an improved mix of software licensingrevenues, a stronger showing from our mid and high end UltraSPARC basedservers, and we managed our pricing actions within the normally competitiveenvironment.

Service gross margins increased 2.1 points sequentially and4.3 points on a year over year basis in Q1. This reflects continued costreductions in our service delivery model and improved product quality.

Looking at operating expenses, you will note that bothR&D and SG&A expenses excluding restructuring were lower sequentiallywhich is typical, and lower than the prior Q1 of fiscal '07. We expect thispattern of year-over-year declines in absolute dollars of ongoing operatingexpense to continue throughout this fiscal year.

As we have signaled in the past, we have ongoing initiativesaimed at lowering our operating expenses both in the short term and longerterm. Q1 expenses were right in line with our expectations. The income taxprovision of $54 million in the quarter was right in the range that we hadexpected as well.

As most of you will recall, during our Q4 fiscal '07 resultsconference call, we gave a range of expectations for the current fiscal year. Lookingforward to the rest of fiscal '08, we expect the following to be reflected inour annual fiscal year business model.

We expect revenue growth to be in the low to mid single-digits.We expect revenue growth to be a bit higher in the second half of the yearrelative to the first half. We expect gross margins to be in the range of 44%to 47% for the year. We have raised this range by 1 percentage point, based onthe Q1 results and our view of the rest of the year.

We expect total operating expenses, excluding any actual orpotential restructuring expenses and based on current exchange rates, to be inthe range of $5.6 billion to $5.8 billion. We expect amortization ofintangibles to be in the range of $250 million to $300 million. We expect approximately$225 million to $250 million of stock-based compensation. We expect netinterest income of approximately $170 million to $200 million, and we expectthe full year tax provision to be in the range of $200 million to $250 million.

In summary, we have not changed our view of the currentfiscal year, with the exception that we expect slightly higher annual grossmargins, as well as slightly lower net interest income given the level of sharerepurchase activity in the quarter. We have increasing confidence in ourability to deliver against our stated financial objectives.

Longer term, we are clearly focused on improving the revenuegrowth rate and will continue to consider organic and inorganic ways to do so.We are on track to deliver at least 8% GAAP operating margin in our fiscal Q4.

With that, I will turn it back to Brett.

Bret Schaefer

Thank you, Mike and Jonathan. Before we begin thequestion-and-answer session, I'd like to request that each of you ask just onequestion consisting of one part. This way we hope to get to most of thequestions in queue today.

If there is time remaining, we'll be happy to take yourfollow-up question. Calvin, will you please start the question-and-answersession?

Question-and-AnswerSession

Operator

Your first question comes from Benjamin Reitzes - UBS.

Benjamin Reitzes - UBS

Could you talk about the demand environment? Jonathan, yousaid financial services, you gave some color there; it sounded like it was atleast in line with expectations and nothing too bad there. If you could justtalk about the overall demand environment as we go throughout the year.

One last thing is Mike, if you can give us an effective taxrate. It looked like there were $0.02 to $0.03 of net charges in the quarter,so the earnings were really $0.05 to $0.06, any clarity there would be helpful.Thanks.

Jonathan Schwartz

Ben, I'll take the first part of it. Congratulations onsneaking in two questions. First of all, obviously we talked about demandgeographically. I think within the U.S, there's obviously sector differencesand industry differences. We certainly have seen some slowing in the financialservices especially those that were more exposed to the sub-prime mortgageissue.

Broadly, I think retail banking, commercial banking, thecapital markets are otherwise pretty strong and are continuing to look attechnology both from Sun and others as vehicles to grow. I thinktelecommunications, we also see as being reasonably strong. These companies andcustomers are seeing more opportunity especially given some of the innovationswe're seeing on handsets.

I think more broadly, more traditional industries are slowand frankly have been for a while and I think beyond that, we'll see as timegoes forward.

Mike Lehman

I am not quite sure about the effective tax rate question.We haven't changed our view of the overall tax provision for the year. It'sstill in the same range that we expect it for the year and the $54 million inQ1 was right in line with what we had expected. So the effective tax rate isessentially that number applied against the annual revenue and then it's not anormalized tax rate for all of the issues we've chronicled for years.

What you may be referring to is that yes, we reported netincome of $0.03 on a GAAP basis, but included in that number was restructuringof $113 million, which was also approximately $0.03 and that may have been whatyou were getting at in the question.

Operator

Your next question comes from Katy Huberty - Morgan Stanley.

Katy Huberty - Morgan Stanley

What product categories drove the acceleration in deferredproduct revenue and does that suggest that we could see some incrementalproduct growth in the coming quarters?

Mike Lehman

The answer is typical, it's the high-end products thatrequire installation. It's typically the same types of products every quarter.It's not unusual to see more, larger deals like this so nothing unusual. It'sjust yes, it does indicate that there were a number of products that are in theprocess of installation that typically will turn into revenue in the nextquarter.

Operator

Your next question comes from Toni Sacconaghi - SanfordBernstein.

Toni Sacconaghi - Sanford Bernstein

Your support revenues were down year over year for the firsttime, I think in history. Can you explain the dynamic that's going on? Unitgrowth has been down the last three quarters, but I think you've stated thatyou felt very comfortable that you were still getting good ASPs and goodrevenue growth. I think the inferencewould be that there wouldn't be an impact on support, but we have seen supportrevenues decelerate very rapidly over the last eight quarters and are nownegative. Can you talk about the dynamic there?

Mike Lehman

Well, withoutagreeing with your characterization of the change in the revenues, it is truethat generally speaking as the unit count does not increase and as there aremore lower-end systems, that all things equal, the revenue captured per servicecould be a little bit less related to those systems. That's offset by theincreased software revenues that we are getting, et cetera, so there's a morecomplex dynamic than just a trailing unit indication.

But there's no doubt, as we've talked about for a long time,that the services business is competitive. People have choice for hardwaresupport out there. People principally come to us for the software support, andthe product quality has been getting better and better over time so we see allof that reflected in the business.

Bret Schaefer

It's also somewhatreflective of having a good quarter on the high end, but also seeing a fairamount of that deferred so obviously that wasn't going to trigger the servicerevenues as well.

Jonathan Schwartz

Tony, I would add that we refreshed the product lineprincipally in the very low end over the last 18 months or two years, so it'snot surprising that we see a little bit of a slowdown in regard to theservices. But as we refresh the rest of the product line, we would begin to seethat pick back up.

Operator

Your next question comes from David Bailey - Goldman Sachs.

David Bailey - Goldman Sachs

I was wondering if you could comment a little bit aboutservices margin and the sustainability of that? Other than the mix going moreto professional services, how sustainable are the gross margins there?

Jonathan Schwartz

I think there's a fair degree of sustainability to it. Againwhat folks pay for when they buy a service from Sun is largely the intellectualproperty that we deliver to them in the form of updates and patches to the operatingsystem and the software that goes around it. So that is a pretty resilientbusiness. I think we're somewhat less exposed to some of the labor arbitragethat characterizes the more traditional break/fix business. So that business isimproving and has been for a while and again we're expecting and planning forit to continue to do so.

Operator

Our next question comes from Harry Blount - Lehman Brothers.

Harry Blount - Lehman Brothers

I wanted to focus on growth again for a second. Mike, youreiterated you expected low to mid single-digit growth with acceleration in theback half and I think you said both organic and inorganic. Could you help us alittle bit there? You guys have been talking about seeing an acceleration ingrowth now for several years. We really still haven't seen it. What gives youthe confidence now, and this is either for Jonathan or Mike, that we truly willsee an acceleration in the back half and hopefully you mean an organicacceleration , not just your acquisition.

Jonathan Schwartz

No, I think whenwe're planning our business we're not planning for inorganic growth. We'replanning for organic growth. I think ifyou look year over year at some of the key businesses, our CMT business and Niagara-basedbusiness is up 70% year over year. The enterprise business is up 23% year over year,the X64 business was up 10% year over year, so I think we're just going to bemore exposed to that growth and so obviously as time goes forward, thoserevenue lines are going to get bigger and we're expecting to see more of thatupside.

Mike Lehman

The other thing too that I tried to point out to you, we'vebeen talking about the change to sell out for quite awhile and in the long rampdown to this process, revenues have been negatively impacted. They will benegatively impacted in Q2 and in the second half of the year. When we getbehind that, as we report revenues on sell out, we're going to finally be ableto have good compares as we go forward, so that's going to begin to show up inthe U.S. and in Asia in the second half of the year. Lots of good things fromthat perspective as well.

Operator

Your next question comes from Richard Gardner - Citigroup.

Richard Gardner - Citigroup

Jonathan, I just wanted to confirm that the 70% year over yeargrowth that you cited for Niagara and the 10% for X64,those were revenue growth rates year over year for the current quarter, thequarter just reported?

Jonathan Schwartz

Billings.

Richard Gardner - Citigroup

Billings.I was wondering if you could give us maybe some qualitative color on Niagara2 and how that's being received within the customer base and whether you thinkthat this is the CMT platform that's going to start to see broad productiondeployments?

Jonathan Schwartz

Well, I think we'realready in broad production deployments with Niagara 1and there's a whole variety of household names that today when you go visittheir website and hit their web services infrastructure they are actually on Niagarasystems. So Niagara 2 has a couple of very big benefitsover Niagara 1.

First of all, it had a chip multithreading predecessor inthe marketplace, whereas when Niagara 1 shipped itreally didn't.

Secondly, as you may know, we doubled the core count, sothis is now a 64-way chip instead of a 32-way chip. We added floating pointsback in, so we're looking at a much broader marketplace as a result of that. I do expect that certainly with some of theearly activity, we just continue to see the right brand names and the rightinfrastructures really embracing Niagara's focus onpower efficiency.

The fact that it's got virtualization built in, we can run64 separate operating systems on the same piece of silicon, and these are allthings that enterprises we talk to find very valuable and so we think there'splenty of opportunity there.

Operator

Your next question comes from Katy Huberty - Morgan Stanley.

Katy Huberty - Morgan Stanley

When KKR invested back in January, you alluded to thepotential for accelerated acquisition spend, but we really haven't seen anymajor deals yet. Has anything changed in terms of the landscape of availablecompanies or your appetite for acquisitions since earlier this year?

Jonathan Schwartz

Nothing has changedat all. I think we're just as interested, just as focused and there's just asmany opportunities that are out there. So I think we certainly see leveragingour balance sheet and our scale as being one of the assets we can bring intothe marketplace and we're fully expecting to continue thinking that way andacting that way.

Operator

Your next question comes from Brent Bracelin - Pacific CrestSecurities.

Brent Bracelin - Pacific Crest Securities

A follow-up question on growth, obviously three consecutive quartershere with server units declining. At what point do you expect to see a reboundin the server business from a unit perspective? With the strong gross marginsyou guys reported over the last three or four quarters, would you plan to get alittle bit more aggressive on price to try to reaccelerate growth there?

Jonathan Schwartz

I think there'sobviously the trend in the server marketplace now isn't to buy lots and lots oflittle servers. It's to buy smaller numbers of very large servers if not to buythem racks at a time, and then simply virtualize them and run them logically asif they are lots of little things but in reality manage them as a small numberof big things.

So I'm not exactly convinced that we're going to see a bigrush to tower servers and one-way product out in the marketplace. I think ifanything, we're seeing the experience and expertise we have in building veryhigh scale systems is now putting us in a position to go consolidate away a lotof the low end systems, but that's a good trend. I think that simply means thatenterprises are going to get more efficiency out of the infrastructure they ownand they are going to look to vendors that have the expertise in how to runvery large scale systems as among the more appealing.

I think we've also seen a tremendous upsurge in interestfrom our customers in our virtualization offerings. The fact that we're goingto be delivering into the free and open source community a virtualizationplatform that gives folks the ability to consolidate both Solaris Windows andLinux makes our systems more appealing as well as makes our software platformsmore appealing.

I think that's the way we see things going forward. Again,we expect a smaller number of more richly configured systems to be pushing onthe right trends to yield more margin, unit volumes are really going to be Ithink more questionable.

Operator

Your next question comes from Bill Shope – JP Morgan.

Bill Shope - JP Morgan

Expanding on that previous question, so you've clearly saidthat top line growth is still the priority for this fiscal year. Why wouldn'twe see you investing more of the gross margin upside into pricing, whetherthat's to drive volume or revenue growth and even if it's in high end systems?

Jonathan Schwartz

So I'm not convincedwe're leaving a lot of demand behind for price right now, and frankly, for someof the systems that we're selling pricing is not the number one issue. It's theefficiency of the overall management of the platform. So we're certainly goingto be investing and growing our market and growing our share. That doesn'tnecessarily equate to dropping our price to win business because again frankly,for a lot of the customers we're talking to, price is really second.

Acquisition price is by far and a way less interesting thantotal cost of operation over a long period of time, and for again, many of thecustomers we're talking to, power actually is beginning to exceed the cost ofthe device itself. So in a couple of our geographies quite literally the powerbill exceeds the price of the server. As that happens, that means our abilityto deliver highly efficient systems and to put the money into go building thosemarkets becomes an avenue to grow, not simply standing still in our existingcustomer base and simply dropping price.

Operator

Your next question comes from Louis Miscioscia - Cowen.

Louis Miscioscia - Cowen

Could you go into gross margins in a little more detail?Obviously you just delivered a fantastic gross margin in really what is aseasonally weak quarter. You've got two seasonally strong quarters coming up.You mentioned already that servers are moving to high end of the range andyou've only raised the basis point range by 100 basis points.

As you look forward to the rest of the year, what do youthink is going to keep it depressed and also if you could tell us if componentsaided gross margins in this quarter and if so by how much?

Mike Lehman

I potentially answered the second part of the question by quantifyingthe $25 million to $35 million impact on the quarter. That's essentially whatwe saw that was better than we had expected, and obviously that's largelycomponent pricing.

From a planning perspective, we don't plan on thatcontinuing. That could happen, but that's not how we plan the company byexpecting above average component cost decreases to go on forever.

The other factors with regard to overall gross margin we'vetouched on a bit. We've gotten a lot of increase in the services gross marginover the last couple years. We expect that to be stable. On the other hand, weare not going to walk away from business. Jonathan talked about that we don'tnecessarily need to drop prices in certain places, but I can tell you that thesalespeople are certainly looking for ways to go do that. They're looking foropportunities to grow the business. Margin is one of the levers they have andin the context of everything Jonathan said we'll be continuing to look at that.

So from our perspective, raising the gross margin range forthe year by 100 basis points is a pretty good indicator that we feel good aboutwhere we're at.

Operator

Your next question comes from Keith Bachman - Bank ofMontreal.

Keith Bachman - Bank of Montreal

I just wanted to focus on storage for a second. Obviouslyyou moved to a positive year-over-year growth rate. Jonathan, if you could giveus a little bit of color on where were the strengths and weaknesses? I didn'thear any commentary on Thumper in particular unless I missed it.

Related, given that this quarter was helped a little bit byan easy compare, would you expect storage to have a positive year-over-yeargrowth rate number for the December quarter? Thanks.

Jonathan Schwartz

Without going into the specifics of the December quarter, Ithink we had a weaker tape quarter than we would have liked. Mid range was upand I think the high end was stable. Thumper was seasonally down Q4 to Q1, butcertainly we've gotten a lot of attention and awareness in the marketplace as aresult of some of the activity occurring around ZFS which is the file systemthat's at the core of our software offerings. We've just seen frankly a hugeupsurge in interest in enterprise beginning to look at ZFS and its ability tohelp them compress prices and get more flexibility out of some of theirproprietary vendors. That's somethingthat we're obviously building our storage platform around.

If you look back in the quarter at how we're building ourplatforms, we're increasingly looking to the supply chains and the designexpertise of the systems team that's building out our Niagaraplatforms and our X64 platforms and simply applying that same methodology andengineering discipline to how we build our storage business. So it's going tobe increasingly characterized by systems that look an awful lot like thecomputing systems we build but based on the ZFS file system and some of the newstorage technology coming in behind that, I think we feel very, very good aboutour position in the marketplace.

Operator

Your next question comes from Kevin Hunt - Thomas WeiselPartners.

Kevin Hunt - Thomas Weisel Partners

I just want to follow-up once more on the component andgross margin question. So you've clearly had some benefit for several quartersin a row now I think from the component side, which has a cumulative effect. Thequestion here is you calculate the about 100 basis point benefit you got thisquarter based on what you said there. How much of that, if you go back say twoor thee quarters, is it 300 basis points better than what you thought or is areyou resetting every quarter down, where you aren't going to get any incrementalbenefit from components? Does that make sense?

Mike Lehman

No, it doesn't makesense but I'll tell you what we do. We reset our standards every quarter basedupon what we expect the component costs to be in the next quarter, and that'show we set our standard and that's how we base our plan. We have gotten someincremental benefit through the last few quarters from component costs. I'vedescribed that benefit every quarter. Again, because we reset standards at thebeginning of the quarter, we don't expect for there to be an upside surprise tothat in the current quarter. If that happens, that certainly isn't somethingthat we've been able to predict.

Kevin Hunt - Thomas Weisel Partners

So it's fair to say you've been accruing some cumulativebenefits but you don't expect any further benefit next quarter?

Mike Lehman

No, I haven't beenable to explain myself. To the extent that component costs have gone down, wereset the standards with those lower component costs. What we don't expect isfurther upside to that or decreases in cost in the next quarter. If it happens,it happens.

Operator

At this time I'mshowing no further questions.

Bret Schaefer

Thank you for joining us today. Investor Relations personnelwill be back in our offices shortly to respond to any further questions and youmay contact us through the Investor Relations main number 408.404.8427.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!