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Network Appliance, Inc. (NASDAQ:NTAP)

F2Q08 (Qtr End 10/26/2007) Earnings Call

November 14, 20075:00 pm ET

Executives

Tara Dhillon - Sr. Director, IR

Dan Warmenhoven - CEO

Tom Mendoza - President

Steve Gomo - CFO

Tom Georgens - EVP of Product Operations

Rob Salmon - EVP of Worldwide Field Operations

Analysts

Harry Blount - Lehman Brothers

Laura Conigliaro - Goldman Sachs

Paul Mansky - Citi Investment Research

Dan Renouard - Robert Baird

Chris Whitmore - Deutsche Bank

Brent Bracelin - Pacific Crest Securities

Aaron Rakers - Wachovia

Clay Sumner - FBR

Bill Shope - JPMorgan

Kevin Hunt - Thomas Weisel Partners

Shebly Seyrafi - Caris

Kaushik Roy - Pacific Growth

Katy Huberty - Morgan Stanley

Bill Choi - Jefferies

Operator

Good day, ladies and gentlemen, and welcome to the Network Appliance Q2 2008 Conference Call. At this time, all participants are in listen-only mode. We will conduct a question-and-answer session towards the end of this conference (Operator Instructions).

I would now like to turn the presentation over to Tara Dhillon, Senior Director, Investor Relations. Please proceed.

Tara Dhillon

Thank you. Good afternoon, everyone, and thanks for joining us today. Our conference call is being webcast live, and will be available for replay on our website at www.netapp.com.

Along with the earnings release, the financial tables, and the reconciliation between GAAP and non-GAAP numbers in the course of today's conference call, we will make forward-looking statements and projections that involve risks and uncertainties, including statements regarding our expectations, with respect to our Q3 pipeline, bookings distribution, and our growth opportunities, our operating results for fiscal Q3 2008, the growth of the virtual server market, and customer demand for our product and service offerings.

Actual results may differ materially from our statements or projections. Factors that could cause actual results to differ from our projections include, but are not limited to, customer demand for products and services, increased competition, and any decline in general economic conditions.

Other equally important factors are detailed in the company's 10-K and 10-Q reports filed with the SEC, and available through our website, all of which factors are incorporated, by reference, into today's discussion.

With me on today's call are Dan Warmenhoven, CEO, our President Tom Mendoza, Steve Gomo, CFO, Tom Georgens, EVP of Product Operations, and Rob Salmon, EVP of Worldwide Field Operations.

Steve will review this quarter's financials and discuss our revised financial outlook for the third quarter, and then Dan will share his thoughts before we wind up with everyone here for Q&A. Steve?

Steve Gomo

Thanks, Tara. Good afternoon, everyone. As you can see in our earnings release, NetApp returned to healthy growth and solid execution this quarter. I will illustrate this with some additional color about our results.

Note that all numbers are GAAP, unless stated otherwise. Please refer to the table in our press release and on our website to see the reconciling items between non-GAAP and GAAP numbers.

Total revenue for the first quarter was $792.2 million, up 15% sequentially, and up 21%, compared to Q2 last year. Foreign currency effects added 7/10 of a percentage point sequentially to revenue growth this quarter, and augmented the year-over-year growth rate by 2 percentage points.

The combination of product revenue and software entitlements, and maintenance revenue was $658.5 million, up 15% sequentially, and 17% year-over-year. Revenue from add-on software, and software entitlements, and maintenance was 40% of total revenue this quarter.

This compares to 41% last quarter, and 40% in Q2 of last year. Add-on software was about 25% of total revenue, and software entitlements and maintenance were about 15% of total revenue. Revenue from services, which includes hardware support, professional services, and educational services, was 17% of total revenue, up 13% sequentially, and up 50% over Q2 of last year.

Service maintenance contracts increased 12% sequentially, and 50% year-over-year. Professional services increased 19% sequentially, and 59% year-over-year. Non-GAAP gross margins were 62.2% of revenue this quarter, up 4 basis points from last quarter.

At 67.6% of revenue the combined product and software gross margin demonstrates the continued competitive strength of our solutions. Non-GAAP service margins were a strong 35.5% this quarter, up substantially from the 31.7% recorded last quarter, due to a slower pace of professional services hiring. We expect service margins to remain in the mid-30s for the rest of FY '08.

Turning to non-GAAP expenses, our operating expenses totaled $367 million, or 46.3% of revenue. Expenses increased less than 5% sequentially, and 26% year-over-year. As a percentage of revenue, all functional categories of operating expense declined from Q1.

Total head count increased by 38 people on a net basis, ending the quarter with 6,852 employees. Limiting the additions to our employment base was a key ingredient for the rapid return to our target business model operating profit.

Going forward, our hiring will balance our intent to support future growth with our business model objectives. GAAP operating expense includes the effect of prior period merger-related costs, like intangible amortization from acquisitions, and the effect of FAS 123R.

Non-GAAP income from operations totaled to $126 million, or 15.9% of revenue. Non-GAAP other income, which consists primarily of interest income, was $15.1 million. Non-GAAP income before taxes was $141 million, or 17.8% of revenue.

Our effective non-GAAP tax rate remains at 17.5%. Non-GAAP net income totaled to $116.4 million, or $0.32 per share. GAAP net income totaled $83.8 million, or $0.23 per share.

And now, I would like to turn our attention to cash flow performance. Generating significant amounts of free cash flow is the cornerstone of the NetApp business model. We define free cash flow as cash from operations, less capital expenditures.

This quarter, our cash generated from operations was $228 million, up 13% sequentially, and down just slightly from the very strong Q2 of last year. Capital expenditures were $37.6 million, so free cash flow totaled to $190.1 million, growing 14% sequentially, and 2% over Q2 last year.

Expressed as a percent of revenue, second quarter free cash flow was 24%, virtually the same as last quarter and 1 percentage point higher than the average of the last three fiscal years.

Moving on to the balance sheet, cash and investments decreased by about $347 million from last quarter to $983 million, due, primarily, to our aggressive stock buyback. This balance, however, excludes approximately $81 million of restricted cash and investments associated with last year's foreign cash repatriation, $300 million of restricted cash related to our secured revolving credit facility, and about $8 million worth of restricted cash, related to security and rent deposits.

The current debt on our balance sheet, of about $48 million, is related to the repatriation, and is expected to be repaid in full by the fourth quarter of this year--this fiscal year. The debt associated with our credit facility is $250 million, and is entirely a long-term liability.

As I just mentioned, the company conducted a significant stock repurchase this quarter. We repurchased a total of 17.6 million shares, 16.8 million of which were recorded in the second quarter. The remaining 774,000 shares will be recorded in Q3. We purchased all these shares in three tranches, for a total outlay of $500 million, with an average purchase price of $28.40. There was approximately $700 million remaining in our stock repurchase authorization.

Accounts receivable day sales outstanding were 49 days, compared to 53 days last quarter, and 51 days in Q2 last year. Last year's Q2 DSO has been recalculated to include the reclassification of $34 million worth of sales tax from accounts receivable to other current assets, which we described to you in detail last quarter.

Inventory turns were 19.2 times this quarter, better than the 18.2 reported in Q1. I expect inventory turns to remain at similar levels in Q3. The total deferred revenue balance increased $68.7 million this quarter, to $1.22 billion, a 6% sequential increase, and a 49% increase in the balance year-over-year.

Before I turn the call over to Dan for his comments, I will discuss our target operating model for Q3. Our outlook is based on our current business expectations and current market conditions, and reflects our non-GAAP presentation.

We're making forward-looking statements and projections that involve risk and uncertainty. Actual results may differ materially from our statements or projections for the reasons Tara cited earlier. We expect Q3 revenue to be between $872 million-$883 million, which represents about a 10%-12% sequential increase from the second quarter, and about a 20%-21% year-over-year growth rate.

In Q3, we're expecting gross margins to decrease by 1-1.5 percentage points due to an increase in the IBM business mix, as well as some selective pricing actions that we're taking to spur additional growth.

In addition, we plan to add about 300-350 employees next quarter, with an emphasis on sales-related activity. As a result, we're forecasting our margin to finish between 15%-15.5%, which is below our targeted range.

This will result in second quarter's non-GAAP earnings of, approximately, $0.33-$0.34 per share. GAAP earnings are expected to be $0.23-$0.24 per share. We expect our diluted share count to decrease by about 2 million-3 million shares in the third quarter, depending on the stock price.

At this point, I will turn over to Dan for his comments. Dan?

Dan Warmenhoven

Thanks, Steve. I am very proud of the NetApp team this quarter, especially from the perspective of sales execution and expense management. We returned to our target operating model faster than we had originally expected.

So, we're in an excellent position to resume investing in our growth going forward, and are entering Q3 with a healthy backlog, and a solid sales pipeline. In Q2, our business rebounded nicely almost everywhere in the world. One notable exception was North America, outside of our U.S. federal subsidiary.

Our federal business was very strong, contributing a record 17% of total revenue, up 49% over a year ago. However, the rest of North America was sluggish, especially in our largest accounts. Total Americas revenues increased 17% over last year contributing, 58% of our total revenue.

When you exclude the federal business, the remainder of the U.S. business grew only 9% over Q2 of last year. And this weakness can be largely attributed to our 22 largest U.S. commercial accounts--our top enterprise accounts--which were down…down about 4%, compared to Q2 a year ago.

The U.S., excluding federal and the top 22 TEAs, grew at 16% year-over-year. Outside the U.S., we're experiencing strength in both our European and Asia Pacific regions. Europe was 30% of revenues, the same percentage as Q2 last year, with particularly solid performance in Germany and Northeastern Europe, tempered by some softness in Western Europe.

Asia Pacific contributed 12% of revenue, up 30% over last year, with strong performance from Australia. The direct channel contributed almost 38% of revenue, about the same as last quarter, but was up only 11% in absolute dollars over Q2 a year ago. This is highly correlated with the weakness we're seeing in the largest U.S. enterprises.

However, our indirect channel did quite well, again, this quarter, accounting for 62% of revenue versus, 59% a year ago. This correlates to our strength in federal, where over 90% of our business is indirect.

Both Aero and Avnet had their largest NetApp quarter, ever ,with a combined revenue contribution of 19% of total revenue. IBM was up from last quarter in absolute dollar terms, but roughly flat as a percent of revenue, and still less than 5% of our total.

The IBM business continues to gain momentum, and our fiscal Q3 is their year end, so we would expect to see an up tick in the current quarter, followed by a seasonal decline in our fiscal Q4.

Looking at our performance from a product perspective, we also have several very positive indicators. The company posted impressive growth in petabytes shipped this quarter, up 24% sequentially, and 86% year-over-year, to another record--138 petabytes of storage shipped.

Fiber channel drives accounted for about 38%, and ATA about 60% of total petabytes. The ATA figure includes a small percentage of SAS drives. Total storage system units shipped also grew nicely, up 15% sequentially, and up 27% year-over-year.

Our low-end products were up the most, aided by the launch of the FAS2020 and FAS2050 series. Our low-end products accounted for nearly half of all storage systems shipped. The mid-range products were not far behind in units, and our mid-range storage systems continue to generate almost two-thirds of our revenue.

At the high-end, our FAS6000 series units grew 9%, sequentially, and approximately 15% sequentially in revenue. The percent of our storage bookings which included block-based protocols, was 41%, this quarter. Within this, 31% had a fiber channel SAN interface, about 15% included iSCSI, and 6% included both fiber channel SAN and iSCSI on the same purchase order.

While block-based storage was down slightly in the mix from 44% last quarter, the business remained strong. It is up 9%, sequentially, in absolute dollars and we're in a range that we're comfortable with. Over the past few quarters, we have increased our emphasis on NFS, in order to maintain a balanced focus on all protocols, as well as to ensure we maintain our leadership in the mass market.

We're seeing more and more customers choosing NAS and database environments because of the cost savings and management simplicity. But customers also use NAS for advanced scale out solutions. Given the additional emphasis we recently placed on NFS, with the availability of NFS version 4.0, and of DNFS, it isn't surprising to see block-based business decline a little bit in the mix.

Our scale out operating systems ONTAP GX also had a good quarter, and it contributed to the strength of our NAS business. Units shipped were up 15% from last quarter, although off a fairly small base.

Our emerging products continue to produce mixed results. The highlight this quarter is our virtual tape library product line, which continues to do very well. Our storage security products were up this quarter. The StoreVault SMB product was down in the mix this quarter, but had some very encouraging deployments.

ReplicatorX, our heterogenous data replication product, is doing well on both business continuity and application development, and test applications. As more than two-thirds of our corporate data, existing as a secondary copy, de-duplication has emerged as an important part of data protection solutions.

We believe NetApp is the capacity leader in de-duplicated storage, and our de-duplication technology has become our fastest adopted feature. The customers' need de-duplication for more than just backing up, and NetApp is the only vendor who offers it in primary, as well as data protection, business continuity, and archival environments.

We don't believe de-duplication requires a separate appliance. We provide it today with our snapshot technology, and also in our NearStore software bundles. We believe de-duplication is rapidly becoming a core requirement for all enterprise storage systems.

Our partner, Ecosystem, is providing greater returns on our investment every quarter. We just had our best revenue quarter ever with Microsoft Installations, and our business with SAP is on track for 50% growth over last year.

If you visit Oracle OpenWorld this week, you'll see a huge NetApp presence, and Oracle itself has reached the 10 petabyte mark with NetApp Storage. Tonight, NetApp is sponsoring the concerts featuring Billy Joel, Lenny Kravitz, and Stevie Nicks and Mick Fleetwood. Let me know if you need tickets.

The most exciting part, or opportunity, we're involved with today is VMWare. We believe that server virtualization is the single largest industry changing phenomena of this decade.

Gartner believes that by 2010 there will be 4 million virtual servers deployed, and customers who want virtual servers need virtualized storage to effectively support them. NetApp is the industry leader in virtual storage, and we're the only vendor who provides deduplication capability for primary VMWare environments.

VMWare drives customer customers to rethink their IT architecture. And with this disruptive change, customers implementing virtual servers are especially well suited to reap the benefits and cost reductions found in NetApp storage. The Apps that we'll see running on top of VMWare will be the likes of Oracle, Exchange, SQL Server, and so we'll be able to leverage the primary work we've already done with our largest partners.

To give you an idea of how committed we are to this opportunity, we're building a new organization around it. We've launched a new unit focused on driving business in conjunction with VMWare. We've asked the Senior Vice President that built our SAN and iSCSI businesses from the ground up to lead the effort to capitalize on this next big emerging market opportunity.

In summary, despite the uncertainty around the U.S. commercial market, we feel we have a diversified set of business drivers that will continue to drive our growth over the coming quarter and years. Our indirect channel continues to expand. Our international business is doing well, and our partners are stimulating more business for us every day. Combining this diversification with a comfortable backlog and a solid sales pipeline as we enter Q3 is the background for the guidance that Q3 will have similar annual growth as we had in Q2.

We expect to see normal seasonal patterns plus continued softness in large U.S. enterprises, which may also seep into the U.K. Given the external economic uncertainty, we believe it is prudent to hold off on providing any Q4 guidance until the end of Q3.

As I've said before, we're optimistic about our future growth potential, but we do not foresee getting back to a 30% growth rate in this fiscal year, given the macroeconomic environment, although we certainly have not surrendered to that objective for the longer term.

At this point, I'll open the floor to questions. We request you limit yourself to one question, and then return to the queue if you have an additional question, so we may address everyone in the allotted time. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from line of Harry Blount, with Lehman Brothers. Please proceed with your question.

Harry Blount - Lehman Brothers

Hi, guys. Quick question, you guys. Steve, at the very end of your commentary, you indicated that you see a little bit of a back step in op margins as you focus on investing for growth and some pricing actions.

I don't think, I've heard you guys talk about pricing actions on a call in awhile, so can you talk about, perhaps, what you're seeing in the environment that may cause you to take some more aggressive actions than, maybe, you have in the past?

Steve Gomo

Sure, Harry--this is Steve. I think we see some opportunity. Basically, we've been doing some--a lot--of analysis around our go-to-market techniques, and the end-markets type of thing.

We see some opportunity, particularly in the indirect channels, to be a little bit more aggressive with some of our pricing, and take some share in some of the selected segments. So, I don't want to give away the marketing program here, but that's basically where it is oriented, at indirect channels in certain segments of the market.

Dan Warmenhoven

Harry, this is Dan. In the direct business it is much easier for to us discount as appropriate to go into business. But in the indirect channel, especially through a two-tier model, it is much more difficult, so you got to have the prices set much closer to what the street and user price would be, in order to drive velocity.

Harry Blount - Lehman Brothers

Got you. Basically, the nature of the question is if it is a change in the competitive dynamics, or not; it sounds like it is more you guys initiating than vice versa..

Dan Warmenhoven

Yeah, absolutely. We think we have got opportunity to expand our presence, especially in the mid-market, kind on the fortune 1,000-10,000 class, and that's mostly indirect business.

Tom Mendoza

Harry, this is Tom. We also have had a number of meetings with our top channel partners around the world, and best saying if we do what--we help you accelerate your business. They've come back with some very, very good ideas, and we've kind of thought through what we would do to help them, and then we're executing those ideas.

Harry Blount - Lehman Brothers

Thank you.

Operator

Your next question comes from the line of Laura Conigliaro, with Goldman Sachs. Please proceed with your question.

Laura Conigliaro - Goldman Sachs

Great. Can I first just follow-up on the pricing thing, and that is you're basically going to use margin to engage in selective pricing. Is this predominantly aimed at your traditional competitors, or is it more of some smaller, newer companies, and to what extent do you think this pricing will also help to stimulate sluggish demand?

And I guess the other thing that I wanted to ask about was your reference, Dan, at the end to possibly seeing some U.K. softening indicators. And I am wondering, considering how much the U.K. exposure--how much the U.K. is exposed to the financial services market--are you actually seeing some of that at this point, and you're just assuming that it might fall into your business at some point going forward? Thanks.

Dan Warmenhoven

Laura, I don't think it is targeting competitors, as much as targeting more channel partners, getting their productivity up, and going after a particular market segment, which is kind of the medium-tier, medium-size enterprise.

Some of it shows up in a form of bundling, which is essentially a re-pricing of sorts, but a channel bundle. Some of it shows up in incentives in the form of rebates that they can earn on certain thresholds of achievement, and that all shows up in the margin line, but it is not aimed at competitors, as much as it is aimed at providing a more attractive solution for our channel partners, both improving their margins and also getting their velocity up.

On the U.K. it is mostly a concern about that we're not see anything specific yet, but as you pointed out, the U.K. business is heavily weighted towards financial services, and they have a tendency to have a fairly close correlation to what happens in the New York financial community.

So, we're expecting to see the pipeline in the U.K. kind of soften up a little bit near the end of the year.

Operator

Your next question comes from the line of Paul Mansky with Citi Investment Research. Please proceed with your question.

Paul Mansky - Citi Investment Research

A couple questions if I could. First and foremost, obviously the fiber channel business as a percentage of the mix, understand what's going on there given what's happening in financial services, but iSCSI dropping down as a percentage of the mix, can you wrap a little bit of color around what's driving that?

Also, and the follow-up there, maybe talk a little bit about the consolidation in the market that was announced last week, specifically Dell acquiring EqualLogic.

Tom Georgens

Okay. This is Tom. On the iSCSI segment--I think if you look at our iSCSI business, it is really broken down by market segment. In the upper market segments, we're actually doing quite well and our market share is actually quite strong. It's actually the lower segments where some of this growth is being reported, and it's where our channel reach hasn't quite gotten us in the past.

But some of the ideas that Steve was talking about-expanding our channel reach and being aggressive to create channel partners to go after that--combined with the fact that we just refreshed our low-end product, and we now have a product offering that extends down there, that's really something that we're going to go after next.

But if you look at the segments, if you go with the standard price bands--the price bands $50,000 and above--our market share is actually quite strong and remaining strong. But below that, there has been a fair amount of growth there.

We just haven't been able to capitalize it, either because of product readiness or the channel, and it looks like we're trying to remedy both of those problems with new product introductions and, now, the channel programs to go with it.

Dan Warmenhoven

Pretty strong iSCSI offensive in the program this particular quarter wrapped around the new 2020 and 2050 series, fairly aggressive bundled pricing, et cetera, to go right after that segment.

Paul Mansky - Citi Investment Research

And then, on the Dell entry into the market?

Dan Warmenhoven

I don't really have a comment on it. I mean EqualLogic was an interesting company, and registration, we'll see how it all plays out.

Tom Georgens

Yeah. And I think Dell was in the market, right? They were selling other partners products, so now they have got the EqualLogic product. And I think it will be interesting. I think it will be interesting how they rationalize their go-to-market on the channel side versus the direct sales force, and how well that works out.

And I think it will certainly be interesting for one of our largest competitors who have a big dependency on Dell. I think it's probably safe to assume that this isn't good for them, and time will tell how bad it turns out to be.

Tom Mendoza

Yeah. This is Tom Mendoza. We've been out there; iSCSI is an important part of our solution offering for quite a while, and we've done very well at it. I think it's also interesting to see if it expands the market to where everyone starts really thinking iSCSI SW is the way to go for lots of different applications to add and consider before. And obviously if they do, we'll have a chance to compete in a more broad fashion.

Paul Mansky - Citi Investment Research

And maybe if I can just ask it in a slightly different way, did this Dell announcement have any bearing on your strategy in that lower end of the market, or is that a strategy that was already in place unchanged subsequent to that announcement.

Dan Warmenhoven

That strategy was already in place and was wrapped around the 2020 and 2050, and most of those programs were launched before there was any news about Dell acquiring EqualLogic. There was no change in our program as a result of that.

Tom Georgens

In fact, that launch, I believe, was on September 10th. And our press tour and our communication around that was every bit as much about channel programs as it was about the product itself.

Paul Mansky - Citi Investment Research

Great. Thank you.

Operator

Your next question comes from the line of Dan Renouard, with Robert Baird. Please proceed with your question.

Dan Renouard - Robert Baird

Hi, thanks. Could you give a little bit more detail around the VMWare division you and I shouldn't say VMWare, server virtualization division, just functionally how was that structured? Who does it report up to? Are there direct quotas, quota carrying reps? Maybe just frame the organization within NetApp,;but how it will interact with your various groups, divisions and geographies. Thanks.

Tom Georgens

Okay. So I don't know if there is that much mystery. I think the first statement is that we clearly recognize: (NYSE:A) that VMWare was a major disruptive force in the enterprise, and it's something at the top of mind with our customers. And perhaps, equally important is that we believe that there is components of the NetApp value proposition as it exists today, which are unmatched by any of our competitors.

So, there is a really sense that there is a sense of urgency here and that the time is now whether it be our deduplication, our thin provisioning, our flexible cloning, our ease of use, our unified storage, all of those things come into play around VMWare driving superior cost of ownership and more rapid deployment.

But wanting to capitalize on that, we actually took one of our most senior people, a person who has led a number of key initiatives in the past. And they're going to lead basically a company-wide initiative that encompasses all of the components of the Company, whether it'd be engineering, marketing, sales, service.

And really be able to take advantage of this opportunity as it sits today. And effectively, what we're doing is taking somebody who has actually kicked off our fiber channel business and our iSCSI business, and has a long track record of success and influence in the Company, and basically giving him the leadership to drive it.

So, specifically to your question, this is Tom Georgens. It's going to actually report to me, but nonetheless, it's going to be very, very cross-functional, and there will be direct and indirect reports across the entire company, as far as this initiative.

Rob Salmon

Yeah. This is Rob Salmon. I'm on the other side, on the field operations side, and to Tom's point, this is absolutely a joint initiative, and we're excited about it. Rich Clifton, that Tom already mentioned, has led some of the things that we're most excited about at Network Appliance, and some of the most successful go-to-market strategies we have.

So, we really have a true joint initiative between product operations and field operations, and we're very excited about it. We announced an internal recently; there is a lot of enthusiasm about it, internal and with our partner community, and Rich has a lot of respect from our partners, as well.

Dan Renouard - Robert Baird

Thank you.

Operator

Your next question comes from the line of Chris Whitmore, with Deutsche Bank. Please proceed with your question.

Chris Whitmore - Deutsche Bank

Thanks. I was hoping to get more color on the weakness you're seeing amongst the largest accounts, the large US enterprise customers. Is it concentrated in any particular vertical, or is it fairly widespread?

Dan Warmenhoven

This is Dan. It is led by the financial services sector as you might imagine and they're quite substantial. But other companies have stories as well. I mean Texas Instruments has been a big customer for a long time. It was a challenge this year.

There is a variety of other stories outside of financial services, but across the board they're down on a composite sense 4%. I don't see any pattern other than the financial services meltdown. And I would encourage all of you who are part of the financial services, especially broker-dealer organizations, please keep that among yourself.

Once you start exporting that set of problems to the rest of the economy, everybody is going to go in the tank. It is not a competitive issue. It is strictly financial services just squeezing down.

Chris Whitmore - Deutsche Bank

So, if I look at your revenue guidance in the context of getting more aggressive on pricing, it doesn't look like you're expecting an acceleration in the growth rate, despite getting more aggressive on pricing. Does that suggest you're expecting the environment to deteriorate next quarter?

Dan Warmenhoven

No, not at all. On a larger account size, I think they're just in a budget crunch, and everything slows down at that point in time. So we think the opportunity to extend the growth is in the mid-market. And I think you've seen that in certain other vendor's results, as well, and we are going aggressively right there, and that's what the pricing is all about. Tom…

Tom Mendoza

Yeah. We're sitting here after a couple of quarters, where things are starting to go well again, as we've talked about, and we're seeing more activity. But when you read the paper every day, we're like you. Every day is another bad day for somebody. And we're just saying, “Look, let's be cautious, let's be aggressive, grab share as much as we can.” People are looking for all types of solutions, but we're telling all the companies the same thing.

We have got to make sure that we got to execute at such a high level, that regardless of what happens to the economy, we'll do better than the other guy. And you all know that the economy, we just have to see how it goes. So if it goes well, and we don't get this, like Dan just said, doesn't happen as bad as people think. That would be great news. And if it does, we just want to be prepared to execute at a high level, take the actions now as opposed to later.

Tara Dhillon

Operator.

Operator

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

Brent Bracelin - Pacific Crest Securities

Thank you. I actually had a follow-up on US commercial. As you look at the FAS6000, that's typically a higher end larger customer product. Its look like it did rebound in the quarter with units and revenue up sequentially. What were the trends you saw in October and November? Are there any signs of life in US commercial?

And then, looking beyond just the US commercial market, do you expect kind of seasonal rebound your business year in the second half of the year like we've typically seen over the last few years here?

Dan Warmenhoven

Let me talk about the US commercial. By US commercial, I am going to talk about all US nonfederal business. And then people have different definitions to the term commercial. If you took out our top 22 accounts, what's left grew at 16%, year-over-year. That's not too shabby, and that really is a reflection of what we see as the strength in the kind of the medium-sized enterprises, and that is pretty consistent across the US. It really is the larger accounts that have difficulty.

The growth of the 6000 units was driven largely by federal, and certain fairly substantial customer, acquisitions outside the US. For instance, you'll notice that SAP announced their business by design, that's based on our infrastructure and it's largely based on 6000. So there is a lot of drivers around the 6000 of substance. It's not just a US commercial product. Does that answer your question?

Brent Bracelin - Pacific Crest Securities

Yeah. And then, just globally, as you think about cost seasonality and kind of budget flushes outside of the US, do you expect to see some sort of seasonal benefit over the next two quarters?

Dan Warmenhoven

No. We see generally a very strong performance on Europe. They seem to have a surge in our fiscal Q3 correlated with the end of the calendar year. We've gotten certain indicators, like the pipeline looks very good. If you look at the most recent Wave 10 of the InfoPro survey, it shows that there is an increase in interest in spending of their interview base.

I think it's about 400 customers interviewed includes financial services, which all show cost significant increase in spending on NetApp in the near future. There is indicators, but we're assuming it's going to be a fairly traditional kind of year, strength in Europe, nothing in surging in North America.

Brent Bracelin - Pacific Crest Securities

Okay. Thank you.

Operator

Your next question comes from the line of Aaron Rakers with Wachovia. Please proceed with your question.

Aaron Rakers - Wachovia

Yeah. Thanks, guys. My question is around last quarter, you had talked a little bit about bookings and backlog and I think you even threw out a few metrics around bookings being up 27% year-over-year, backlog building at the end of the quarter. So my question is, going into this quarter DSOs down, how much of this quarter was a result of just the deals that had kind of slipped or the backlog that wasn't converted entering or exiting last quarter?

And also, if you can--on the pricing comments--you made a reference to gross margin being down, but then you also referenced IBM growing as a larger percent. If you can give us some flavor around that 1-1.5-percentage point decline in gross margin, what is attributed to IBM versus pricing, that would be helpful.

Steve Gomo

Okay. So let me start with the IBM mix versus the pricing. About roughly two-thirds of it is pricing and roughly one-third of it is the IBM mix, in terms of the margin decline. If we want to talk about backlog, we're not prepared to provide any more information with respect to it, except to say, that as we exit the second quarter and Dan pointed this out, we think our backlog is in a very healthy position.

Aaron Rakers - Wachovia

Okay.

Operator

Your next question comes from the line of Clay Sumner, with FBR. Please proceed with your question.

Clay Sumner - FBR

Thanks very much. Steve. I guess following up on the last question, the last quarter you had said that don't pay so much attention to the 11% revenue growth, because bookings grew in the high 20s, so that was clearly an indicator that the business was still growing pretty strongly. Can you just say if that bookings growth slowed? Are we talking about an incrementally slower growth environment, or roughly on track with where we were in the July quarter?

Steve Gomo

All I can tell you is, that the disparity between revenue growth and order growth is not nearly what it was last quarter. And so, I don't think you'll be overly misled by the rate of growth in revenues.

Dan Warmenhoven

I should remind you guys that bookings don't directly relate to revenue in the near term. So much of it goes to the contra programs, or to deferred revenue, or professional services backlog, or a variety of other things. It is very difficult to correlate the two directly. Bookings are a leading indicator. The bookings are up in a manner very similar to last quarter on a year-over-year basis.

Clay Sumner - FBR

Okay. Thank you.

Dan Warmenhoven

So was deferred revenue.

Operator

Your next question comes from the line of Bill Shope, with JP Morgan. Please proceed with your question.

Bill Shope - JP Morgan

Okay. Great. Thanks. Is there any way you guys can help us quantify your exposure to financial services as a percentage of revenue for this quarter and how that compares to your exposure in the past?

Steve Gomo

I don't think we've done the math this quarter to be very honest with you. We did the bookings number and not necessarily the revenue number. Financial services in the mix? I would have to get back to you. I don't have it.

Dan Warmenhoven

I don't have it in front of me either.

Bill Shope - JP Morgan

Okay. And any sort of rank order versus other verticals, I mean is it one of your top two, top three verticals?

Dan Warmenhoven

Typically, it has always been number two in the mix. If you add all tech together--that's generally still number one--it's somewhere in the high to mid-teens, and financial services is right behind it, typically in the 14%-15% range, and the federal at the 10%-12%. And my guess is, that the financial services this quarter is closer by 12% or 13%--it's down a couple percent.

Bill Shope - JP Morgan

Okay. Great. That helps. And then, quick question on working capital management. Not sure if you guys touched on this, but your payables came down quite a bit this quarter. Was there any supply chain hiccup here, or is there something else driving that?

Steve Gomo

No. It's just the, basically the normal timing cut off, and whatnot, and when the paychecks get cut and go out, so that's going to fluctuate a little bit each quarter. So there is nothing unusual going on there.

Bill Shope - JP Morgan

Okay. Great. Thank you.

Operator

Please hold for your next question. Your next question comes from the line of Kevin Hunt, with Thomas Weisel Partners. Please proceed with your question.

Kevin Hunt - Thomas Weisel Partners

Hi. Thank you. I wanted to clarify, I think, Steve, you had said something about the gross margin going down from a change in the IBM mix. I didn't hear if it was decreasing or increasing, and I just wanted to understand why it was changing, if it is, whatever direction it's going?

Dan Warmenhoven

IBM receives larger discounts in general. Therefore, we recognize lower gross margins from a transaction through IBM. It also has got lower expense structure. So, in terms of operating income, it's pretty neutral, but on the gross margin side, it has lower gross margins than any other channel we work with.

Steve Gomo

Yeah. Next quarter in Dan's commentary he mentioned that we're expecting to see IBM step up their business level with us because it is their December quarter, and there is always a strong quarter for them. So they're going to increase as a percent of mix, but the impact they have on gross margins.

Kevin Hunt - Thomas Weisel Partners

I just misheard you. I didn't hear if you said increase or decrease. That's it. Thanks.

Steve Gomo

Okay.

Operator

(Operator Instructions) Your next question is from the line of Shebly Seyrafi with Caris. Please proceed with your question.

Shebly Seyrafi - Caris

Yes. Thank you. So I think some of the bearers on your stock may make light of the fact that your deferred revenue growth of 6% sequentially was less than your 15% overall revenue growth, and they may say that you drained the backlog to hit your number, or beat the expectations.

I just want to see what you have in terms of visibility to guide the way you're guiding, which is quite aggressive. You talked so far about strength in Europe. I am wondering if the federal strength is continuing. Maybe you can elaborate on why you're so confident and why you're providing such good guidance?

Dan Warmenhoven

Shebly, this is Dan.

Shebly Seyrafi - Caris

Yes.

Dan Warmenhoven

I'll reiterate what I said in my opening remarks. We have a comfortable backlog. That backlog is largely product backlog as well as professional services. Those are items we can convert to revenue this quarter.

We have a very healthy pipeline of sales activity, and assuming that something doesn't happen in a changed sense, in terms of macroeconomic, we will convert a normal piece of that pipeline into bookings and, therefore, revenues this quarter.

The problem with predicting the future, is it hasn't happened yet, and we're forecasting based on what we see as our current situation and the order pipeline that we're looking at. And assuming nothing material changes, we should see a performance consistent with the forecast we gave you.

Now, that said, in Q3, we generally see Europe up in the mix, federal drops off. Our Q2 contains the end of the federal fiscal year in September and that's why they surge. They do in fact have yearend buying phenomena. That will not recur in Q3. But we factor all those things into the guidance we gave you. And our expectation is that unless something dramatic changes in the global economies, we will be able to meet those expectations.

Shebly Seyrafi - Caris

I am just trying a find a list of drivers, Europe being one, FAS2000 uptake perhaps being another. Can you just continue the list of drivers guiding, leading you into this guidance?

Dan Warmenhoven

I believe that next quarter's growth rate will be consistent with this quarter's growth rate, and it will come from a different set of drivers than what we had this quarter. That's all I can tell you. We're looking at a bunch of large numbers meaning large pipeline activity, et cetera, and trying to factor that down to what we think is the most likely revenue outcome. I would not if I were you try to get too granular about going underneath that in any particular form.

Shebly Seyrafi - Caris

Okay. Thanks.

Operator

Your next question is from the line of Kaushik Roy, with Pacific Growth. Please proceed with your question.

Kaushik Roy - Pacific Growth

Congratulations on the snap back in operating margin, and your guiding 15-15.5 in Q3, but is that your new target going forward, or can we still expect 15.8-16.4? Is that your long-term target for operating margin?

Steve Gomo

Our long-term operating margin target has not changed. It is still 15.8-16.4.

Kaushik Roy - Pacific Growth

So, maybe starting Q4 onwards, you can get to that level or--?

Steve Gomo

Well, we'll let you know next quarter when we guide to Q4.

Kaushik Roy - Pacific Growth

Okay. Fair enough. Thanks.

Operator

Your next question comes from the line of Katy Huberty, with Morgan Stanley. Please proceed with your question.

Katy Huberty - Morgan Stanley

Hi, there. Great quarter, guys. If we believe some of what the economists are saying on Wall Street now, there is a risk of a full-blown US recession over the next couple of quarters. So can you just talk about some of the levers you have and are willing to pull, in order to sustain earnings growth in that scenario and, I guess specifically, are you willing to step up share repurchases even more, and/or start to think about cutting direct sales force headcount?

Dan Warmenhoven

I will not cut direct sales force headcount, unless I see a real collapse in the opportunity out there. We're all about growth. We're going to try to find it any way we can get it. And all you have to do is look back on our performance in 2001 to figure out what our strategy is going to be.

If there is a collapse in the general economy, we'll resize the company appropriate, and keep the emphasis on growing our topline ,and gaining share and pressing forward. I don't expect us to increase the share buyback. This particular quarter was particularly aggressive. And I don't think we'll be doing that at that kind of rate again in the near future. So we've got the traditional levers, right--drive for revenue growth is objective, number one in all quarters.

Steve Gomo

To build on Dan's point, we convert that incremental revenue at a pretty high rate to operating profit and to the fund of operating expenses. So it's all about growth here because the combination of margin and growth is what drives this engine.

Katy Huberty - Morgan Stanley

Thanks.

Operator

Your next question comes from the line of Bill Choi, with Jefferies. Please proceed with your question.

Bill Choi - Jefferies

Thank you. Just some clarification on the pricing action. Is that limited to the low-end 2000? Have you introduced the new products or has that been the pricing action extended to FAS3000 and FAS6000, and when we look at terms of product gross margins going forward your guidance suggests that product gross margins could fall below 60%. Can you help us think about either product gross margins specifically going forward, or overall gross margins over kind of the fiscal '09 timeframe? And then I have a follow-up.

Dan Warmenhoven

I think you have a problem with your math. Product gross margins don't fall below 60% in any scenario that we've ever forecasted. Our product gross margins right now are about 65%, 66%, and should be coming down even higher than that. They should be coming down a couple points, so I encourage you to recheck your math on that one.

To answer the re-pricing. When you re-price some systems, there is spillover effect to others. Disk price, as a for instance, right; expansion shelves, or whatever it may be. And, therefore, we have over 1,000 products in the product line, right? And they're all knitted together to form a particular system. So there will be ricochets into all kinds of other things.

The 2020 and the 2050 were priced appropriately going to market. Those are brand new. Those didn't have to be touched. But a lot of software products were moved around, disk prices were moved around, a variety of other things like that.

Steve Gomo

To build on Dan's point, we're coming off two quarters here, this one and the previous one where our product margins are at record highs over the past five years so we have room to move and we're taking advantage of that to disperse some growth in some of the segments Dan was alluding to earlier.

Bill Choi - Jefferies

Okay. I guess I was thinking very specifically to the product hardware which…

Dan Warmenhoven

Our product gross margins this quarter were 67.6%, which were higher than any quarter in fiscal year '07.

Bill Choi - Jefferies

Okay. I have another follow-up, then on the two-tier distribution model. It was very strong, probably the highest it has been as a percent of total revenue. Can you just talk about level of inventory, whether you believe that sell through will be there or what kind of inventory levels you should be looking at for that segment?

Dan Warmenhoven

We don't have any stocking in the channel, whatsoever. There is no inventory out there. Everything is build to order and the flow is from the reseller right on through our two-tier partner if there is one in the mix, like Arrow and AvNet right into our order processing, and we ship it out.

Steve Gomo

So, in accounting parlance, we're on a sell to model.

Bill Choi - Jefferies

Okay. Thanks.

Operator

Your next question is a follow-up from the line of Dan Renouard, with Robert Baird. Please proceed with your question.

Dan Renouard - Robert Baird

Hi. Can you guys talk a little bit about headcount and how you're planning to grow the business? Obviously coming out of the July quarter you had cut back on headcount and that showed up this quarter, and then going forward you're talking about 300 plus heads, which would be from the hiring over the last 60 or 90 days.

Should we be expecting that level of headcount additions for the January quarter somewhere on the order of some 300, plus or minus, is that reasonable for us to just assume?

Steve Gomo

No, Dan, I would hold off on that. We're right now from a control standpoint, we think we can afford the 300-350 next quarter, and achieve the guidance we gave you. Again, we haven't projected what the next quarter after that or out quarters are going to look like, and if we knew that we would have a better handle on it, and probably give you some interpretation of what we might do, but right now let's just see how it goes. We stand ready to respond to the economic conditions in our growth rate.

Dan Renouard - Robert Baird

Okay. Thank you.

Steve Gomo

You bet.

Operator

There are no further questions at this time. I would now like it turn the call back over to management.

Dan Warmenhoven

Thank you very much for joining us this afternoon. We look forward to having you join us again on February 13th of 2008, as we report the results for our fiscal third quarter. Have a wonderful holiday season, everybody. Take care.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect.

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Source: Network Appliance F2Q08 (Qtr End 10/26/07) Earnings Call Transcript
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