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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 NetworkAppliance Q2 2008 Conference Call. At this time, all participants are inlisten-only mode. We will conduct a question-and-answer session towards the endof this conference (Operator Instructions).

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

Tara Dhillon

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

Along with the earnings release, the financial tables, andthe reconciliation between GAAP and non-GAAP numbers in the course of today'sconference call, we will make forward-looking statements and projections thatinvolve risks and uncertainties, including statements regarding ourexpectations, with respect to our Q3 pipeline, bookings distribution, and ourgrowth opportunities, our operating results for fiscal Q3 2008, the growth ofthe virtual server market, and customer demand for our product and serviceofferings.

Actual results may differ materially from our statements orprojections. Factors that could cause actual results to differ from ourprojections include, but are not limited to, customer demand for products andservices, increased competition, and any decline in general economicconditions.

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

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

Steve will review this quarter's financials and discuss ourrevised financial outlook for the third quarter, and then Dan will share histhoughts 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 healthygrowth and solid execution this quarter. I will illustrate this with someadditional 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 thereconciling items between non-GAAP and GAAP numbers.

Total revenue for the first quarter was $792.2 million, up15% sequentially, and up 21%, compared to Q2 last year. Foreign currency effectsadded 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, andmaintenance was 40% of total revenue this quarter.

This compares to 41% last quarter, and 40% in Q2 of lastyear. Add-on software was about 25% of total revenue, and software entitlementsand maintenance were about 15% of total revenue. Revenue from services, whichincludes hardware support, professional services, and educational services, was17% 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, and59% 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 grossmargin demonstrates the continued competitive strength of our solutions.Non-GAAP service margins were a strong 35.5% this quarter, up substantiallyfrom the 31.7% recorded last quarter, due to a slower pace of professionalservices hiring. We expect service margins to remain in the mid-30s for therest 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 categoriesof 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 ouremployment base was a key ingredient for the rapid return to our targetbusiness model operating profit.

Going forward, our hiring will balance our intent to supportfuture growth with our business model objectives. GAAP operating expenseincludes the effect of prior period merger-related costs, like intangibleamortization from acquisitions, and the effect of FAS 123R.

Non-GAAP income from operations totaled to $126 million, or15.9% of revenue. Non-GAAP other income, which consists primarily of interestincome, was $15.1 million. Non-GAAP income before taxes was $141 million, or17.8% of revenue.

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

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

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

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

Moving on to the balance sheet, cash and investmentsdecreased by about $347 million from last quarter to $983 million, due,primarily, to our aggressive stock buyback. This balance, however, excludesapproximately $81 million of restricted cash and investments associated withlast year's foreign cash repatriation, $300 million of restricted cash relatedto our secured revolving credit facility, and about $8 million worth ofrestricted 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 thefourth quarter of this year--this fiscal year. The debt associated with ourcredit facility is $250 million, and is entirely a long-term liability.

As I just mentioned, the company conducted a significantstock repurchase this quarter. We repurchased a total of 17.6 million shares,16.8 million of which were recorded in the second quarter. The remaining774,000 shares will be recorded in Q3. We purchased all these shares in threetranches, for a total outlay of $500 million, with an average purchase price of$28.40. There was approximately $700 million remaining in our stock repurchaseauthorization.

Accounts receivable day sales outstanding were 49 days,compared to 53 days last quarter, and 51 days in Q2 last year. Last year's Q2DSO has been recalculated to include the reclassification of $34 million worthof sales tax from accounts receivable to other current assets, which wedescribed to you in detail last quarter.

Inventory turns were 19.2 times this quarter, better thanthe 18.2 reported in Q1. I expect inventory turns to remain at similar levelsin 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 balanceyear-over-year.

Before I turn the call over to Dan for his comments, I willdiscuss our target operating model for Q3. Our outlook is based on our currentbusiness expectations and current market conditions, and reflects our non-GAAPpresentation.

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

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

In addition, we plan to add about 300-350 employees nextquarter, with an emphasis on sales-related activity. As a result, we'reforecasting our margin to finish between 15%-15.5%, which is below our targetedrange.

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-$0.24per share. We expect our diluted share count to decrease by about 2 million-3million 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 thisquarter, especially from the perspective of sales execution and expense management.We returned to our target operating model faster than we had originallyexpected.

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

Our federal business was very strong, contributing a record17% of total revenue, up 49% over a year ago. However, the rest of North America was sluggish, especially in our largest accounts. Total Americasrevenues 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 largelyattributed 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. Europewas 30% of revenues, the same percentage as Q2 last year, with particularlysolid performance in Germanyand Northeastern Europe, tempered by some softness in Western Europe.

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

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

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

The IBM business continues to gain momentum, and our fiscalQ3 is their year end, so we would expect to see an up tick in the currentquarter, followed by a seasonal decline in our fiscal Q4.

Looking at our performance from a product perspective, wealso have several very positive indicators. The company posted impressivegrowth 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 about60% of total petabytes. The ATA figure includes a small percentage of SASdrives. 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 launchof the FAS2020 and FAS2050 series. Our low-end products accounted for nearlyhalf of all storage systems shipped. The mid-range products were not far behindin units, and our mid-range storage systems continue to generate almosttwo-thirds of our revenue.

At the high-end, our FAS6000 series units grew 9%,sequentially, and approximately 15% sequentially in revenue. The percent of ourstorage 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 from44% last quarter, the business remained strong. It is up 9%, sequentially, inabsolute dollars and we're in a range that we're comfortable with. Over thepast few quarters, we have increased our emphasis on NFS, in order to maintaina balanced focus on all protocols, as well as to ensure we maintain ourleadership in the mass market.

We're seeing more and more customers choosing NAS anddatabase environments because of the cost savings and management simplicity. Butcustomers also use NAS for advanced scale out solutions. Given the additionalemphasis 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 littlebit in the mix.

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

Our emerging products continue to produce mixed results. Thehighlight this quarter is our virtual tape library product line, whichcontinues 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 veryencouraging deployments.

ReplicatorX, our heterogenous data replication product, isdoing well on both business continuity and application development, and testapplications. As more than two-thirds of our corporate data, existing as asecondary copy, de-duplication has emerged as an important part of dataprotection solutions.

We believe NetApp is the capacity leader in de-duplicatedstorage, and our de-duplication technology has become our fastest adoptedfeature. The customers' need de-duplication for more than just backing up, andNetApp 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 separateappliance. We provide it today with our snapshot technology, and also in ourNearStore software bundles. We believe de-duplication is rapidly becoming acore requirement for all enterprise storage systems.

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

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

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

Gartner believes that by 2010 there will be 4 millionvirtual servers deployed, and customers who want virtual servers needvirtualized storage to effectively support them. NetApp is the industry leaderin virtual storage, and we're the only vendor who provides deduplicationcapability for primary VMWare environments.

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

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

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

We expect to see normal seasonal patterns plus continuedsoftness 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 offon providing any Q4 guidance until the end of Q3.

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

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

Question-and-AnswerSession

Operator

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

Harry Blount - LehmanBrothers

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

I don't think, I've heard you guys talk about pricingactions on a call in awhile, so can you talk about, perhaps, what you're seeingin the environment that may cause you to take some more aggressive actionsthan, 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-markettechniques, and the end-markets type of thing.

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

Dan Warmenhoven

Harry, this is Dan. In the direct business it is much easierfor 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 tohave the prices set much closer to what the street and user price would be, inorder to drive velocity.

Harry Blount - LehmanBrothers

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

Dan Warmenhoven

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

Tom Mendoza

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

Harry Blount - LehmanBrothers

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, andthat is you're basically going to use margin to engage in selective pricing. Isthis predominantly aimed at your traditional competitors, or is it more of somesmaller, newer companies, and to what extent do you think this pricing willalso help to stimulate sluggish demand?

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

Dan Warmenhoven

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

Some of it shows up in a form of bundling, which isessentially a re-pricing of sorts, but a channel bundle. Some of it shows up inincentives in the form of rebates that they can earn on certain thresholds ofachievement, and that all shows up in the margin line, but it is not aimed atcompetitors, as much as it is aimed at providing a more attractive solution forour channel partners, both improving their margins and also getting theirvelocity up.

On the U.K. it is mostly a concern about that we're not seeanything specific yet, but as you pointed out, the U.K. business is heavilyweighted towards financial services, and they have a tendency to have a fairlyclose 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 withCiti Investment Research. Please proceed with your question.

Paul Mansky - CitiInvestment Research

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

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

Tom Georgens

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

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

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

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

Dan Warmenhoven

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

Paul Mansky - CitiInvestment Research

And then, on the Dell entry into the market?

Dan Warmenhoven

I don't really have a comment on it. I mean EqualLogic wasan 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 wereselling 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 theyrationalize their go-to-market on the channel side versus the direct salesforce, and how well that works out.

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

Tom Mendoza

Yeah. This is Tom Mendoza. We've been out there; iSCSI is animportant part of our solution offering for quite a while, and we've done verywell at it. I think it's also interesting to see if it expands the market towhere everyone starts really thinking iSCSI SW is the way to go for lots ofdifferent 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 - CitiInvestment 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 endof the market, or is that a strategy that was already in place unchangedsubsequent to that announcement.

Dan Warmenhoven

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

Tom Georgens

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

Paul Mansky - CitiInvestment Research

Great. Thank you.

Operator

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

Dan Renouard - RobertBaird

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

Tom Georgens

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

So, there is a really sense that there is a sense of urgencyhere and that the time is now whether it be our deduplication, our thinprovisioning, our flexible cloning, our ease of use, our unified storage, allof those things come into play around VMWare driving superior cost of ownershipand more rapid deployment.

But wanting to capitalize on that, we actually took one of ourmost senior people, a person who has led a number of key initiatives in thepast. And they're going to lead basically a company-wide initiative thatencompasses 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 asit sits today. And effectively, what we're doing is taking somebody who hasactually kicked off our fiber channel business and our iSCSI business, and hasa long track record of success and influence in the Company, and basicallygiving him the leadership to drive it.

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

Rob Salmon

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

So, we really have a true joint initiative between productoperations and field operations, and we're very excited about it. We announcedan internal recently; there is a lot of enthusiasm about it, internal and withour partner community, and Rich has a lot of respect from our partners, aswell.

Dan Renouard - RobertBaird

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 weaknessyou're seeing amongst the largest accounts, the large USenterprise customers. Is it concentrated in any particular vertical, or is itfairly widespread?

Dan Warmenhoven

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

There is a variety of other stories outside of financialservices, but across the board they're down on a composite sense 4%. I don'tsee any pattern other than the financial services meltdown. And I wouldencourage all of you who are part of the financial services, especiallybroker-dealer organizations, please keep that among yourself.

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

Chris Whitmore -Deutsche Bank

So, if I look at your revenue guidance in the context ofgetting more aggressive on pricing, it doesn't look like you're expecting anacceleration 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'rejust in a budget crunch, and everything slows down at that point in time. So wethink the opportunity to extend the growth is in the mid-market. And I thinkyou've seen that in certain other vendor's results, as well, and we are goingaggressively right there, and that's what the pricing is all about. Tom…

Tom Mendoza

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

We have got to make sure that we got to execute at such ahigh level, that regardless of what happens to the economy, we'll do betterthan the other guy. And you all know that the economy, we just have to see howit goes. So if it goes well, and we don't get this, like Dan just said, doesn'thappen as bad as people think. That would be great news. And if it does, wejust want to be prepared to execute at a high level, take the actions now asopposed 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. Asyou 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 upsequentially. What were the trends you saw in October and November? Are thereany signs of life in US commercial?

And then, looking beyond just the UScommercial market, do you expect kind of seasonal rebound your business year inthe second half of the year like we've typically seen over the last few yearshere?

Dan Warmenhoven

Let me talk about the UScommercial. By US commercial, I am going to talk about all USnonfederal business. And then people have different definitions to the termcommercial. 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 wesee as the strength in the kind of the medium-sized enterprises, and that ispretty 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'sbased on our infrastructure and it's largely based on 6000. So there is a lotof drivers around the 6000 of substance. It's not just a UScommercial product. Does that answer your question?

Brent Bracelin -Pacific Crest Securities

Yeah. And then, just globally, as you think about costseasonality 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 thecalendar year. We've gotten certain indicators, like the pipeline looks verygood. If you look at the most recent Wave 10 of the InfoPro survey, it showsthat there is an increase in interest in spending of their interview base.

I think it's about 400 customers interviewed includesfinancial services, which all show cost significant increase in spending onNetApp in the near future. There is indicators, but we're assuming it's goingto be a fairly traditional kind of year, strength in Europe, nothing in surgingin North America.

Brent Bracelin -Pacific Crest Securities

Okay. Thank you.

Operator

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

Aaron Rakers -Wachovia

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

And also, if you can--on the pricing comments--you made areference to gross margin being down, but then you also referenced IBM growingas a larger percent. If you can give us some flavor around that 1-1.5-percentagepoint decline in gross margin, what is attributed to IBM versus pricing, thatwould 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 theIBM 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, exceptto say, that as we exit the second quarter and Dan pointed this out, we thinkour backlog is in a very healthy position.

Aaron Rakers -Wachovia

Okay.

Operator

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

Clay Sumner - FBR

Thanks very much. Steve. I guess following up on the lastquestion, the last quarter you had said that don't pay so much attention to the11% revenue growth, because bookings grew in the high 20s, so that was clearlyan indicator that the business was still growing pretty strongly. Can you justsay if that bookings growth slowed? Are we talking about an incrementallyslower growth environment, or roughly on track with where we were in the Julyquarter?

Steve Gomo

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

Dan Warmenhoven

I should remind you guys that bookings don't directly relateto revenue in the near term. So much of it goes to the contra programs, or todeferred revenue, or professional services backlog, or a variety of otherthings. It is very difficult to correlate the two directly. Bookings are aleading indicator. The bookings are up in a manner very similar to last quarteron 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, withJP Morgan. Please proceed with your question.

Bill Shope - JPMorgan

Okay. Great. Thanks. Is there any way you guys can help usquantify your exposure to financial services as a percentage of revenue forthis 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 veryhonest with you. We did the bookings number and not necessarily the revenuenumber. Financial services in the mix? I would have to get back to you. I don'thave it.

Dan Warmenhoven

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

Bill Shope - JPMorgan

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

Dan Warmenhoven

Typically, it has always been number two in the mix. If youadd all tech together--that's generally still number one--it's somewhere in thehigh to mid-teens, and financial services is right behind it, typically in the14%-15% range, and the federal at the 10%-12%. And my guess is, that the financialservices this quarter is closer by 12% or 13%--it's down a couple percent.

Bill Shope - JPMorgan

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

Steve Gomo

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

Bill Shope - JPMorgan

Okay. Great. Thank you.

Operator

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

Kevin Hunt - ThomasWeisel Partners

Hi. Thank you. I wanted to clarify, I think, Steve, you hadsaid 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 tounderstand why it was changing, if it is, whatever direction it's going?

Dan Warmenhoven

IBM receives larger discounts in general. Therefore, werecognize lower gross margins from a transaction through IBM. It also has gotlower 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 channelwe work with.

Steve Gomo

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

Kevin Hunt - ThomasWeisel Partners

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

Steve Gomo

Okay.

Operator

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

Shebly Seyrafi -Caris

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

I just want to see what you have in terms of visibility toguide the way you're guiding, which is quite aggressive. You talked so farabout strength in Europe. I am wondering if the federalstrength is continuing. Maybe you can elaborate on why you're so confident andwhy 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 acomfortable backlog. That backlog is largely product backlog as well asprofessional services. Those are items we can convert to revenue this quarter.

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

The problem with predicting the future, is it hasn'thappened yet, and we're forecasting based on what we see as our currentsituation and the order pipeline that we're looking at. And assuming nothingmaterial changes, we should see a performance consistent with the forecast wegave you.

Now, that said, in Q3, we generally see Europeup in the mix, federal drops off. Our Q2 contains the end of the federal fiscalyear in September and that's why they surge. They do in fact have yearendbuying phenomena. That will not recur in Q3. But we factor all those thingsinto the guidance we gave you. And our expectation is that unless somethingdramatic changes in the global economies, we will be able to meet thoseexpectations.

Shebly Seyrafi -Caris

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

Dan Warmenhoven

I believe that next quarter's growth rate will be consistentwith this quarter's growth rate, and it will come from a different set ofdrivers than what we had this quarter. That's all I can tell you. We're lookingat a bunch of large numbers meaning large pipeline activity, et cetera, andtrying 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 thatin any particular form.

Shebly Seyrafi -Caris

Okay. Thanks.

Operator

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

Kaushik Roy - PacificGrowth

Congratulations on the snap back in operating margin, andyour guiding 15-15.5 in Q3, but is that your new target going forward, or canwe 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 isstill 15.8-16.4.

Kaushik Roy - PacificGrowth

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

Steve Gomo

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

Kaushik Roy - PacificGrowth

Okay. Fair enough. Thanks.

Operator

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

Katy Huberty - MorganStanley

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

Dan Warmenhoven

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

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

Steve Gomo

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

Katy Huberty - MorganStanley

Thanks.

Operator

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

Bill Choi - Jefferies

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

Dan Warmenhoven

I think you have a problem with your math. Product grossmargins don't fall below 60% in any scenario that we've ever forecasted. Ourproduct gross margins right now are about 65%, 66%, and should be coming downeven higher than that. They should be coming down a couple points, so Iencourage 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 1,000products in the product line, right? And they're all knitted together to form aparticular system. So there will be ricochets into all kinds of other things.

The 2020 and the 2050 were priced appropriately going tomarket. Those are brand new. Those didn't have to be touched. But a lot ofsoftware products were moved around, disk prices were moved around, a varietyof 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 highsover the past five years so we have room to move and we're taking advantage ofthat to disperse some growth in some of the segments Dan was alluding toearlier.

Bill Choi - Jefferies

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

Dan Warmenhoven

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

Bill Choi - Jefferies

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

Dan Warmenhoven

We don't have any stocking in the channel, whatsoever. Thereis no inventory out there. Everything is build to order and the flow is fromthe 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 DanRenouard, with Robert Baird. Please proceed with your question.

Dan Renouard - RobertBaird

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

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

Steve Gomo

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

Dan Renouard - RobertBaird

Okay. Thank you.

Steve Gomo

You bet.

Operator

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

Dan Warmenhoven

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

Operator

Thank you for your participation in today's conference. Thisconcludes 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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