Network Appliance F3Q06 (Qtr Ending Jan 27, 2006) Earnings Conference Call Transcript (NTAP)

| About: NetApp, Inc. (NTAP)
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Network Appliance (NASDAQ:NTAP)

Q3 2006 Earnings Conference Call

February 15th 2006, 1:30 PM.

Executives

Tara Calhoun, Senior Director of Investor Relations

Steve Gomo, Chief Financial Officer

Daniel Warmenhoven, Chief Executive Officer

Tom Mendoza, President

Analysts

Andy McCullough, Credit Suisse First Boston

Jeff Brickman, UBS

Tom Curlin, RBC Capital Markets

Brian Freed, Morgan Keegan

Aaron Rakers, A.G. Edwards

Harry Blount, Lehman Brothers

Laura Conigliaro, Goldman Sachs

Paul Mansky, Citigroup

Kaushik Roy, Susquehanna

Daniel Renouard, Robert W. Baird

Andrew Ness, Bear Stearns

Clay Sumner, FBR

Brent Bracelin, Pacific Crest Securities

Glenn Hanus, Needham & Company

Carolyn Cowen, Cowen

William Fearnley, FTN Midwest Securities

Mamba Barowa, Banc of America

Shebly Seyrafi, Kaufman Brothers

Kevin Hunt, Thomas Weisel Partners

Operator

Good day ladies and gentlemen and thank you for standing by, and welcome to the Network Appliance Third Quarter Fiscal Year 2006 Conference Call. My name is Carlo and I will be your coordinator for today's presentation. At this time all of our participants are in listen only mode, we'll be facilitating a question-and-answer session towards the end of today's prepared remarks. At that time if you would like to ask a question you may do so by pressing "*" and "1". If at any time during this call you require any assistance please press "*" "0" and the conference coordinator will be happy to assist you. I would now like to the turn the presentations over to your host for today's conference Tara Calhoun, Senior Director of Investor Relations

Tara Calhoun, Senior Director of Investor Relations

Good afternoon everyone, and thank you joining us today. Before we begin, I would like to invite you to registry for upcoming Analyst Day on March 14th, in San Francisco. In addition to the respective presentation providing an update on our corporate vision and direction, we will host the solutions pavilion in the afternoon, where you will be able see a live demo of data ONTAP GX, our next generations operating system, as far as several other NetApp solutions that are driving our growth today. Please contact the IR team for details and registration information.

Today's conference call has being webcast live and also be available on our website at www.netapp.com along with our earnings releases, the reconciliation between GAAP and non-GAAP numbers and other financial and statistical information presented during our call. In the course of today's call, we'll make forward-looking statements and projections that involve risk and uncertainties, including statements regarding our expectations for stock repurchases, potential declines and total shares outstanding, higher end goals, operating result for Q4 and FY'06, timing of future product introduction, growth in our SAN and SCSI business, and growth rates relative to the industry.

Actual results may differ materially from our statements or projections. Important factors that could cause actual results could differ from those in the forward-looking statements include, but are not limited to customer demands for product and services, increased competition, and declined in general economic condition, and foreign currency exchange rate fluctuation. Other equally important factors that could cause actual result to differ from those in the forward-looking statements are detailed in the risk factors section of our Company's 10-K and 10-Q report on filed with the SEC and are accessible through our website. All of which are incorporated by references in today's discussion. We disclaim any obligations to update information contained in these forward-looking statements, whether as a result of new information, future events or otherwise.

With me on today call are Dan Warrenhoven, our Chief Executive Officer, Tom Mendoza, President, Steve Gomo, our Chief Financial Officer, and Tom Georgens, Executive Vice-President of our Enterprise Storage System group. Steve will review this quarter's financial and discuss our financial outlook for the fourth quarters and then Dan will share his thoughts before we windup with everyone here for Q&A. Steve?

Steve Gomo, Chief Financial Officer

Thanks, Tara. Good afternoon everyone. As if you could see from the results, Network Appliance had a robust third quarter, which again was driven by the strength of our new FAS 3000 midrange product. Our business was also strong across all geographies.

Now, I will walk through the details of our results to provide additional color. Please note that all numbers comply with GAAP unless stated otherwise. For the third quarter, total revenue came in at $537 million up 30% over 3Q of last year and an increase of 11% sequentially. The foreign currency effect subtracted approximately half percentage point on a sequential basis, and three percentage points year-over-year.

Product revenues are $474.2 million grew 29% year-over-year, almost 12% sequentially. And-on software and software subscriptions, accounted for 36% of total revenue this quarter. This figure is a combination of software subscriptions, which were 11% of total revenue, and add-on software products they were 25% of total revenue. Revenue from IBM and Decru, both increased, with IBM just over 1% of total revenue this quarter. Decru finished the quarter a little under 1% of total revenue. Revenue from services, which include hardware support, professional services, and educational services was just under 12% of total revenue, up 8% sequentially and up 40% over the third quarter of last year. Service maintenance contract increased 9% sequentially and total professional services grew 6% sequentially.

Non-GAAP gross margins were 61.6% this quarter. Non-GAAP product gross margins returned to a more normal level of 66.3% despite a modest increase in the mix of add-on software. This decline in product margin was mostly due to a significant increase in the amount of low margin storage sold this quarter. Sequentially, period expenses were also higher as we responded to product demand that exceeded our expectations. Non-GAAP service margins up 25.9% declined six-tenth of one-percentage point from last quarter. As expected, the credits we received last quarter for service parts and European VAT not reoccur this quarter. Underline service productivity showed continued improvement and will allow us to continue to build our professional services capability.

Turning to expenses. Our non-GAAP operating expenses totaled $238.4 million or 44.4% of revenue. Expenses increased 11% from Q2 despite a hiring pattern that was backend loaded. Employment headcount increased by 299 people this quarter ending with 4,631 employees not including over 75 pending starts. With over 400 open racks in our system and our goal to hire another 300 people this quarter, we expect to achieve our annual target to hire 1,200 people, by the end of April. GAAP operating expenses include the affect of intangible amortization previous merger related stock compensation charges and some very minor adjustments of restructuring charges this quarter. At $92.5 million, non-GAAP operating profit finished at 17.2% of revenue. Other income, which consists primarily of interest income finished at $10.9 million. Non-GAAP pretax operating income for the quarter was $103.3 million or 19.2% of revenue. Our effective non-GAAP tax rate remains at18%.

Moving on to the balance sheet. Cash and investment totaled $1.14 billion up approximately $31 million from Q2. We repurchased just over 5 million shares of outstanding common stock at an average price of $28.97 per share for a total cash outlay of roughly $145.6 million. We will continue to buyback stock and expect our total shares outstanding to decrease modestly by our fiscal yearend subject primarily to fluctuations in stock prices. Cash generated from operations totaled $114.9 million. Capital purchases were $33.5 million and depreciation, amortization was $21.4 million. The deferred revenue balance increased $59 million this quarter to $593.5 million and 11% sequential increase and up 52% year-over-year. As we said before, increases in deferred revenue are a strong indicator of continued penetration into enterprise accounts.

Accounts receivable day sales outstanding were 62 days, compared to 61 days reported last quarter. DSOs remained in the low 60s due primarily to a shipping profile weighted toward the second half of the quarter. With demand exceeding our forecast during December coupled with some unexpected mix-shifts towards storage. Our supply of Shelf was constrained during the middle month of our quarter. This situation was temporary as we both caught up and built inventory by the end of the quarter. As a result, our turns in inventory were 12.9 times, compared to 16.4 times in Q2. Rumors about supply chain issues and their impact on the quarter were dramatically overblown.

Before I turn the call over to Dan for his comments, I would like to share our operating model for the fourth quarter. Our outlook is based on current business expectations and current market conditions that reflects our non-GAAP presentation. I will remind you that we are making forward-looking statements and projections that involve risks and uncertainties. Actual results may different materially from our statements or projections.

We expect FY'06 fourth quarter revenue growth to be in the range of 28% to 30% year-over-year, which reflects about an 8% to 9% sequential increase over Q3. We expect total gross margins to fall by about one percentage point as the add-on software mix moves back towards 35% level and we continue to invest in our professional services capability. Our target operating margin for the fourth quarter is expect to be right around 16%, as our expense structure will increase slightly reflecting our hiring pattern.

As noted earlier, we expect to achieve our employment target for the full year. Fourth quarter non-GAAP earnings are expected to be in the range of $0.22 to $0.23 per share. GAAP earnings are expected to be $0.20 to $0.21 per share. Our fourth quarter targets translate the full year revenue growth expectations in the range of 28% to 29% year-over-year. Non-GAAP earnings per share are expected to be in the range of $0.80 to $0.81 with GAAP earnings of 73% to 74% per share. We will discuss our expectations for FY'07 at our analyst day on March 14th. At this point, I will turn the call over to Dan for his update. Dan?

Daniel Warmenhoven, Chief Executive Officer

Thank you, Steve. The NetApp team delivered another terrific quarter, and I am particularly pleased with our progress in penetrating and expanding our presence in enterprises data centers. NetApp's business with mission critical application partners like Microsoft, Oracle and SAP continues to grow. We have seen business supporting databases increased steadily in our mix to well over 40% of our business today. In addition to going deeper within our product line innovation and expansions are broadening our addressable market; Database cloning, data encryption and disc-to-disc data protection to name a few.

Before I tell you about our newer products, let's review the performance of our core business which drives the current growth. Total storage systems shipped were up 11% sequentially driven again by the adoption of our FAS 3000 product line. For the 40% increase in unit shipped, the 3000 series accounted for over 40% of all systems sold. At our high-end of FAS960 continued to decline as it is solely replace by the 3050s with the 980 and quite a resurgence this quarter with 30% sequential increase in unit shipped. Our new high-end which many of you may have referred to by it's code name Excelsior is on tract to begin shipping in Q4 to pre-selected sets of large accounts, who are part of our earlier adopter programs. This new high-end positioned well above the 980 will bring substantial increases in both performance and capacity, increase in the breadth of our product offerings in the market.

Turning to the low-end, unit shipped of our FAS250 increased again this quarter, while units of the FAS270 declined slightly. We suspect that decline may have been a result of customer choosing to buy entry level 2 terabyte 3020 systems with ATA drives as their cost for gigabyte is very similar and the functionality is significantly higher. Net cash this quarter again contributed over 3% of revenues. Looking at our business from a geographic prospective, all three major Geos turned in a very strong performance. The Americas accounted for little over 55% of revenue and EMEA which is typically strong in Q3, contributed to strong 33% of revenue this quarter. Asia-Pacific showed healthy improvement this quarter accounting for almost 12% of revenue.

Our indirect channel business accounted for 57% of revenues in Q3, after a seasonally strong Q2 from the federal sector. Our federal business decreased about 7% of revenue and the vast majority is the Fed business is indirect. The decline in federal also reduced the volume due to error on AppNet, which declined a little over 9% of revenue. One fourth of their business was from federal sector in Q2, but they had only about one fifth of that level contribution from federal in Q3. On the other side our direct business in Americas had a terrific performance and several of our global resellers also had very strong result. IBM continues to progress, as Steve said with just over 1% of revenue, with just two of our product lines rolled out with them so far, we are very pleased with our progress and optimistic about the interactions and development efforts we have with them.

One of the most notable phenomenal of the quarter was a dramatic increase in total terabytes shipped. If you recall last quarter, I mentioned that increase is in our total capacity shipped maybe less predictable for next several quarters. And that certainly turned out to be an understatement. In Q3, we shipped 48 terabytes of storage up 30% sequentially from the 37 terabytes of last quarter. We think there are several drivers for the surge, while the biggest single impact was increased in units in FAS3000, and then the resurgence of the 980, as well as the introduction of 320 gigabyte drives. The unique component this quarter was the significant increase in add-on storage shelves, with unit shipped increasing over 30% in Q2. While customers don't have to buy as much storage upfront with the NetApp solution given the higher utilization they get, their data volumes still grow rapidly. So, we would expect to see add-on shelf purchases to continue to trend up overtime.

In addition this quarter, we think this is exaggerated by yearend buying storage where some customers had to use their remaining budget to lose it. Expansion shows that the quicker and easiest place to spend their dollars, and they know they will need that capacity eventually anyway.

Customers continue to report back to us as the disk utilization rates are increasing from industry norms around 30% to 35% utilization to all over 50% to 60% and often even doubling, by using the NetApp FlexVol technology. Customers don't have to buy as much disk storage capacity to achieve their business objectives, making our systems sold over data ONTAP 7G, even more competitive in the market place. According to our autosupport tracking figures 42% of our installed base is now running 7G with FlexVol. 7G continues to fastest up tick of a new operating system in our history. These features are now standard in all new systems shipped including our coming high-end.

Looking at our SAN and iSCSI contribution, there are two areas of business that contribute large components to the SAN and iSCSI mix, federal sector and indirect channel. Pullback on our federal business, as well as our indirect business this quarter, we saw a corresponding declined in the SAN and iSCSI component of our orders. We have 32% of orders including block-based connectivity, of this 22% of orders included SAN and 14% include iSCSI with the 4% overlap where both represent. We believe this mix is also skewed by the amount of add-on storage sold during the quarter, compared to the higher piece of the total revenue and not attributing to either SAN NAS or iSCSI. And as this quarter's absolute performance in SAN and iSCSI is the 75% increase over Q3 of last year. We believe that our SAN and iSCSI business will continue to grow and be a healthy part of our business and they will fluctuate quarter-to-quarter as part unified storage mix.

We have seen a correlation between increased sales and the mission critical and mix in critical data center environments. An increase in our mix of fiber channel drive shipped, a sell-through again this quarter, with fiber channel accounting for 59% of total petabyte shipped, compared to the 55% last quarter. ATA petabyte shipped increased about 17% sequentially and NearStore held it's own accounting for about 13.5% of revenues. While the overall number of NearStore systems shipped decreased modestly the average capacity per system increased sequentially, further solidifying its roll as a secondary storage system. Going forward, with the launch of our NearStore virtual tape library solution on February 7, the concept of NearStore is evolving into brand encompassing a category of platforms, software and services optimized for data protection and retention applications.

Data protection includes disk-to-disk backup, and disaster recovery solutions and data retention includes compliance retention, archival and content storage. NearStore VTL significantly expands our market opportunity, so we can now provide non-disruptive disk-to-disk backup solutions to any storage environment including AMC, HP, Hitachi, IBM and Sun.

VTL is a natural extension of our business allowing us to go after the portion of the $1.8 billion tape market. While tape is not likely go anytime soon, and it's going make solid business sense, historically center media archives on disk for after recovery. Our VTL platform interacts with customers existing backup software solutions like Symantec, Tivoli and Legato, by appearing to behave just like a tape with all the advantages of spinning media.

We continue to be very excited about the market opportunities unfolding with Decru. Customers can now effectively protect their data from loss or theft with our DataFort encryption products. Tape encryption is certainly the strong area, we are also seeing demand increasing to other encryption products including our large deployment for SCSI security.

This quarter, enterprise revenue from Decru exceeded in the government sector, closing business with several large institutions that have broad center verticals including Financial Services, Insurance, Healthcare, Life Sciences, Manufacturing and Publishing. Marked key customers include Ameritrade, Amgen, Guardian life, Iron Mountain, the Mizuho bank in Japan. The fact not only as Iron Mountain was Decru customer, but they have gone on record publicly recommending that all tapes with sensitive data to be encrypted before they are transferred.

The development of our next generation operating system is also progressing well. We will release the first version of ONTAP GX, as on option to FAS 3000 in a very near future. Initially we targeted a higher performance computing environments. ONTAP GX is the first operating systems to support true storage grid architecture; built using modular storage devices that can scale the hundreds of systems, with the single global name space. As Tara mentioned you will have the opportunity to see a live demo of ONTAP GX, in the Solutions Pavilion at our analyst day next month.

To summarize, it feels great to post the 30% growth quarter again, our strategy is working. We have many reasons to be optimistic about our future. In addition the strong performance from our core business, with new high-end products coming, new markets opening up with VTL, Decru and our other emerging business segments and more contribution look forward to from IBM.

We expect to continue delivering the highest growth rates in the industry. With that I will open the floor to questions. Again I will ask to limit yourself to one question each. If you have a follow up please return to the queue, so immediately we may address everyone in a timely manner. Thank you. Operator?

Question-and-Answer Session

Operator

Thank you, sir. Operator Instructions Sir, our first question is from the line of Andy McCullough with Credit Suisse.

Q - Andy McCullough

Thanks, guys. Can you dig in a little bit more as to what drove the strength in the add-on software mix and then looking ahead, why do you think that add-on software, the add-on software mix goes down, particularly when you got a high-end product cycle coming online this quarter?

A - Steve Gomo

Andy, Steve Gomo here. There's no single driver behind the add-on software mix. Several categories of software picked up during the quarter slightly and matched the contribution to the increase. We think, and we still are modeling here, a target of 35% add-on software as we go forward. We think there is a absolute penetration level that our software can reach and we think at 35% we pretty much reached that. That said, think there will be quarters when you could see a point, maybe even a 2-point uptick in that level, but you could also see a point or two-point level down tick, so I think that targeting 35% is safe and representative of what you'll see over the longer haul.

A - Daniel Warmenhoven

This is Dan. We also find on a new high-end systems that the percent of their total value that's associated with add-on software declines initially. And so as the new systems come out, I think you'll see they carry less than 35% going out the door than you'll see add-on software for the systems pick up later.

Operator

And, sir, our next question is from the line of Ben Righteous with UBS.

Q - Jeff Brickman

This is Jeff Brickman for Ben. I was wondering if you could give a little more detail on inventory, obviously, understand what happened in the middle of the quarter, but clearly there was a pretty large uptick here and when are you expecting DSO's could possibly go down and maybe if you could give a little more color on how you see things ending the quarter.

A - Steve Gomo

This is Steve Gomo here. You'll notice, again, we had the, we had the superior growth this quarter and indeed, December was a challenging month for us, as orders significantly outstripped our expectations. So obviously we had to build some inventory to catch up. We also have seen, DSO deteriorate now for two quarters and we've decided that it would be prudent to have a little bit more inventory on hand, given the robust demand we're seeing across the board. So we're going to start the new quarter in a better inventory position, hopefully to avoid any kind of challenges this next quarter.

A - Daniel Warmenhoven

Two other things in that inventory number, inventory supplies that are essentially consigned to IBM, who now does their own manufacturing JVIL, and that's a significant component as they start ramping up. And we have a significant amount of material in there for the new high-end systems and they won't convert to revenue until, if at all, until the very end of this quarter.

Operator

And, sir, our next question is from the line of Tom Curlin with RBC Capital Markets.

Q - Tom Curlin

Thank you. Can you comment on Decru revenue contribution? I think everything else was pretty clear, but that piece.

A - Daniel Warmenhoven

This is Dan. I think in Steve's script he had it just under 1% of revenue.

Q - Tom Curlin

Okay. Thank you.

Operator

And, sir, our next question is from the line of Brian Freed with Morgan Keegan.

Q - Brian Freed

Hi, guys, great quarter. Could you comment a little bit more about the IBM relationship you just mentioned, how that's going to be manufactured by IBM, maybe give a little bit more detail about the stable relationship you mentioned.

A - Daniel Warmenhoven

You broke up on that. Could you repeat?

Q - Brian Freed

Could you give a little more clarity on the IBM manufacturing? You just mentioned, I think you said they are going to manufacture through JVIL.

A - Daniel Warmenhoven

Yes, JVIL is our contract manufacturer, IBM also uses JVIL, so the arrangement we have is that JVIL will manufacture the IBM logo and branded equipment and pull essentially raw material stock for that, and we get the invoiced or whatever as, or they get invoiced from us automatically, I should say, as they pull a kit.

Q - Brian Freed

And the inventories will be on whose balance sheet?

A - Daniel Warmenhoven

They are on ours until they actually pull one to go to fab, they are on ours.

Operator

Sir, our next question is from the line of Aaron Rakers with A.G. Edwards.

Q - Aaron Rakers

Hi, guys. Thanks a lot. Nice quarter as well. Maybe you can talk a little bit about the high end business. I see that the 980 was pretty strong in the quarter ahead of a product cycle, forthcoming. Maybe you can help us understand what type of ramp we expect with the new high-end product coming on board, any type of revenue expectations, contributions for the current quarter from that new high-end solution?

A - Daniel Warmenhoven

Yes, high end solution, you know, is kind of on the cusp for this quarter. We're putting in basically beta systems. They are not revenue. They are still on our inventory, et cetera, although they are in customer hands. My guess is if we do anything at all it, will be very close to the end of the quarter in terms of revenue recognition. It may not be in the quarter at all. Relative to 980, the new Excelsior System is well above the 980, as I made in my comment. I expect the 980 to stay as a very healthy contributor in the product portfolio for quite sometime. We're talking like 2 X of differential between them. There's plenty of room between a 980 and Excelsior.

Operator

Sir, our next question is from the line of Harry Blount with Lehman Brothers.

Q - Harry Blount

Hi, guys. Quick question, Dan, you mentioned that part of the contribution to the significant growth in petabytes is you saw an uptick to add-on shelves. Can you give us a sense of where that's at? You thought that might grow as a percentage of revenue.

A - Daniel Warmenhoven

I think the surge in the add-on stuff was $3 or $4 million. The way we have it quantified, add-on shelves was up 30%, but that really means $3 or 4 million in the mix. Like I said, I really believe that was customer who is took it at the end of the year because they had money to spend, they'll probable set it aside and install it when they need it. I should also clarify a misstatement I made in the, in my remarks on the introduction. I misstated a number. I had said that total systems shipped were up 40%. That number is actually 47%.

Operator

And, sir, our next question is from the line of Laura Conigliaro with Goldman Sachs.

Q - Laura Conigliaro

We had two quarters in a row where you've taken your strong revenue growth and allowed for some large earnings upside, is this indicative of a slight change or attitude toward rewarding in investors with upside or is it more of an operation to give you strong revenue growth, misstep in July, and it seems like you've been strong higher expectations, higher revenue outlook would suggest that your margins can move higher.

A - Daniel Warmenhoven

I don't think that's the case. We're still operating through a target operating model of somewhere between 15.8 and 16.4% on the operating income, and if we see a surge in revenue, it's got to fall to the bottom line because you just don't have time to spend it. But nominally what were trying to plan to is 15.8 to 16.4.

Operator

Our next question, sir, is from the line of Paul Mansky with Citigroup.

Q - Paul Mansky

Can you hear me?

A - Daniel Warmenhoven

Yes, sir.

Q - Paul Mansky

Oh, great. Thank you. Just wanted to touch base on Decru again. You indicated it was about 1% of revenue, suggests 5, $6 million roughly. I think that may be tracking now for the second quarter slightly behind expectations. Can you give us some guidance as it relates to what you expect ultimately that revenue run rate to look like over the next couple of quarters?

A - Daniel Warmenhoven

It's really very lumpy. I think that's part of the challenge. In fact, we don't normally disclose bookings, but Decru's bookings in this quarter were about 3 X their revenue contribution because some large deals close at the end of the quarter and they didn't get converted. As a start-up business, selling into large enterprises with lumpy deals, it's very difficult to predict what the linearity is going to look like. I'm much more interested in looking at the deal slow and sales cycles and so we were pleased this quarter that the enterprise business exceeded the federal business. Think we're starting to get a handle on those sales cycles, but I, I would be reticent to predict any particular number for this quarter, and hopefully we'll give you better guidance for next year, in March, at the analyst day.

Operator

And, sir, our next question is from the line of Kaushik Roy with Susquehanna.

Q - Kaushik Roy

Congratulations on a great quarter there. There has been some talk about the delay if the integration of the spinerest, can you comment on the time line and what impact it may have on revenues?

A - Daniel Warmenhoven

That new operating system, we call ONTAP GX is in the hands of at least five or six customers as we speak in a beta condition and we know they use it because they filed bug reports, so I think it's right on track. It's, yes, again, you'll see it in the March 14 analyst day, and we'll be right on the cusp of, of making that a generally available release, or available to any customer who wants, I should say. GA is a different term, but FCS release, right at the end of this fiscal quarter. You should, you'll not see any revenue impact, though. Realize it's on the same 3000 systems that you buy data ONTAP today.

Operator

And, sir, our next question is from the line of Daniel Renouard with Robert W Baird.

Q - Daniel Renouard

Thanks. Going back to the high end product for this quarter, you kind of indicated you'll be in beta mode for the April quarter. Does that imply that we'll be in full, be shipping to everybody for the July quarter so you'll be at a sort of normalized run rate, or would you expect that to be a ramp for the next couple of quarters? Then when would it be a reasonable timeframe, and I know it's hard to predict, but just some sort of goal post around when IBM, you might expect IBM to qualify in that OEM product.

A - Daniel Warmenhoven

You would have to ask IBM on that one, but the last one they took was roughly a three-month separation and obviously both parties are looking to try to improve that. I think on the, on the new high-end, I know, I'm not encouraging to you include any revenue in your model for this particular quarter. We'll be in a ramp quarter in our fiscal Q1. Generally the high end, as it comes out has a tendency to have a fairly quick takeup and, but I would think it would be kind of in its steady state in the mix, probably during our Q2.

Operator

And, sir, our next question is from the line of Andrew Ness with Bear Stearns.

Q - Andrew Ness

Hello?

A - Daniel Warmenhoven

Hi.

Q - Andrew Ness

I know that you wanted to save some of this for your upcoming analyst meeting, but are there factors that you see they are going to slow down your growth as you go into fiscal '07, or do you see same sort of, that will effect your margins as you look out at '07?

A - Daniel Warmenhoven

Matt, this is, we're not forecasting any change in our normal business model.

Operator

And our next question is from the line of Clay Sumner with FBR.

Q - Clay Sumner

Thanks, and my congratulations, too, on the quarter. Can you guys say what percentage of the 3000 series or of the total product line shipments shipped with dual controllers this quarter?

A - Daniel Warmenhoven

Yes, if I could find the data.

Q - Clay Sumner

I generally understand that the trend has been markedly up in the last couple of quarters.

A - Daniel Warmenhoven

I do recall that the volume was up 12% sequentially.

Q - Clay Sumner

Volume of dual?

A - Daniel Warmenhoven

Yes, of clusters, right.

Q - Clay Sumner

Of clusters.

A - Daniel Warmenhoven

As I recall, it's approaching over 70%.

Q - Clay Sumner

Okay. Great. Thank you very much.

Operator

And, sir, our next question is from the line of Brent Bracelin with Pacific Crest security.

Q - Brent Bracelin

Thank you. Two-part clarification on IBM, if I may. Obviously we're in early days here, but what was the order linearity, from IBM in the quarter? Was it anything different than what you saw with your kind of reseller base? Then secondly, Dan, you did mention that IBM is only shipping two products from NetApp today. Can you talk a little bit about what other products you anticipate IBM taking on over the next one to three-year period?

A - Daniel Warmenhoven

Yes, I certainly expect them to continue to take most of our primary storage systems, so they will pick up Excelsior, is my guess. In fact I'm pretty sure that's going happen. But I think that will kind of be the conclusion for them and they will track with us relative to refreshes. When we refresh the low end, I'm sure they will introduce that as well. Did you have a second piece of that? Oh, the linearity in the quarter. Pardon me. So IBM's fiscal year ended in December. So we saw a surge in both bookings and shipments during that month. It was a very atypical relative to the rest of our channels, so we had a really strong December from IBM. Other than the IBM surge right there, which is only 1% of revenue, our booking profile this quarter looked virtually identical to last year. We were stronger through December, a little weakest at the beginning of January, then a pretty strong finish. IBM was actually part of the December challenge relative to materials selling.

Operator

And, sir, we a question from the line of Glenn Hanus with Needham & Company.

Q - Glenn Hanus

Could you maybe give some color around how you'll be offering the GX pricing it, how you'll be upgrading people, sort of the basic marketing tactics around that?

A - Daniel Warmenhoven

I'm not going to say anything about pricing, but let's think about new shipments first. The customer who chooses a 3000 or one of the new high end systems will have their choice as to which operating system they want installed when it's shipped, and customers who have current 3000 systems have the opportunity to upgrade those if they so choose. That upgreat process requires that they have Flexball enabled on their current ONTAP environment, and from that point it, should be a fairly straight forward process.

Q - Glenn Hanus

Thank you.

Operator

And, sir, our next question is from the line of Carolyn Cowen with Cowen.

Q - Carolyn Cowen

Yes, good afternoon. Could you give a little bit more detail on your inaudible plans, specifically how you're going to allocate new hires, whether it's more toward R&D or field direct sales, given it looks like you might be able to harvest some of the fruits of our R&D efforts.

A - Steve Gomo

Steve Gomo there. Basically there's been no change in our hiring profile or planned hiring profile. Roughly we plan to hire roughly 300 people next quarter, about 100 in sales, 100 in the services area, predominantly professional services, and about 100 in engineering.

Operator

And, sir, our next question is from the line of William Fearnley with FTN Midwest Securities.

Q - William Fearnley

Thanks. Quick question regarding availability for you. There was a lot of questions on third quarter, certainly, but for the fourth quarter, is it fair to say that you guys are out of the woods in regard to availability? You mentioned the inventory build in your introductory remarks. Thanks.

A - Daniel Warmenhoven

We were never in the woods. We did not, we were never in any kind of difficulty whatsoever. I think we lose the fact that we had a surge in the number of add-on shelves, which stressed the supply chain. IBM had a really good December, which was cocurrent with that. Many of our customers gave us orders which were conditional upon receipt of the product by the end of the calendar year, and so we were in a churn of rescheduling to give them priority. But none of those were severe, nor did any impact our performance during the quarter. So we got plenty of supply, got plenty of material and I should point out that if you look back at Zyrtec's reports in January, you can see we had a very, very strong performance through the end of the calendar year, correlated with their results. So I mean Steve said, I think the comment he made was that the rumors concerning our supply chain issues were greatly exaggerated, so, again, I stand by my opening comment. We were never in the woods.

Operator

And, sir, our next question is from the line of Mamba Barowa (phonetic) with Banc of America.

Q - Mamba Barowa

Hey, guys. Thanks for taking the call. Sir this business had another really strong quarter. Just wondering if you guys sort of have a goal there for, you know, I guess, as a percentage of total revenue and I mean how long here should we expect you to continue to sort of outgrow the rest of the business?

A - Daniel Warmenhoven

You know, I think it goes on for quite a while. I can foresee the day when services represents 20% of our business or more. So I expect that to keep growing faster than the product business and I think that's very appropriate. I mean the service set is used to accelerate customer acceptance of the product and there's a strong demand for it.

A - Steve Gomo

Yes, in fact, to add on to Dan's point, think, or to emphasize his point, professional services is the fastest growing piece or fastest growing category of our business today and so while it's small in terms of its absolute size, it's going to continue to grow quickly, particularly as we continue to add resources to pull our technology and to, into customer accounts.

A - Tom Mendoza

This is Tom. One of the big requirements, we had a very strong enterprise quarter, as you've heard. One of the big requirements there is consistent service offering globally and they are willing to fund that. So when you get into bigger and bigger enterprises, spreading major applications onto our products, they want to have professional services involved at each end and that could be on every continent in some cases. We're in front of that. Rather than trying to be reactive to it, we're being proactive and hiring and, the whole strategy is to provide the customer what is they need by more of our products. Obviously the margin structure is good. We don't have to find the new business, just make sure this one works well. We want to be on the front end so we're not reacting. I think that's what you're seeing here.

Operator

And, sir, our next question is from the line of Shebly Seyrafi with Kaufman Brothers.

Q - Shebly Seyrafi

Yes, thank you very much. Looking at your geographic trends, your intercontinental revenue grew quite nicely for the first time, I would say, in a fiscal Q3 for several years. Maybe you can talk about the geographic trends and whether or not you expect broad-based geographic growth in the fourth quarter.

A - Daniel Warmenhoven

Shelby, we had actually forecast sometime ago that Asia-Pac would outgrow the rest of the world and they really struggled during Q2, so they kind of rebounded in Q3 was the way I viewed it. I expect to see the fastest growing region still be Asia-Pac, next several years, and probably Europe in second place. I would expect to see a few points of our mix shift towards Asia-Pac from the U.S. I should point out that the currency issues in Europe created interesting challenges, especially as compares year-over-year. As Steve mentioned in his remarks, that basically, that took three points off our growth rate on a year-over-year comparison. Without the currency issues, we would have been at 33% year-over-year. I'll give you just a pattern on Europe in the mix for those of you who are wondering why it was up. If you look at fiscal, or Q3 '04, fiscal year '04, Europe was 34%. Q3 fiscal year '05, Europe was at 34%, and this year they are at 33%. So they always have those Q3 spike. It would have been higher, as I said, if it wouldn't have been for the currency.

Operator

Sir, our next question is from the line of Kevin Hunt with Thomas Weisel Partners.

Q - Kevin Hunt

Thanks. I think I missed when you said earlier, did you say what the net cash number was for the quarter?

A - Daniel Warmenhoven

Yes, it was about 3% of revenue.

Q - Kevin Hunt

Okay, thanks, guys.

Operator

Operator Instructions Sir, our next question is from the line of Clay Sumner.

Q - Clay Sumner

Thanks. You know, now that you guys are going, when you launch the new DX operating system, you'll have two OS's to, I assume so, but can you just confirm its a full family of other add-ons software products will be fully compatible with both OSs?

A - Daniel Warmenhoven

No, not initially especially. As GX comes to market as a subset of the total ONTAP capabilities, it would be adding additional features to it over time. Over a period of a couple years. The interoperability will be preserved, but it will actually be different code, you know what I mean?

Operator

And, sir, our next question is from the line of Kaushik Roy.

Q - Kaushik Roy

Can you comment, what are your expectations from IBM this quarter? Could it be 4, 5% or 6, 7%?

A - Daniel Warmenhoven

I doubt it. 1% last quarter. I don't think we should model more than 2, certainly and probably 1.5 might be more appropriate.

Operator

And, sir, our next question is from the line of Shebly Seyrah.

Q - Shebly Seyrafi

Yes, your product sales were quite strong this quarter, up 12% sequentially, yet Hewlett Packard arrested also reported this evening and their storage results were down 9% sequentially. So did you notice an easier time winning against them and separately, they are supposed to have an iSCSI announcement next week. Do you think that will change the playing field?

A - Daniel Warmenhoven

No. I think we've gotten some visibility to their upcoming announcements and I would, I think that's just a mid life kicker. I didn't attach any particular significance to what I saw. No, I don't think it will impact the iSCSI field at all. We actually did not see a change in competition or a change in win rate with Hewlett Packard arrested, although I must say we cannot track that very well through the channels, so there may have been, we really saw the increase in engagements with the MC and I think that was largely at our initiative. We're really going after them, as Tom said in the enterprise. HP was flat in that mix.

A - Tom Mendoza

The overriding themes I would leave you with is that many customers are now concluding that they should have two storage vendors. There's a large number in the enterprise that have relied on one and we would come in the logical second, similar architecture and you can decide which does it better, but if you're looking for a true different company that's innovating, most people have concluded that we're the other innovator and we are getting that shot. Over the last year, I would say it's been building and building and building, but over the last two quarters, it's been very obvious. The number engagements and size of the engagements have increased dramatically. That's another reason for the professional services piece. If you get larger opportunities, you got to be prepared to meet a certain need. That's exciting. This is where we've been heading for a long time. The last thing I would say is the unified storage message and the ability to enhance their infrastructure in different way with things like our D filer, and then when you combined with the ability to not only consolidate information, but cover that information, but secure it with Decru, the whole message is resonating very well with the large accounts.

Operator

Sir, your next question is from the line of Daniel Renouard.

Q - Daniel Renouard

Hi, just a housekeeping question. Can you give us a rough sense of what the option, stock option expense would be for the April quarter?

A - Daniel Warmenhoven

There won't be any in the April quarter.

A - Steve Gomo

Yes, we don't, this is Steve Gomo here. We don't start reporting, we don't implement FAS 123R until our first quarter.

A - Daniel Warmenhoven

Fiscal quarter.

A - Steve Gomo

First fiscal quarter, so we continue to footnote it in our Q and K.

A - Daniel Warmenhoven

And Steve's going have a section in his presentation at the analyst meeting to cover what the forecast is on options expensing.

Operator

And, sir, our next question is from the line of Aaron Rakers.

Q - Aaron Rakers

Yes, thanks, guys. I guess kind of along those same lines, you guys continue to make some meaningful investments in terms of head count. Maybe you can talk about the environment you're seeing in terms of making those hires. Is it becoming increasingly challenging for you on a hiring front, and then maybe on the same lines, if you can talk about maybe it's a little bit early, but maybe talk about Steve, what your approach is in terms of options expensing, in terms of possibly seeing that decline at some point going forward.

A - Daniel Warmenhoven

This is Dan. On the hiring, we haven't seen any significant change in profile this. Past quarter obviously we were again included in the, as Number 27 on the Fortune List of the Top 100 Great Places to Work. We've got a lot of assets that attract very talented people and we've had no difficulty whatsoever with finding and having the right people join us. And it shows in the numbers, so we've been able to, I think, keep very, very high quality level as we go about hiring several hundred people a quarter. What was the second question? The question on option expensing, I would like to table that whole thing until March 14th so we can treat it in its entirety.

Operator

And, sir, our next question is from the line of Glenn Hanus.

Q - Glenn Hanus

Just a follow-up on the increase in low margin storage. Are we going to continue to see that become an increasing portion and how should we think about how that translates to product margin, possible product margin declines, sort of sequentially over the next year or so.

A - Daniel Warmenhoven

I'm not sure we have enough of a, a vision to be able to give you any guidance on that one. I think it's going to fluctuate in the mix a fair amount. We saw in this quarter that a lot of customers chose to just buy add-on shelves. My guess is that does not recur next quarter, but our product architecture is moving to the point where our systems can grow than incredibly large. You'll notice even on the R 200 when we brought that out, it's configurable from 8 terra bytes, to 96 terra bytes in increments of 8 terra byte, 8 terra bytes is a shelf, so customers start small and add-on I think you're going to see that trend continue and we're going to encourage our customers to buy what they need and then buy the expansion later because it's probably going to be at a lower price as the rate, drive prices come down. So it's hard to predict how all those things are going to fluctuate in the mix. We've seen it trend up maybe a point every, every other quarter or so, half a point a quarter in the mix. This time it surged a little bit. My guess is goes back down. I don't think it's going to be material. If you think about it, it's about 2 to 4/10 of a point of gross margin was the result of the, gross margin decline quarter- over-quarter sequentially, was the result of the increase in the stand-alone storage.

Operator

And with that, ladies and gentlemen, this concludes the question and answer session of today's program. I will now turn the call back over to Daniel Warmenhoven for any closing remarks.

Daniel Warmenhoven, Chief Executive Officer

Thank you all for joining us today. Again, we want to remind that we're looking forward to seeing you at our analyst day on March 14, in San Francisco and also on sharing our Q4 results with you on May 24th. So, again, thank you all for your interest and look forward to seeing you on March 14th. Take care.

Operator

Ladies and gentlemen, we thank you for your participation in today's conference. This concludes your presentation and you may now disconnect.

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