NetApp, Inc.
Q3 2007 Earnings Call Transcript

Published: 15 Feb 2007

[Operator:]

Good day, ladies and gentlemen, and welcome to the Network Appliance Third Quarter 2007 Earnings Call. My name is Jeremy and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session toward the end of the conference. (Operator Instructions). I would now like to turn the call over to Ms. Tara Dhillon, Senior Director of Investor Relations. Please proceed, ma'am.

[Tara Dhillon:]

Good afternoon, everyone. Thank you for joining us today. Our conference call is being webcast live and will be available for replay on our website at www.netapp.com, along with the earnings release, the financial tables, and the reconciliation between GAAP and non-GAAP numbers. In the course of today's call, we will make forward-looking statements and projections that involve risks and uncertainties, including statements regarding our expectations for operating results for fiscal Q4 and FY '07, our stock repurchases, the decrease in our effective tax rate, hiring goal, our intentions to pay down our debt, the success of emerging businesses, the impact of our Topio acquisition and the growth of our partner ecosystem. Actual results may differ materially from our statements or projections. Important factors that could cause the actual results to differ include, but are not limited to, changes in customer demand for products and services, increased competition, a decline in general economic conditions and foreign currency exchange rate fluctuations. Other equally important factors that could cause the actual results to differ from those in the forward-looking statements are detailed in the Risk Factor section of our 10-K and 10-Q report on file with the SEC and accessible through our website, all of which are incorporated by reference into today's discussion. We disclaim any obligation to update information contained in these forward-looking statements, whether as a result of new information, future events or otherwise. With me on the call toady are Dan Warmenhoven, CEO; our President, Tom Mendoza; Steve Gomo, our CFO; and Tom Georgens, our EVP of Product Operation. Steve will review this quarter's financials and discuss our financial outlook for the fourth quarter, and then Dan will share his thoughts before we wind up with everyone here for Q&A. Steve?

[Steve Gomo:]

Thanks, Tara. Good afternoon, everyone. As you can see from our revenue growth rate, NetApp had a tremendous quarter. The demand for products and solutions was extremely strong. To put in perspective, if you look at the combination of our Q3 revenue and deferred revenue growth, you would find that it grew just over 43% compared to Q3 last year, giving you a sense for the true strength of our business. During the quarter, given the strength of the business combined with the market opportunity we saw, we took the initiative to increase investments to fuel additional growth. As a result, this quarter market returned to our target operating profit model range of 15.8% to 16.4%. At the same time, we generated a record amount of cash from operations. I will discuss that shortly. As I walk through the details of our results, please note that all numbers comply with GAAP, unless stated otherwise. Total revenue for the third quarter was $729.3 million, up 36% compared to Q3 last year, and up almost 12% sequentially. Foreign currency effect added about half a percentage point to this quarter's sequential result and 3 percentage points on a year-over-year basis. Revenue from IBM accounted for almost 6% of total revenue driven by the strength of their fiscal year-end. Due to the seasonality of the business, we expect our contribution to pull back in our fiscal Q4, but still end the year between 3% and 4% of our full fiscal year revenue. Decru contributed a little over 1% of total revenue, bringing our expectation through their contribution to total revenue to a little under 2% for the full year. Revenue from net cash was just under 2%, down 33% sequentially and down 26% year-over-year. The combination of product revenue and software subscription revenue was $635.9 million, growing 34% year-over-year and almost 13% sequentially. Add-on software and software subscription accounted for 37% of total revenue this quarter. This is a combination of Add-on software products that were about 25% of total revenue, and software subscriptions, which were about 12% of the total revenue. Revenue from services which includes hardware support, installation, professional services and educational services was 13% of total revenue, up 5% sequentially and up 49% over Q3 of last year. Service maintenance contracts increased 6% sequentially and 48% year-over-year. Professional services grew 1% sequentially and 60% year-over-year. Non-GAAP gross margins were 62.0% this quarter. The combined product and software subscription, non-GAAP gross margin was 67.2%, down slightly from last quarter, but still reflecting the impact of the strong software component in our business this quarter. In operations, we experienced the benefit of favorable volume, which in turn drove favorable manufacturing variances. Non-GAAP service margins decreased to 26.5%. As we discussed last quarter, we plan to increase our rate of hiring in services in the second half. In fact, our hiring ramp accelerated as the quarter progressed due to the level of enterprise demand we saw. In addition, we increased our discretionary expenditures and field service enablement including training, process development and system to prepare for the demand that our service and support businesses will experience in the future. You should expect service margins to return to about 30% in the fourth quarter. Turning to non-GAAP expenses. Our operating expenses totaled $334 million or 45.8% of revenue. Expenses increased 15% sequentially and 40% year-over-year as we adjusted our investments, spending and hiring upward during the quarter in response to the strong current demand and future opportunities that we saw. With the focus on expanding sales capacity, about three quarters of the sequential increase in operating expenses went into sales, marketing and global support. For the company, total headcount increased by 516 people and in the quarter with 6,148 employees. To-date in FY '07 a total of 1,172 people have been added and we expect to add about 400 more people in the fourth quarter. Third quarter operating expenses also include the impact of Topio, which closed on December 7. GAAP operating expenses include the effect of prior merger-related costs like intangible amortization and acquisitions, as well as the effect of FAS 123R. GAAP OpEx returned to more normal levels after benefiting last quarter from the one-time gains related to the sale of our net cash assets. About $117.8 million non-GAAP income from operations finished at 16.2% of revenue, returning to our targeted range. Removing the impact of Topio, non-GAAP operating profit would have been 16.3%. Non-GAAP other income, which consists primarily of interest income, was $15.3 million. Non-GAAP income before taxes for the quarter was $133.1 million or 18% of revenue. Our effective non-GAAP tax rate decreased in the third quarter and also included the cumulative adjustment to reduce our full-year FY '07 tax rate to 17.5%. This reduction resulted from Congress's passage of the extension for R&D tax credit within the quarter. Therefore, our current quarter's non-GAAP tax rate is artificially low at 16.6% to catch up with the previous FY '07 quarters. We expect our tax rate to remain at 17.5% for the foreseeable future. Non-GAAP net income totaled to $111.1 million or $0.29 per share. GAAP net income totaled $66.5 million or $0.17 per share. Please refer to the table provided in our press release and on our website to see the reconciling items between GAAP and non-GAAP. Cash generation was another highlight this quarter. Our cash generated from operations set another record at $250.3 million this quarter, up 78% over Q3 of last year. Free cash flow, that is cash from operations less capital purchases, totaled $213.9 million this quarter, growing 99% over Q3 last year and up 15% sequentially. Turning to the balance sheet, cash and investments totaled $1.3 billion, a decrease of about $84 million from Q2. We repurchased about 6.2 million shares of outstanding common stock at an average price of $39.22 per share to a total cash outlay of $241 million. In the fourth quarter, our plan is to repurchase roughly another $200 million worth of stock. Our net cash outlay related to the Topio acquisition was $131.2 million. Cash and investments exclude $180.2 million of restricted cash associated with our foreign cash repatriation last year. The debt on our balance sheet related to the repatriation is currently $151 million. We paid down approximately $42 million of this debt during the third quarter and we expect to pay off the remaining balance within 12 to 18 months. Accounts receivables days sales outstanding were 55 days compared to 56 days recorded last quarter. Inventory turns increased to 18.2 times this quarter. Total deferred revenue increased $126.3 million this quarter to $944.9 million, a 15% sequential increase and up 59% year-over-year. As mentioned earlier, this is another impressive indicator of the strength of our business. Now, before I turn the call over to Dan for his comments, I'll discuss our target operating model for the fourth quarter and revised expectations for the full year. Our outlook is based on current business expectations and current market conditions and reflects our non-GAAP presentation. We are making forward-looking statements and projections that involve risk and uncertainty. Actual results may differ from our statements or projections. We expect Q4 '07 sequential revenue growth to be in the range of 8% to 10% over the third quarter, which translates to about 32% to 34% year-over-year growth rate. This takes into account the reduction and contributions from IBM and net cash in the fourth quarter. We expect non-GAAP operating margins to remain in our target range at 15.8% to 16.4%, resulting in fourth quarter non-GAAP earnings of approximately $0.30 per share. GAAP earnings are expected to be $0.19 to $0.20 per share. We expect our diluted share count to decrease by about 0.5 million shares in the fourth quarter depending on the stock price. Our expectations for the fourth quarter translate into FY '07 revenue growth of 35% to 36% over FY '06. Non-GAAP earnings per share are expected to be approximately $1.11 to $1.12 per share. Our forecasted GAAP EPS is estimated to be around $0.73 per share based on top of the information we have and the assumptions that we make today. Now at this point, I'll turn the call over to Dan for his update.

[Dan Warmenhoven:]

Thank you, Steve, and good afternoon, everyone. As our revenue growth this quarter clearly demonstrates, Network Appliance continues to grow significantly faster than the markets we serve. As our level of investments spending also indicates, we believe a great opportunity exists for us to capture additional market share in the future. Let's walk through some of the quarter's highlight. Our enterprise storage systems had a stellar quarter, growing rapidly on all major axis. But the most fundamental level, our petabyte shipped increased 40% sequentially that is 40% from last quarter to a record 104 petabyte. ATA drives accounted for 55% of our total petabytes shipped and Fibre Channel petabytes were also up a healthy 30% sequentially to 45% of the total shipped. This increase in ATA drives correlates with the strong increase in data protection and replication software revenue this quarter, which was up almost 20% sequentially. Total storage systems shipped increased 23% sequentially, the strength across the entire product line. Our high-end FAS6000 series increased over 50% from Q2. The mid-range FAS3000s were up almost 20% and our [historic] low-end 200 series was up a remarkable 31% in total units shipped this quarter. The new FAS3070 is off to a good start, showing particular strength in mid-range SAN deployments. The number of systems shifted out just returned to more normal levels this quarter. The SAN competitors for new FAS3070 along with the strength of our high-end 6070 SAN configured systems attributed to a healthy increase in the block-based protocols component of our business. This quarter, block-based protocols were included 41% of our storage business. Within this, 33% of our business had a fibre channel SAN component, 18% included iSCSI, which is increasingly being referred to in the industry as IP SAN and there were 9 percentage points of overlap for both fibre channel SAN and IP SAN were included on the purchase order. Revenue from our application management software family with products like SnapManager for Oracle, SnapManager for Exchange and SQL Server was up 20% sequentially, indicating their primary storage business is also growing at a very strong cliff. Customers are increasingly seeing the value from our overall data management capabilities driving increase in software tax rates. The performance and feature sets of the 6070 and 3070 also stimulate additional sales with Data ONTAP GX clusters. Our largest GX customer this quarter is going into production with the 20-node system. We are seeing purchases from our targeted high-performance computing environments, particularly in technology and graphics rendering. We've also got big customers in oil and gas base and potential customers from financial services, telecom and Internet verticals, which are currently evaluating this leading edge technology. Results from our emerging business were mixed this quarter. The Virtual Tape Library business is demonstrating very healthy growth, particularly in Europe. Unit shipped were up over 80% albeit of a relatively small base. Business has gained traction setting into a different part of the enterprise, which is really helping us to expand our footprint and we only have to penetrate new segments over the long run. We saw smaller contribution in this quarter for encryption products despite win rates have remained consistently high. Encryption business continues to be very lumpy, characterized by big deals, and we saw a several large deals delayed past the end of the quarter. We continue to be very pleased with our overall progress, as reflecting the fact that to-date over half of our top enterprise accounts have purchased our encryption products, demonstrating initial success of expanding our enterprise footprint well beyond storage. But these series had additional success for quarter to-date, aided by a new highly focused team. Our sales reps are getting more proficient selling the value proposition into competitive strongholds. One of these series controller placed in front of a competitive storage array provides customers with all the data ONTAP manageability and functionality on their legacy system. By penetrating heterogeneous environment to this way, we got it foot in the door, the accounts where we previously had little leverage followed by the opportunity in growing those accounts, as customers get a sense for how much more they can accomplish with Network Appliance. Number of reps actually selling these series is still small today; but you should expect to see a consorted effort to increase this very effective penetration through over the next year and a commensurate increase in our penetration to competitors' accounts. Our acquisition Topio in December will also help us to expand heterogeneously. Topio software allows customers to mirror any incumbent primary storage to NetApp storage. You get all the data management benefits that come with an NetApp functionality. At the same time, they can reduce the amount of storage required to support your infrastructure. Based on our small and medium business, overall products have been very slow. We have received some very positive external reviews on the product, including a Small Business Computing Excellence Award for the best storage product. We've made good progress in our VAR recruitment and will be supporting and watching this business closely as its sales bandwidth increases. This quarter, the bulk of the revenue from net cash came in the form of deferred revenue, but we also had some customers extend their service contracts, resulting in slightly higher than expected revenue from this legacy business. At a little under 2% of total revenue, it's still down 33% from last year and we will continue to decline, as future revenue will consist almost entirely of deferred revenue coming off the balance sheet related to the support of existing net cash service contract. Our indirect channel was up over 13% sequentially, again accounting for 60% of revenue. Contributions from Arrow and Ad-net was down slightly after a record second quarter, generating a little under 11% of total revenue. And as Steve mentioned, IBM more than offset that decline with a surge consistent with their fiscal fourth quarter. We're very happy with the progress of our IBM relationship. But they do have a seasonally lighter first quarter. So, we are forecasting that their contribution will return to about 3% of our business in our fourth fiscal quarter. Our partner ecosystem is one of the keys to our growth and our team continues to cultivate strong relationships with the major application vendors. This quarter the joint Microsoft exchange road shows got under way and it was a particularly strong lead generation machine for Network Appliance. We were recently certified for Oracle Enterprise Linux, and joint development continues on our upcoming SnapManager for SAP products. Geographically, just under 54% of total revenue came from the Americas. As we mentioned previously, the Federal sector is very cyclical. Historically, we have seen seasonal strength in Federal in our fiscal second and fourth quarters, but a pull back in our first and third. Correspondingly, the Fed contributed 9% of total revenue, down from 13% last quarter, which has reflected on a roughly flat Americas [geo] performance and in the somewhat lower contribution from our aero distribution partner. EMEA had a tremendous quarter, contributing 35% of total revenue and Asia-Pac grew to 11.5% of total revenue. In summary, we believe network appliance has its strongest arsenal ever of highly competitive solutions, and we are becoming more and more effective at selling them. We are also investing the increase to avenues through which we sell because we tremendous opportunity to capture additional market share ahead of us. The hiring we did last year is contributing to today's success, and the hiring we are doing today will help to fuel our future growth. To wrap up, I would like to emphasize how proud I am of the consistent efforts from the entire Network Appliance team, who collaborate so well together to create value for our customers and to drive hard for our success. I encourage the investment community to register for our upcoming Analyst Day to learn more NetApp and our plans for future growth. It will be held in New York City on the 13th March. Please contact either Tara or Billy in Investor Relations for additional information. At this point, I'll open the floor to questions. I request that you limit yourself to one and if you have a second to return to the queue, so we may address everyone in the allotted of time. Jeremy, will you now open the floor for questions?

[Operator:]

(Operator Instructions). And your first question is from the line of Richard Farmer with Merrill Lynch. Please proceed.

[Richard Farmer:]

Thank you. I would like to ask a question about the services margins and the factors that are affecting your margins more generally. If you look at your results, at least relative to our model, all of the revenue upside was in product. Services were a little bit light, at least relative to our model. It would seem to imply maybe some price impact in the services margins. Is that a fair read or is all of the services margin pressure from the hiring and the cost impact? And then, just more generally would you mind just clarifying your comments on the other factors? I think you said mix was less favorable with less [hedge] than last quarter, is that right? And how is pricing as an effect in the products as well?

[Steve Gomo:]

Okay, that's one long question. All right, Steve Gomo here. The biggest factor in the service margin was the fact that we added more people than we had originally planned, as I mentioned. And by far the most important thing, was the number of discretionary investments that we made. I talked about the service field enablement. So, we are building a lot of processes and systems, particularly around the professional services organization, it's going to serve us well into the future, but we are incurring a lot of those costs now. As far as the revenue line is concerned on services, if you look at the growth of professional services that has been growing around 70%, year-over -year 75%. This quarter you will note, it grew 60%. It was a little light relative to prior quarters. What happened there is, in our growing professional services business, we are seeing larger statements of work, larger projects if you will, they take a little longer to complete. So, we didn't complete them in this quarter. We don't recognize the revenue.

[Richard Farmer:]

But you don't particularly see price pressure in services contract?

[Steve Gomo:]

No. The services revenue line to the extent is the support contracts, that's coming off the balance sheet. That's business has been booked years ago.

[Dan Warmenhoven:]

You are right. In the professional services side, we are not seeing any particular price pressures whatsoever.

[Steve Gomo:]

In professional services, we are not seeing right now.

[Richard Farmer:]

Okay. Thank you.

[Steve Gomo:]

You are welcome.

[Dan Warmenhoven:]

The question on the upgrades. Last quarter we had an unusually high amount of control only upgrades that were sold basically as diskless system through upgrade systems in the field. That was non-recurring. Those carry a very high margin because in our particular mix, the disks have lower gross margin than do the controllers which carry all of the software.

[Operator:]

And your next question comes from the line of Keith Bachman with Banc of America. Please proceed.

[Keith Bachman:]

Hi guys. Steve I think this is for you. Just talk a little bit about the deferred revenue. I think you've highlighted some of it on the past question but it was up fairly substantially this quarter relative to certainly our expectations in past quarters. What was the key driver there? I think some of it was certainly the support side of those contracts you just mentioned. But if you could add some color to that, and with all that deferred revenue and cash, I know you identified how the buyback was going to go this quarter. But how should we be thinking about all that cash that's sitting on the balance sheet on a longer-term basis? Thanks.

[Steve Gomo:]

Okay. So, the elements that are deferred at Network Appliance are both the service contracts and the software subscription. And we've actually seen an increasing ratio in terms of our total mix of business in both of those categories. You will note that over the past eight quarters, if you go back and you look at the transcripts of the information we provided you, look at the increase in software subscriptions as a percent of revenue. Now that's historical and that's coming off the balance sheet. But nonetheless it shows that that's been growing and today both software subscription and service contracts are growing slightly faster than the rest of our business. And you see that in a variety of instances if you look at the revenue information correctly. The second part of the question was -- Keith Bachman - Banc of America. With all that cash?

[Steve Gomo:]

What we are going to do with all that cash? So, basically, we look at our cash, we have cash that is domestic and cash that is international, and you typically can't mix those two things. Basically, what we do is we first make sure that we have enough cash to run the business. Then we make sure that we have enough strategic reserve to give us the flexibility. If we see something out there that can help us fill a gap or whatever the case from an M&A standpoint. And finally, if there is excess cash above and beyond those two categories, that's the cash that we use for the buyback of stock. And that's how we think about it. Next question.

[Operator:]

Your next question is from the line of Harry Blount with Lehman Brothers.

[Harry Blount:]

Hi, guys. You guys obviously continue to put up good top-line growth rates. The question really relates to the sustainability of that as we look forward here essentially as I look at the network storage piece of the business. It looks like that gradually will slow a little bit, which suggests you will need to continue to take share may be at a higher rate going forward. Obviously, you're coming up against the bigger base. I would like you to comment, if you will, on terms of the sustainability of top-line growth rates that have at least 30% type number?

[Dan Warmenhoven:]

Hello Harry this is Dan. We have obviously provided guidance for Q4, so in a near term some of the growth rates were up in the 30s. For anything beyond that you will have to come to the Analyst Day on March 13th, where we will provide you with guidance for our next fiscal year.

[Harry Blount:]

All right. Any other factors that you would point to that are more qualitative that you can help us with there as we look at things like the encryption and Topio, etcetera, in terms of what you think addressable opportunities are?

[Dan Warmenhoven:]

If you really look at the market [TAM] in storage and by TAM I mean everything thrown in. Everything south of the server including services and others. It's in the order of about $75 billion. So, we think we've got a lot of opportunities as we pick up adjacent segments to continue to grow at a very healthy rate. For quantification, that's going to have to wait for about a month.

[Harry Blount:]

Fair enough. Thanks.

[Operator:]

Your next question comes from the line of Laura Conigliaro with Goldman Sachs.

[Laura Conigliaro:]

Hi, to what extent have you actually changed your hiring policy and are now hiring, let's say, more in advanced than you had been, so setting yourselves up for more extended period of higher future growth. And to what extent was some of that at least reflected in this quarter's numbers?

[Dan Warmenhoven:]

Hello, this is Dan. We actually did a catch-up this quarter. We've put in some more professional services heads than we had originally forecasted at the beginning of the year. Well, this was really catch-up. Last quarter we felt as though we fell behind. If you recall beginning of the year we said we wanted to hire about 100 a month or 300 a quarter. I think we were behind by 100 as we exited the first half. And we just really did a catch-up. Was there a second part to that?

[Laura Conigliaro:]

It was really more of that. Even on a go forward basis, are you now hiring more in advance than you had been? You seemed to have been hiring really for the next quarter. You are now putting people in place, let's say, for your new fiscal year such that you can really get them trained and on the ground running?

[Dan Warmenhoven:]

No, although we did that more last year in fiscal Q4 then we are planning for this year. This was a much more linear progression as we go through the year. Our forecast for hiring this quarter is somewhere in the range of about 400 people. So, anyhow there will be a sizeable percentage of those that goes into sales. But it's not going to be disproportionately weighted in that regard at all. So, now this is more of just an ongoing continuation of execution of the plan that has been in place.

[Steve Gomo:]

Yes, Laura I will just add on top of Dan's comment. I don't think there has been any philosophical change here. We have always been trying to balance current quarter needs and future needs also. Professional services is something that typically doesn't pay off for us for two to three quarters out type of thing. Sales reps, depending on how much experience they have, they can come up to the speed anywhere in four months to nine months depending first on the person, they are given, etcetera. So, I don't think you are seeing any change at all in terms of our philosophy about whether we are investing for the current quarter or the future quarters.

[Operator:]

And your next question comes from the line of Ben Reitzes of UBS.

[Ben Reitzes:]

Yeah. Good afternoon. Along the lines on some of these costs, when I look at the model, the bottom line is blowout revenue, but your SG&A was up with it. And I know you've talked about hiring and what not as being one of the factors in there. It seems like SG&A would be the reason that you don't let the upside flow through to the next quarter. And can you just clarify and then can you just talk about on the SG&A side, just I guess or even more detail, just in terms how we should think of that line because it's quite impressive revenue. I'd love to flow it through. I am just wondering what you are thinking as in holding it back, I assume with that line?

[Dan Warmenhoven:]

This is Dan.

[Ben Reitzes:]

Yeah.

[Dan Warmenhoven:]

You shouldn't assume anything is going to flow through. I have been, I think, incredibly consistent to the point of being boring that we think our optimum range to maximize growth in revenues and EPS is only running in our operating income level between 15.8 and 16.4. That SG&A line expansion is really reflected in sales expansion, sales capacity. It's investing not only in people, but channel programs etcetera and channel marketing etcetera to really drive our sales performance in the future. You should not be disappointed. I have told you in the past and I said it last quarter, we were disappointed last quarter when we got the 18-point something that we lost an opportunity to invest in our future growth. And I tried to make it just as clear as I possibly could that this quarter we are going to back in that target operating model, and we are. As revenue growth takes place in the future, you will see it proportionally flow to the bottom line. But last quarter was the one where the big surprise occurred, where we didn't spend enough. And we corrected that situation this quarter.

[Ben Reitzes:]

Got it. With the revenue upside you are seeing, I was wondering if you thought maybe though you are being conservative with the $0.30 and your assumptions even for that -- any assumptions for that, but that is my try. Thanks a lot, Dan.

[Dan Warmenhoven:]

Good comment.

[Operator:]

Your next question comes from the line of Kathy Huberty with Morgan Stanley.

[Kathy Huberty:]

Good afternoon guys. Just quickly on geo mix. Is the improvement in the EMEA growth rate macro related or do you feel like you are gaining traction in that region?

[Dan Warmenhoven:]

Europe had a particularly strong quarter, but if you look historically, they surge every Q3 in the mix. I think last year, as a matter of fact, they were right at 35%. And then, you will see them drop off in Q4. I get this series of questions every year. What happened to Americas in Q3, why was Europe so strong? And then I will get it in the inverse next quarter, the Americas were blow it out and Europe was flatten off.

[Tom Mendoza:]

To complement that -- this is Tom. This is very, very clear. Our European team is executing at extremely high level. Germany and UK have been a powerhouse for a while, for a long time actually. And they are really executing at superb levels, taking both enterprise business. Their channel business is extremely strong. On top of that though, our French organization has responded extremely well. We had new leadership come in about nine months ago and has executed tremendously well. Italy has taken off our emerging markets business which we invested in a year ago is actually done very, very well.

[Dan Warmenhoven:]

One of our higher market share is I think, in Ethiopia.

[Steve Gomo:]

That wasn't one I was going to comment on. But we actually have built a very big business in a number of places you wouldn't expect. Nigeria has been very big with the oil and banks. Israel continues to be a shining star. But the fact of the matter is, if the top two keep going at such a great level and the other guys all kicking above goal, which they did, that makes a big impact. So, I don't think it's macro for everybody else. I think it's execution on our side.

[Kathy Huberty:]

Great. Thanks.

[Operator:]

Your next question comes from the line of Bill Shope with J.P. Morgan. Please proceed.

[Bill Shope:]

Okay great, thanks. Can you give us a read on the linearity of the quarter? Was it similar to prior years or is IBM starting to throw it off a bit?

[Dan Warmenhoven:]

No Bill, it was very similar to prior years. Our pattern through the fourth quarter is a very strong November, December and then the things goes slack in the early part of January because lot of customers just don't have a budgets to put together. And then it picks up again in the last couple of weeks. And that's exactly we saw this quarter. It didn't move materially. IBM did surge obviously at the end of their fiscal year, but it wasn't so much significantly to alter the distributions through the quarter

[Bill Shope:]

Okay, thanks.

[Operator:]

And your next question is from the line of Paul Mansky with Citigroup.

[Paul Mansky:]

Great, thank you. You touched on it a little bit a moment or two ago, but I wondered you may be go in a little bit more detail as we look forward to that Q1 guidance. Are you indeed expecting a resurgence in business tier domestically versus international markets? And how is the Federal vertical shaping up thus far in the quarter?

[Dan Warmenhoven:]

You mean, Q4, I hope. You said Q1.

[Paul Mansky:]

Oh, excuse me, sorry. The calendar I think, sorry.

[Dan Warmenhoven:]

That’s all right. I thought that's what you meant. The upcoming quarter my guess is you will see American surge again. The US always comes on really strong in our fiscal Q4. Europe will probably flatten off and therefore decline in a percentage sense. And Federal normally has a really good finish to the fiscal year. For some reason the Fed buying pattern obviously is associated with the end of the year, September. Right, that's the end of the Federal fiscal year. That's why our fiscal Q2, you see the big surge in Federal spending. But we see another one in our Q4. Something about the March-April period in particular the Feds unleashed a lot of money. So, we think the Federal government business is coming back stronger mix than was this quarter.

[Paul Mansky:]

Great. And Steve on the software mix, I know that we targeted 35% as the sustainable level historically, obviously we've been pushing north of that here for the past few quarters, should we be thinking about a recalibration upward from here?

[Steve Gomo:]

No, I wouldn't at this point. I would still encourage you to use around 35%. We're looking at that. There will be fluctuations around that number and I'll give you an update on that at the analyst day in a month.

[Dan Warmenhoven:]

Almost all of that increases -- the two points that come from software subscription. The basic percent of revenue each quarter coming from new licenses has held pretty constant.

[Paul Mansky:]

Right. Thank you.

[Operator:]

The next question is from the line of Dan Renouard of Robert Baird.

[Dan Renouard:]

Hi, thanks. My question is on the security mark. And just backing up, obviously Decru is pretty lumpy. But if you just backup EMC RSA closed and a lot more noise around the security market. Has that acquisition in anyway validated the market for you? And have you seen kind of your pipeline or level of engagement increase in the last three to six months as a result of EMC RSA? Thanks.

[Steve Gomo:]

Actually, yes, it has. In fact, I believe RSA will turn out to be a great partner for us. Our solutions are fairly complementary. It may seem a little strange to have EMC and NetApp partnered, but this is one area where partnering actually makes a lot of sense. The Decru market this quarter I think -- the pipeline is actually pretty good, but the issue has been the expectation in not too distant future a number of vendors will have LTO-4 tape drives and embedded encryption. Customers would help purchases until they can evaluate the various alternatives of which that is one. So instead of committing a particular architectural solution they are waiting until they can make that evaluation. So, pipeline is good. We haven't lost any deals, but they are hard to close right now.

[Dan Renouard:]

Thanks.

[Operator:]

Next question is from the line of Bill Fearnley, FTN Midwest.

[Bill Fearnley:]

Yes, good afternoon. I had a question on the competitive environment and how you are seeing deal flow. To ask it another way, are you getting more chances to quote and are you seeing any changes in your win rate in either geographies or versus specific competitors? Thanks.

[Dan Warmenhoven:]

At this time, I don't think there is any doubt that we are getting quote a lot more. Let me be a little more granular. Our channel in North America has really-really performed. I mean it is close to 50% of our business. Now put that in context, we were $1 billion at 2000, it was 25%. So, as we've ascended the scale, they have ascended with us. They are investing heavily and that has really taken off the arrow and having that situation is extremely strong for us. When you look in Europe, the channel has been strong, but the thing that's often striking me is the size of the transactions that we are getting. In some cases, in a fairly rapid fashion, has grown dramatically. I've put that to leading with services. The things that have really built out the services and usually in the largest markets in the enterprise are bringing down very large transactions. It's not just number of transactions, it's the size of those transactions. The third thing I would say, we are seeing a lot of markets that previously we hadn't really paid much attention to Southeast, some parts of the Northwest, some countries I have already mentioned, are starting to really kick and start to makes an impact because of execution. I think the company is getting better recognized. I think, Dan would agree that the speaking engagements students around the world are having bigger and bigger audiences and bigger impacts and yet deal flow from those is growing. So, I think NetApp is getting branded in a lot better way. And part of that also is the partnership we do with Microsoft to be in their Technology Centers to bring a lot of people through. Oracle and NET Data Centers are getting lot of flow-through. SAP has been much more active with NetApp over last year, both in North America, and we've been strong in Europe. Our relationship with Symantec was both for shows and speaking engagements. So, I've just been traveling quite a bit as is Dan, and as I said to Rob Salmon, and as we sat and talked to each other, it is very-very clear we've increased momentum first quarter, second quarter, third quarter everywhere in the world. So, we're feeling very-very strongly that our teams are executing at a high level. We have had very low turnover. We don't talk about culture much on these calls, but being in the best places to work five years in a row is attracting a lot of people to our business and a lot of people are staying in a benign place four or five years, and now we're seeing results of that.

[Bill Fearnley:]

Excellent. Thank you.

[Operator:]

And next from the line of Chris Whitmore with Deutsche Bank.

[Chris Whitmore:]

Thanks. Good afternoon. Hoping to get some color on mix between new products and older generation products, in particular if you can provide any quantification of the contribution of the 6000 line and the 3070 in the quarter that would be great?

[Steve Gomo:]

I wouldn't consider the other ones you didn't mention at all, still pretty new. The 6000 series, I think I mentioned that in the prepared comments. It was up about 80% sequentially, and was really quite strong. Most of the growth actually was in the 6030 which is up more than a 100 units quarter-over-quarter. Primarily it is quite substantial. And the ASPs in those systems are also really quite large, the 6030s and 6070s go for somewhere around $200,000 a piece. So, when they go up by 80%, you see a significant increase in the revenue. The 3070, which is kind of half the price, whereas about 100K configuration, that in its first quarter of shipment got off to a really good start and we are really pleased with it. But in any first quarter you look at numbers like a 100 units being a lot. That’s the kind of number you would see.

[Chris Whitmore:]

How big is the 6,000 as a percentage of total revenue?

[Tom Mendoza:]

Close to 6030 to 6070.

[Chris Whitmore:]

So, historically --

[Steve Gomo:]

Historically we've had a third of third of third. The 6000 series is a little lower, because it is such a high-end system that customers are still gaining confidence. I think ultimately it'll be a third of our revenues. It's growing to that kind of revenue.

[Chris Whitmore:]

Is there anyway to provide some quantification of the GX ramp in terms of percentage of systems shipped with GX or petabytes with GX shipped? Any idea?

[Tom Georgens:]

I don’t think we have any specific quantification there. I think that we've had a number of customer testimonials about the customer valuation many of which closed with the introduction of our trail system in November. So, the GX basically has the cluster capabilities, describe thousand capability and we are seeing a lot of demand, and lot of [Evals] and lot of Evals closing. So, as quantifying it, I am not quite sure that we quantified at that particular level. But in the terms of penetration of the target market, we are definitely seeing the customer value proposition as we expected.

[Steve Gomo:]

It continues to be largely single digit number nodes but turns out to be on average well over $1 million for each single system installed. So, near very high end.

[Operator:]

And your next question from the line of Brent Bracelin with Pacific Crest Securities.

[Brent Bracelin:]

Thank you Dan, I actually had a follow-up question on kind of margins, it's clear here you are reinvesting the maximized growth and share gains. You've talked about the 16% operating margin goal here for the last kind of three years. But with IBM ramping, with the software mix increasing, the software subscriptions increasing, why can’t you expand the margins and maximize the growth rate perhaps at a higher level, given the increasing contribution from software and IBM?

[Dan Warmenhoven:]

Our goal would be to drive the growth rate even higher, and that requires even additional investment in sales capacity in particular. We think that yields the best long-term result. And also, yes, could I drop it yes, but I think we would give up the opportunity to add a couple of points at growth rate to top-line. Name another company that is in the fortune 1000 other than Google that is growing at over 30% per year?

[Brent Bracelin:]

I certainly can't, that --

[Dan Warmenhoven:]

I don’t know of one either, and I don’t know one in particular sees his growth rate increasing. I mean our growth rate went up this quarter.

[Tom Mendoza:]

And if I could, just remember that we have a couple of market opportunities, we have the mid-market that has really got a big opportunity for NetApp. That takes channel expansion, and we've been doing that aggressively. Then you go into the enterprise and you are leading with services and you are taking down big numbers. We see that if we do more of the same, we are going to take bigger deals globally. So, we are still an emerging company, I would say that has a big market opportunity. We are taking share, to Harry's earlier question saying you guys have to keep taking share; well guess what, we are only 8% of the market. We have got a lot of shares to take yet. And if we have that opportunity, we have always believed we should grab it now, get the units out there, that we can attach software to and this will all work out real well in the end.

[Steve Gomo:]

This is Steve here. If you back net cash out of the comparable period and this quarter, you would find revenues actually up about 39%, so. And if you haven't [referred] to it, what I actually think is a representation, the strength of the business. It's a bookings growth rate, right? You are up in the 40s. So, this is a model where we think we can invest to cover more markets, more segments, more verticals with more channels, and more partners and that takes investment.

[Steve Gomo:]

Right. And I think that the investments that we've made over the past year have enabled this quarter. And frankly the investments we are making now are going to be the most help in the future quarters.

[Dan Warmenhoven:]

I just reiterate. Brent, I felt bad about last quarter, because we really felt like we left the growth opportunity on the table.

[Brent Bracelin:]

That makes sense. Thank you.

[Operator:]

Your next question is from the line of Shebly Seyrafi of Caris.

[Shebly Seyrafi:]

Yes. Thank you very much. So you are clearly now investing for growth. You have great opportunities. Your revenue growth is over 30%. You are talking about capping your operating margin at 16.4%. I am wondering as we project in our models. If you think your revenue growth is going to decelerate below 30% year-to-year, do you expect to expand your operating margin target above 16.4%, maybe 17%, or 18%?

[Dan Warmenhoven:]

First of all, I am not going to comment what the future growth rates could be or speculate on it. But, we think somewhere between 25% and 35% growth rates probably to sustain that level given the size of our base business, we are going to require that level of investment going forward.

[Steve Gomo:]

I think you have to look at this, Shebly, in light of the market opportunity that we are trying to address. And, yeah, we may have a quarter where growth rates slow down a little bit or growth rates pick up. But the opportunity in front of us is absolutely astounding and we have the ability to capture that and the thing that we are missing today to capture that is sales capacity. Sales capacity in terms of salesmen, channel programs, other marketing programs we need, and building up a support infrastructure when we are going to need to be able to support those customers and that's where we are investing it. And so this investment is of course, this quarter, next quarter, it's down the road, and there is a long game to play here.

[Shebly Seyrafi:]

Okay. Thanks.

[Operator:]

And next is from the line of Glenn Hanus of Needham and Company.

[Glenn Hanus:]

Maybe just little more detail on how you are feeling about IBM from the standpoint of being incremental in the U.S. is do you feel that. I assume abroad it's pretty much all incremental for you and in the U.S., do you feel like a portion of that is coming out of other channel partners or maybe you could characterize that for me?

[Dan Warmenhoven:]

This is Dan. I really think that IBM is very much focused on what we jointly refer to as whitespace, so this is an area that we don't have to cover. An example is state and local government. We are just not there and we are really focused on it. Other example is retail. We have never targeted retail as a target vertical and if you'll notice the growth in the low-end systems this quarter, is was largely associated with purchases by retailers, store-based systems in particular. Somehow, I think it's largely incremental. They have done an excellent job of trying to manage the conflict by focusing on areas where we are not, and I think that's true around the globe.

[Glenn Hanus:]

And if I sneak one more in, what really surprised you guys on the upside this quarter from a product or geo standpoint. I mean a lot of good statistics you have provided. Can you summarize it into one or two, or is it really just across the board?

[Dan Warmenhoven:]

Glenn, it was across the board. I will give a couple and Tom will give you a couple as well. I was surprised that we crossed over the 100 petabyte mark and that we saw sequential growth in storage of 40% from Q2. And that was really driven by a large number of customer projects and deployments associated with secondary storage. That is, stuff that's not in production. It's there for data replication, protection et cetera and largely is an alternative to save some for business continuity et cetera. But the asymmetric mirroring where we can mirror from a NetApp primary to any fiber channel drives to an ATA base system is a very attractive price solution. So yeah, lot of demand for secondary storage it was really high in the mix. And large deal size. Tom?

[Tom Mendoza:]

Specific deal that came in that was very, very large. It wasn't even forecasted. It wasn't forecasted because it was a take out of a major competitor. It seem like they had every advantage in the world, and I happen to visit with that customer about a year ago and they basically said how would you do this? And they told us I was architect, so we could do this with fax machines if you don't want us to think. But, perhaps we could come in and look at your business and come back if you use NetApp's the best way as possible, you would be at advantage. This is how we won many, many big deals. All the net of it was ended up using iSCSI and fiber channel and eventually some of that took 30% out of their equation, handed us a very, very large order and the guy told me he was surprised we won. We were like one of those add-on RFPs. And I'm seeing all over the world people now instead of saying to NetApp, beat it the way the other guy does it. They are starting to realize have a very different way of thinking about the problem and by utilizing all of the protocols the right one for the right job, mailing it over to ATA drives which are dual-rate protected, so you can take a double display without going down, which makes it so you really can use it as opposed to what other people do with ATA. And we're seeing massive footprints even on .initial implementation that happened more this quarter and last quarter I would say then we've seen before. And that's the work of leading with services, architecting it, delivering it, testing and proving it. So, we were real surprised expect with the fact that we executed almost everywhere at a very, very high level. The entire quarter looked good from right at the beginning. Wasn’t like we said; wow, what a save. It was like, boy, this is looking good.

[Steve Gomo:]

We had almost 100 deals this quarter of $1 million or more. And deal size is definitely going up.

[Glenn Hanus:]

Thank you.

[Operator:]

Your next question is from the line of Tom Curlin with RBC Capital Markets.

[Tom Curlin:]

Hey good afternoon on the VFiler on the FAS6000 series, are you seeing a higher attach rate in same environments for those two products versus the broader product set and is that by design just if you will penetration strategies in the same market and how those might play out?

[Steve Gomo:]

No, I won't say the mix is a especially strong there. I think we are seeing strength across the board. Certainly our entry in mid range products have been very strong in IP SAN, iSCSI we are certainly seeing tremendous amount of growth there. But the 6070 we are seeing across the board, we are seeing it in high performance computing, we are seeing it in survey consolidation, on the net side and we are certainly seeing it peek SAN deployment, fibre Channel and iSCSI. A lot of these big machines are also driving large what we call secondary storage for either data protection, data retention, disk-to-disk backup, archiving compliance. We're also seeing the high dry count capabilities of the 6000 driving very, very large machines with very-very large drive counts to basically leverage our replication technology and these are the solution areas. So, Dan talked about that segment of our business earlier and what we are seeing is with particularly the 6000 that has drive to scale-up to a 1000 drives per unit, that is very, very high drive count application at primary and secondary storage area, and are a big part of our growth. As far as V-Series, V-Series has been all over the map. One of the standard applications of the V-Series is just a NAS gateway and that will continue to be a significant part of our business. However, we also see V-Series as the way we introduced the NetApp value proposition or on Data ONTAP and our replication and management and total cost of ownership value. To an infrastructure, the customer has already invested in from a competitor. So it's our way of basically bringing SAN provisioning, bringing flexible clones, bringing replication, bringing the best recovery to an investment that the customer has already made. In the long run, that could stay, as purely a V-Series sale while the customer ultimately moves that over to a full system sale for Network Appliance and ultimately sweep the floor with our product.

[Tom Curlin:]

How does the support model work? For example we've heard that you have VFiler working in front of the EMC storage in some accounts. I'm sure there's some other vendors already that you have qualified as well.

[Steve Gomo:]

Well this all started with a -- [we integrated] with Hitachi sometime ago and I think that was 2002 about five years ago. And yes, we have expanded to include other systems as well. I mean our view is we ought to be able to put it in front of any vendor's equipment. The industry is changing quite a bit, right. You have got to think of this a little bit like a switch. It's between the server and the storage infrastructure that's got the disks, and with some value-added functions, very similar to the crew.

[Tom Curlin:]

Great. Do you take over the essentially the support of that or let's say it's an EMC system behind? I mean does EMC continue to offer any support for that box or do you have to, if you will, take that over for the customer?

[Steve Gomo:]

Now the agreements we have with all these vendors is interoperability, certification and mutual support. Now we are not trying to build expertise on every vendors' storage array. It's a joint support agreement.

[Tom Curlin:]

Is there an agreement with the EMC in that regard?

[Dan Warmenhoven:]

I can't comment on that one. We do have some supportive customers.

[Tom Curlin:]

Okay. Thank you.

[Operator:]

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

[Clay Sumner:]

Thanks very much and congratulations on a strong quarter. Just looking for an update on your plans for SAS-based storage. It seems that the industry has kind of underestimated the difficulty of the integration there; and just looking for an update there and may be with your plans (inaudible)?

[Steve Gomo:]

Yeah. As far as our plans there, they are no different from the last call. We've talked about our reluctance to introduce new products in Q4, so you should expect to see some activity on that front in Q1. But I would add, in Dan's prepared remarks, he talked about the strength of all of our product lines, including the FAS200. So I would share your concern that the complexity of that technology probably proved to be more than most of us anticipated. On the other hand, I don't think we're feeling any particular strain to rush that product to market any sooner than it's going to be ready. The FAS200 was very strong. We had a record shipment quarter this quarter on top of a record shipment quarter last quarter. We saw a fair amount of momentum there. So when technology is ready, we will ship it, but I don't feel like we have a high vulnerability there. We are not going to rush it.

[Dan Warmenhoven:]

I would like to underscore that one. There is no reason to think the 200 series out of the product line and inject any risk.

[Steve Gomo:]

Don't forget, a lot of these as I indicated also that's [right beyond] the retailers. And it's really hard to go and make a service call on a store. And we want to make sure that is absolutely rugged before we start pushing out into remote locations.

[Clay Sumner:]

Very well. Thank you.

[Operator:]

And your final question is a follow-up from Harry Blount.

[Harry Blount:]

Thanks. Glad to get under the wire. Dan or Tom, this is probably more of a strategic question regarding -- seems like there are some broader changes going on in the structure of the competitive for the storage business in general. Sun is openly talking about partnering with different people. HP has restructured the storage business. Dell has cut kind of an interesting deal with Microsoft; even saw some things on the Intel front. So I was wondering if perhaps you could maybe comment in terms of just a few new structures that we might likely see you guys even partnering in some ways with EMC and RSA. Some of the new structures and new competitive dynamics that we might see going forward, and how business can be won against some of these players?

[Tom Mendoza:]

Okay. My personal view on it, I really do believe and I have said this in the past that the server vendors become more channels than manufacturers. I think you'll see an increase in OEM arrangements, much like ours with IBM or some of the ones you mentioned Dell with EMC whatever. I think you will see that if you look at market shares by as manufacturer, you are really down to four market leaders that stand out right now, at least take out mainframe right because you have a different class there. But in the open system space it's EMC network appliance, Hitachi and Hewlett-Packard; and Hewlett-Packard seems to be struggling in the EVA family, which is the non-OEM portion. I believe that it continues to decline and ECM [in general] is a pretty strong player there as part of UltraLogic in the OEM base model. It's definitely going horizontal. The IDC market shares can be very misleading because it doesn't show as manufactured. You've got to make adjustments for product line. As such I think what you are going to find is the market leaders namely EMC, Hitachi and ourselves are obligated to cooperate more even though we compete and EMC is a channel for the crew. RSA is going to be a channel for the crew. And I think you will see other forms of partnering like that. Our V-Series in front of Hitachi and other vendors, I just think that's inevitable. As you concentrate all the technology, if you will, intellectual property into three or four different vendors, the customer community is going to demand that those vendors partner and cooperate.

[Steve Gomo:]

One thing if I could add Tom is that, the biggest advantage we have and hear customers tell me this all the times that we are very, very focused company. We know exactly what our business is. If you've listened to our message for years, it has not changed that much. It's flushed out, it's broader. But, the fact for that matter is, it's pretty consistent over [facts]. So, I think customer say you are the only vendors since years, you are in the same business. So, I really do think the fact that we are an extraordinarily focused company. When we do alliances, it doesn't distract us, doesn’t kind of whips to all over the place. I mean, I can -- almost everybody you named have started strategies and gone in different directions. Few years later, we wonder what happened to that strategy. We are pretty much -- I have had more customers and even our own people say the reason I like it is that you know exactly what we are going to do when we wake up in the morning. They know how we are attacking and they know the set of products we are going to push. That's easier to manage than some of competitors. So, I think that you will see us do some things, and people approach us, almost everybody wants to partner with us at this point. But, the ones that we do won't distract us and we're about growth. If we do what, can we grow faster. And we tell everybody who wants to partner, you go to speed yourself, or we are not interested. That’s -- I think that's our situation.

[Tom Mendoza:]

I think you're also going to find more emphasis on heterogeneity, multi-vendor environments, that's where the V-Series plays, that’s were those behind our Topio acquisition. And I think you will see a lot of more emphasis on interoperability going forward as well.

[Clay Sumner:]

Thanks.

[Dan Warmenhoven:]

Ladies and gentlemen before we signoff, I see no one in the queue at the moment, so -- and our time is up. I want to remind you once again about the Analyst Day in New York City, March 13th, and I look forward to seeing you all there. Thank you for joining us today. Have a wonderful Valentine's Day.

[Operator:]

Thank you for your participation in today's conference. Ladies and gentlemen, this does conclude the presentation, and you may now disconnect. Have a wonderful day.