Operator: Welcome to the NetApp Second Quarter Fiscal Year 2012 Conference Call. My name is John, and I'll be your operator for today's call. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session at the end of our conference. Please note that this conference is being recorded.
I will now turn the call over to Ms. Tara Dhillon. Ms. Dhillon, you may begin.
Tara Dhillon - VP, IR: Good afternoon, everyone. Thank you for joining us. With me on today's call are our CEO, Tom Georgens; our CFO, Steve Gomo; and our SVP and Global Controller, Nick Noviello. This call is being webcast live and will be available for replay on our website at netapp.com, along with the earnings release, the supplemental commentary, our financial tables, and the non-GAAP to GAAP reconciliation.
As a reminder, during today's call, we will make forward-looking statements and projections, including our financial outlook for Q3 and future operating metrics, the benefits to us and our customers of new product introductions, the adequacy of our future inventory supply, our expectations regarding our future competitive positions, and the benefits we expect from our partnership and strategic alliances, all of which involve risk and uncertainty. Actual results may differ materially from our statements and projections.
Factors that could cause actual results to differ include, among others, general macroeconomic and market conditions particularly the continuing fiscal challenges in the U.S. and Europe, the effects of the flooding in Thailand, customer demand for our products and services including our recently announced new product introductions, and other equally important factors which are detailed in our accompanying press release, which we have filed on an 8-K with the SEC, as well as our 10-K and 10-Q reports also on file with the SEC and available on our website, all of which are incorporated by reference into today's discussion.
All numbers discussed today are GAAP unless stated otherwise. To see the reconciling items between non-GAAP and GAAP, you may refer to the table in our press release, our supplemental commentary, or on our website. In a moment, Steve will provide you with some additional color on our financial results, Nick will walk you through our guidance for Q3 of FY '12, and then Tom will walk you through our guidance for Q3 of FY '12, and then Tom will walk you through his perspective on the business this quarter. I will now turn the call over to Steve for his thoughts. Steve?
Steve Gomo - VP, CFO: Thank you Tara and good afternoon everyone. This quarter's financial performance can be characterized by its contrast. In terms of business demand, we continue to see strength across most of our business, with some normal puts and takes. For instance, our European enterprise and our Asia-Pac geographies were robust, and our E-series OEM had another stellar quarter. Similarly, our volume channel businesses were very strong, and our largest channel partners demonstrated solid growth. Where we saw underperformance to our revenue forecast was in our major account programs.
Our Q2 guidance included an analysis of the business dynamics associated with these large accounts, their seasonality, as well as relatively modest expectations for sequential revenue growth from them. Of the 46 accounts in the program, just 9 of the U.S. accounts produced the entire shortfall from the midpoint of our revenue guidance. Nevertheless, despite lower than expected revenue, both our non-GAAP operating margin and non-GAAP earnings per share were quite strong, with non-GAAP EPS above our targeted range and at record level.
Our total OEM revenues were strong this quarter, at $230 million, growing 8% sequentially from Q1. NetApp branded revenues grew 3% sequentially, impacted primarily by softness in those nine major accounts I just mentioned. Software entitlements and maintenance revenue, and services revenue, showed a sequential decline in the quarter. In the case of SEM, the revenue decline was a function of a minor perturbation in our deferred revenue schedule. For the services revenue, the sequential decline was due to a Q2 drop in professional services revenue, which tends to be lumpy. The underlying revenue growth trends for both SEM and service maintenance contract remain intact. Moreover, our deferred revenue balance increased by $56 million sequentially and grew 25% year-over-year. We expect that the absolute revenue levels will increase for both of these revenue categories next quarter.
Our non-GAAP product gross margins declined 0.6 percentage points from Q1 levels as the favorable effects of increased volume and configuration mix were more than offset by increased mix of E-Series OEM business, warranty costs and some pricing discounts, normalizing for mix, these product margins remain within the range of our expectations. Non-GAAP service gross margin declined 3.2 percentage points sequentially, primarily as a result of a loss on a single transaction. We expect the services margin to bounce back next quarter. The underlying service maintenance contract gross margins remains very healthy.
Our non-GAAP operating expenses increased less than 1% sequentially this quarter as we maintained our discipline on expense management. Employment growth moderated during the quarter and was lower than every quarter in the past year.
The Q2 non-GAAP tax rate was also lower than forecast finishing the quarter at 16.4% as we are now anticipating a larger mix of our FY '12 pre-tax earnings will come from international geographies. We expect our tax rate to return to about 17.5% next quarter and average 17.5% for FY '12. Our balance sheet remains strong with approximately $4.6 billion in cash and investments down only slightly from Q1 despite the $400 million accelerated share repurchase we executed early in the quarter. Our accounts receivable day sales outstanding was relatively steady as it increased to 38 days from the 37 days reported in Q1.
Inventory turns decreased again this quarter to 14.1 times. There are several reasons for this including a large proactive pre-buy of flash memory and a large disc drive pre-buy as the flooding in Thailand was unfolding. We believe we will have sufficient drive inventory through the end of December but is difficult for anyone to predict the business impact beyond that.
Cash from operations at $370 million increased 4% from the same period last year. Free cash flow finished the quarter at $277 million.
Our diluted share count decreased by 29.5 million shares sequentially to about 376 million shares, primarily due to a lower average quarterly share price and to our share repurchase. Our average quarterly closing price was down from last quarter $38.25 per share.
The accounting for shares associated with our convertible notes and warrants had a large impact removing about 17 million shares from the diluted share count on a sequential basis leaving about 7 million shares to account for the convertible notes. As you may recall 80% of the convertible notes are hedged. If we were to adjust the share count to reflect the bond hedge then the non-GAAP EPS would have been about $0.01 higher.
You can find the table on our website which shows the impact on the diluted share count for a range of stock prices. In a moment I'll turn the call over to Nick to talk with you about our guidance given that he'll have responsibility for it come January.
As I said last quarter it's been a goal of mine to retire by the time I am 60 and that milestone is all too close. December 31 will be my last day at NetApp and therefore this is my last earnings call. I have enjoyed working with all of you over the years and I hope to have an opportunity to say goodbye over the next six weeks. In the meantime, my CFO responsibilities remain the same as Nick and I work together to facilitate a smooth leadership transition. You will be in great hands come the 1st of 2012.
So, at this point, I'll turn the call over to Nick.
Nicholas R. Noviello - SVP of Finance and Global Controller: Thank you, Steve, and many thanks for your mentorship over the years. I'm sure I speak for everyone at NetApp when I say you will truly be missed. Now, looking forward, our target revenue range for Q3 is $1.52 billion to $1.61 billion, which at the midpoint implies approximately 4% sequential growth and 21% year-over-year growth.
Consolidated non-GAAP gross margins are expected to finish around 60%. We expect that non-GAAP operating margins will finish around 17%. As Steve mentioned earlier, we expect our blended consolidated non-GAAP effective tax rate to be approximately 17.5%, based upon a shift in distribution of our earnings to our international geographies, bringing our non-GAAP earnings per share estimate to approximately $0.56 to $0.60 per share.
Dilutive share count is forecast to increase to about 380 million shares in Q3 based on our average stock price of $41.84 for the first 10 days of the quarter. This will include about 9 million shares from the convertible notes and 0.5 million shares from the warrants. Recall that the favorable impact of the note hedges is not included as an offset. If we were to adjust the share count for the convertible note hedge, that would add about $0.01 to the EPS guidance.
To summarize, our business model continued to show its underlying resiliency in the second quarter, as we exceeded our operating margin and EPS targets despite some revenue softness. In fact, for the first half, we generated 23% year-over-year revenue growth, and a non-GAAP operating margin of 18.5%. However, the original financial targets we laid out at our analyst day, did not foresee the two substantial macroeconomic factors we find ourselves managing through today. Those being the increasing economic turmoil in Europe, and flooding in Thailand. These conditions make forecasting both revenue and cost of sales going forward far less predictable. Therefore, we cannot confidently forecast a specific range for Q4 revenue and earnings per share at this time. We will provide you with an update on our Q3 earnings call.
At this point, I will turn the call over to Tom for his thoughts. Tom?
Tom Georgens - President CEO: Thanks Nick and good afternoon everyone. As Steve indicated, the sequential decline in our major account program in a quarter where we expected seasonal growth was the biggest deviation from our forecast. While we were not anticipating sequential growth comparable to last year, we needed better performance from this group to meet our objectives. Fortunately, most of the unexpected shortfall was confined to a small number of accounts, where the customer specific dynamics can be understood. Unlike last quarter, the companies were not concentrated in any specific industry. Beyond this concentrated shortfall, the rest of the business was generally positive.
The strength in the other areas of our business is evident, when looking at it from a geographical perspective. Our U.S. commercial business grew 24% year-over-year, our Asia-Pacific business grew 55% year-over-year, and our EMEA business grew 12% year-over-year in a challenging environment. Our E-series OEM business remains well ahead of plan with 11% sequential growth. We even saw some rebounded spending from the financial services sector. We also saw some budget flush in the U.S. public sector, which while up only 9% year-over-year, it was over our mantra to compare and it grew 56% sequentially. Outside of those nine major accounts, our enterprise business was generally strong. Our number of transactions over $1 million was the second highest ever, increasing 17% sequentially and over 30% year-over-year while the total net new customer account acquisition is that of 2.5 year high.
Volume segments of the business around mid-size enterprises and state, local and higher education were very robust and were the highest growth areas of the portfolio. Our emphasis on pathway diversification continues to pay off as we saw record sales from our indirect channels representing the highest ever percentage of our revenue.
Our largest distribution partners, Arrow and Avnet grew to 31% of total revenue and grew 18% year-over-year. CDW, our largest reseller in fiscal year '12 grew over 75% year-over-year.
Our Alliance Program continues to generate leverage as we broadened our portfolio of tightly integrated solution offerings in partnership with other best-of-breed vendors. We're in the process of conducting our global insight events, where we trained thousands of technical resources both internally and from our resellers and partners.
At the event, we further enhanced our solution offerings by introducing four new verified architectures, Microsoft Private Cloud, Oracle Database, Media Content Management and FlexPod data center solutions. FlexPod is a modular data center solution developed in conjunction with Cisco to provide partners and customers with an integrated, standardized and scalable infrastructure to support a variety of workloads.
Together, we offer validated designs for VMware, SharePoint, SAP, Citrix and Red Hat Linux. FlexPod had another strong quarter and our relationship with Cisco continues to deepen as a result. We now have over 400 FlexPod customers and a robust pipeline for future FlexPod business.
On the product side the newer 3000 and 6000 platforms both had solid quarters. Units shipped of the 3000 were up 34% year-over-year and FAS6000 more than doubled over last year's Q2 levels.
The 2000 was down year-over-year and down slightly on a sequential basis. We saw a decreased demand in both channel and our large enterprises as well as a shift in business to the newer 3000 family.
However last week we introduced newly designed 2000 class models for this segment with our smart decision our built on NetApp campaign.
With refresh technology, attractive price points and our latest Data ONTAP 8.1 operating system it represents a compelling solution for each of its target segments. Our product launch had a particular focus on the mid-sized enterprise and our state, local and higher education channels where our momentum is strong and the partners are eager to introduce the offerings to their customers.
In addition to being standard operating system on our 2000 series Data ONTAP 8.1 is now available on our 3000 and 6000 platforms. Our 8.1 operating system is the first product in the market to marry the industries richest portfolio of data management and storage efficiency technologies with clustering. To enable unmatched scalability and non-stop operations.
Previous architectures including both traditional approaches and newer niche implementations have forced customers to make trade-offs amongst these features. NetApp is the only vendor to have the functionality and configurability to produced optimized solutions for the widest range of applications, including virtualization technical computing content repositories and traditional business applications all from a single architecture. Evidenced on its scalability was demonstrated while recently published compelling results from an independent spec FFS benchmark test in which a 24 node cluster of NetApp FAS6000 running 8.1 produced 1.5 million ops per second. It is over 35% faster than the previous record and we did it with 50% fewer discs and 80% fewer controller nodes, demonstrating a real-world configuration with far better results and far lower cost.
Our total E-Series product family continues to make a big impact as well. Our 14% sequential growth was driven by especially strong demand from Teradata and Dell, but our other two major OEMs, IBM and Oracle were up sequentially as well. We have been sufficiently clear about our commitment to this business, initially in words and now in behavior, that each of our major OEM partners have confirmed the expectation of an ongoing relationship and a couple have already introduced new offerings based on E-Series technology.
The E-Series products are also key to our big data strategy in the areas of analytics and big bandwidth. For analytics, E-Series has now been designed into three integrated analytic appliances. We also have integrated it into our initial Hadoop solutions and partner engagements. For big bandwidth, we are continually broadening the solution offerings to our field, enabling some high-profile slow-motion video and high performance computing wins.
All in all, our business operated largely within the bounds of our expectation this quarter, and we're now for the exception of an unexpectedly large slowdown in a handful of our biggest accounts, we are going at least be at the midpoint of our targeted revenue range.
Given continued instability in Europe, the persistent economic concerns in the U.S. and associated uncertainty around federal spending, all things considered, the rest of the business was essentially in line or slightly better than we anticipated 90 days ago.
Nonetheless, in response to the aggregate revenue performance, the organization once again demonstrated its ability to manage through the business model, enabling us to increase operating margins over last quarter and produce record earnings per share.
Looking ahead, the impact of the Thailand flooding could potentially be the biggest swing factor, on both our top and bottom line in the second half. The large buy of drives we did, as this is all unfolding, should sustain us through a good part of Q3, but probably not all of it. Although enterprise-class drives are considered to be the least impacted, we still anticipate some amount of supply and pricing complexity. We have all heard the predictions of the industry analysts and the drive vendors themselves. Some of the information is conflicting, and most of it is changing daily in regards to scope and ultimate impact. I expect NetApp to fare better than most in this process, but it is far too early to state the exact extent this will impact our business, either directly, or through our OEM partners.
On the other hand, our FAS business will begin to get uplift from the just refreshed 2000 series, and our partners and technical teams are coming off an invigorating symposium, where they will brief on ONTAP 8.1 and competing using NetApp products. I believe NetApp continues to have the best product portfolio and the best partnerships in the industry, both of which will pay off in the long run.
Before I open up the call to Q&A, I'd like to again thank Steve for more than 9 years of tremendous contributions to NetApp. I would also like to congratulate the entire NetApp team, for being ranked number three on the world's best multinational workplaces list, by the Great Place To Work Institute. The culture at NetApp is one of our keys to success, and this recognition is strong validation of our commitment to creating a model company. It is this commitment that will drive us to continue to gain market share, in both good and challenging times.
At this time, I will open up the call for Q&A. As always, I will ask that you be respectful of your peers on the call, and limit yourself to one question, so we can try to address everyone in our allotted time today. Thank you.
Operator: Katy Huberty, Morgan Stanley.
Katy Huberty - Morgan Stanley: You obviously did a great job in the channel as well as with signing up new accounts this quarter but just a question on pricing because Dell last night talked about more price competition in the mid range. I wonder if there is some variability in pricing in order for you to win those deals in the mid range this quarter.
Tom Georgens - President CEO: Katy, I had say in the channel probably not so much. Clearly, that's a competitive business and certainly our largest competitor there is being aggressive in the channel and certainly is doing a number of incentives to gain market share or gain mind share but I would say frankly the pricing dynamics are a lot more complicated at the large accounts for safety, obviously lesser demand and the opportunity to take advantage of that. So I say the pricing environment is probably no different which isn't to say that it's calm, it's just to say that it's no different but to the extent that pricing is relevant. I'd say it's probably a little bit more on the major account side.
Operator: Mark Moskowitz, JPMorgan.
Mark Moskowitz - JPMorgan: I wanted to ask a question to Tom regarding the overall connotation you have unexpected in terms – unexpected weakness in your largest accounts. Was this due to macro events, Company specific events, NetApp's inability to deliver, is there a competitive demand, I guess if just kind of qualify or provide us some context that'd be really appreciated.
Tom Georgens - President CEO: I think that there is two things in play here. One of them is the performance of the accounts and the other one is what was our expectation of the performance? I think there are certainly some accounts that certainly have well known headlines that we knew going into the quarter were going to have some issues associated with them. Certainly there was concern about the DOD and federal spending and obviously some individual accounts that we probably are well aware of, that we knew were going to be problematic and we factored that into that forecast. I think that the other ones we actually probably expected more of our normal Q1 to Q2 seasonality as we think about them. And that’s really not what happened. And I’d also add that these were not necessarily problem accounts. These were accounts many of them actually on the ascendency that shows the slow down. So we don’t want to indicate that we actually have more problem accounts on our major account portfolio I think some of those are clearly in ascendency with NetApp, it is just that we were expecting more for them this particular quarter. I think from competitive pressures I think certainly pricing clearly in a market where demand is limited and there is lot of capacity chasing deals, customers are using that through for their advantage. From a pure competitive perspective in those nine accounts there is probably only one that I would say has a meaningful competitive component to it. I think all the other ones are either macro related or company specific.
Operator: Aaron Rakers, Stifel Nicolaus.
Aaron Rakers - Stifel Nicolaus: I want to ask on first of all clarification I heard you say 11% sequential growth on E-Series and then I also heard you say 14% sequential so clarifying that and if I look at that and I look at your organic revenue growth at roughly 6% by my math, I know you talk about gaining market share in down and up markets, how do we think about your organic growth profile or how are you thinking about the organic growth profile here over the next couple of quarters in that mindset of what is the market going to grow here, looking out in the 2012?
Tom Georgens - President CEO: I think first of all, on the E-Series, prior to two different data points; one was E-Series OEM business, and the other one was E-Series overall. So, the E-Series OEM business had a more natural compare to the overall, since we really just started with the branded business. That's why that number was a little bit higher. Of course, those are revenue number. I believe on the last call, I talked about a large $14 million deal that would not come to revenue this quarter, and that's clearly still true, if you're wondering where the $14 million went. I think on the broader question, the real question, here as we think about the market and we think about the macro, NetApp focuses almost exclusively on market share, because that's really the true measure of our penetration. The key component in market share, or the only thing that gets actually counted in the market share as reported by the industry analyst is actually product revenue growth. So, as we think about companies in this space with product transitions and acquisitions, and I think we're dealing with a different macro environment this year than we were last year, I think probably be the best way to think about that is actually thinking about sequential growth. So, if I look at our sequential growth on last quarter, there was about 5.2% on the product side. So, if I compare that to, say, EMC's product growth in storage, the most recent quarter, I think that number is about 1.2%. So, you could say, well, it's a NetApp Q1 to Q2; for them, it's Q2 to Q3, but if you go back another quarter with EMC and look at the Q1 to Q2 transition for them, that's only about 2%. So in terms from a market share perspective, which is really a measure of product growth, NetApp actually had more sequential growth in the last three months that EMC has had in the last three months, on a percentage basis. So to the extent that we are the number one and number two market share players in this market, I'd have to say that our market share gains are greater than this.
Operator: Jayson Noland, Robert W. Baird.
Jayson Noland - Robert W. Baird: Thank you and Steve, good luck with the next step. A question for you or Nick, just trying to get a sense for what's in the guidance – expectations for the 2240. Are you assuming constraints in the HDD world and then on the major accounts, is there any pushout there into this upcoming quarter?
Nicholas R. Noviello - SVP of Finance and Global Controller: Jayson, it's Nick. Just to give you some perspective on the new products. Certainly, there is pickup of new products that's built into the guidance. As we mentioned, on the drive side of the sense, we talked about availability through the end of the calendar year. Certainly, it gets a little bit more complicated once you get into the new year. So, what we have built in on the guidance side, is many of the positives that we talked for this quarter continuing, the new products coming in, but those overall constraints on drives from Thailand and macro, being there that we have to consider when we build the guidance.
Tom Georgens - President CEO: The one other thing I'd say on the 2240 is, we have seen a decline in low-end units over the past, replenish over the last nine months or so. And I would say, it would be real easy for us to just say, we should expect to get all those units back, and it would all be incremental. But the one thing to notice about our business, is that the segments for the market that are most dependent upon products of that class, which is our volume channel business, have been the strongest part of our business. So clearly, they have moved some of the demand to the newer 3000. So I would expect some of that demand to actually come back from the 3000 into the 2000. It would be really good for me to say that it won't be incremental, but I think that there will be some reverse cannibalization of 3000 just like we saw when the 3000 came out. As far as the enterprise and Department of Defense or just say U.S. public sector, those are big consumers of this class of product as well. There are some attributes to these products in terms of size and compatibility with prior products, which actually will enable the product transition in our favor here, that was held up at the previous generation. So I do expect, not only just to impact our channel business, but I do expect its impact on enterprise and our U.S. public sector business as well.
Operator: Bill Shope, Goldman Sachs.
William Shope - Goldman Sachs: I'm a little confused on the weakness in the nine accounts. Can you help us understand – I understand you can't lump in the weakness to one specific reason for all of them, but how are you addressing the weakness? Is there some execution issues that you're looking at? My memory may be foggy, but this sounds somewhat similar to the shortfall you guys had in mid-2007, where you had some issues with large accounts, and I know you were able to reconcile that with basically a different approach to a broader customer base. How should we compare to that prior hiccup, understanding that there is a big recession here later and sort of how should we think about how you're addressing this weakness and preventing it from spreading frankly?
Tom Georgens - President CEO: I think, if you think about it from last quarter, clearly the federal side was a concern for us. We were wrapping up the quarter in the face of the debt ceiling crisis. So I don't really know whether that impacted us or not, but we also – on the last call, we talked about the U.S. public sector and we talked about financial services. So you can actually argue that it's actually even more concentrated than it was last quarter. So instead of spreading it might actually be contracting. As far as the accounts are we need to look at every single one of them. One of them clearly is really competitive and or is largely competitive and I think we need to take that on clearly and I don’t think that less than anybody. I think most of the other ones I think most of those are accounts that are actually doing quite well from a NetApp perspective and they took a pause and some of them obviously we did some insight to see when we expect them to come back some of them will, some of them will pause a little bit longer based on their company dynamics. So I think that the advantage of it having being at the fine of all set of named accounts. Is that we can build an extra plan around every single one of them. As opposed to if we saw a broad weakness in the channel that would be 1000 account problem. So I think there were things that we're going to jump on to I'd say that most of those accounts are still relatively favorable in NetApp and we are not losing any share in them. We may or may not depending on each individual situation I should see rebound in them next quarter. That’s what factored into our guidance.
William Shope - Goldman Sachs: In the comparison to 2007 is that relevant or…
Tom Georgens - President CEO: I think 2007 had much, much greater concentration of financial services in fact I would argue that last quarter's dynamic was more like 2007 than this one. I also want to be really clear it's not like financial services came back in a big way. Certainly they didn’t have 50% something sequential increase like out Federal business. So but some of them did come back, and some of them came back in a meaningful way. And we anticipate that some of that in our guidance as well. So it's not universal I think last quarter we had six major accounts in financial services and they were all down it was big more balanced this time.
Operator: Bryan Marshall, ISI Group.
Bryan Marshall - ISI Group: I guess a little bit of confusion with respect to your nine large customers in the top 46, I mean, if that was really the shortfall, and call it $50 million, to call it roughly $5 million per account, are we talking mostly on the 6000 series here because that business was up 100% year-over-year. So, I'm just trying to tie those two together. What these guys are actually buying and what went down?
Tom Georgens - President CEO: I wouldn't necessarily tie it to the 6000, and simply put is there are two things to factor in. One of them is the amount of money that they were down, and the other one is the amount of uplift that we were expecting from Q1. So, I think there's both of those that come into play, but suffice to say that if they came in as expected, we would have sold even more 3000s and 6000s, and probably some 2000s as well. So, I think that the strength of those business – I think we're heartened by the fact that the significant movements in certainly the high end, and clearly, that had some indication about the customers and the types of applications we're deployed in, but the 3000 was quite strong. I wouldn't rule out that we'll see some reverse cannibalization of 3000 going into next quarter moving back to the 2000, but the 6000 remains robust and it could have been even more so, certainly had some of these accounts come through.
Operator: Glenn Hanus, Needham & Co.
Glenn Hanus - Needham & Co: Let's talk about the intermediate term business model. You were pretty responsive in controlling operating expenses. You mentioned 17% operating margin this quarter. Is there sort of an intermediate target we should be thinking and how will you sort of manage to that target?
Nicholas R. Noviello - SVP of Finance and Global Controller: Glenn, just to help you understand on the operating expense perspective, where we have taken some measures there. What you see in the 17% is the impact from Thailand though. So that is something that we have to build in to our planning and really driving that change from what you might see on the business model side and on that 18% plus model that we have been aiming at so far. And you will see it actually in the gross margin that I gave you the guidance on earlier.
Tom Georgens - President CEO: The one thing I – just from a point of view of managing the business, I think from this particular quarter, I think once again we proved that we want to put some control on expense that we can snapback. We used the 2007 analogy, I think. When things started to slow down, we said we would be back on the model on a year, and we were back on a quarter. The one thing that's a little bit different this time, is on the matter of Thailand, clearly, there is concern about availability of drives, but there is also concern about pricing of drives. And from the point of view of managing to the P&L and managing to the business model, I think under normal circumstances, clearly we would modulate operating expenses to protect the business model, but if we think that we were going to get a hit to gross margin as a result of this transaction, and certainly modeling some of that in. But that's going to be temporary in nature, and I don't want to whipsaw the operation and modulate operating expenses based on pricing of disk drives. But frankly to the extent that the gross margin is impacted by the drive situation, that's going to flow through the bottom line on a temporary basis, and the operating expense is going to be more modulated by the overall size of the opportunity that we see.
Operator: Keith Bachman, Bank of Montreal.
Keith Bachman - BMO Capital Markets: I have a similar question. So Steve or Nick, just to be clear. The software margins that you expect in January, those will be -- in the services margins, those will both be roughly comparable to July margins. In other words, there was that blip there in services. I just want to make sure I'm clear, so that the variance therefore is all in the product side. That's part A, and I have something I want to follow with on the product side. Could you just confirm if that's accurate?
Steve Gomo - VP, CFO: I think that's accurate, Keith. Steve here. You're going to see a little bounce back as I mentioned in my narrative, in the services margin.
Keith Bachman - BMO Capital Markets: Will it clear 60, Steve?
Steve Gomo - VP, CFO: It will be on the order of 60. And then, there is not going to be virtually any change at all in the SEM margins. So, to your point, entire impact is in the product margin side of the house.
Keith Bachman - BMO Capital Markets: Is it all, Steve, HDDs or is there something on mix, say with the new product that would also negatively impact margins as we look out?
Nicholas R. Noviello - SVP of Finance and Global Controller: Keith, this is Nick. In the third quarter, we're going to expect to see some impact on those product margin from customer mix, from OEM as we get into the third quarter and the end of the calendar year. Those things are built into the guidance and they show up on the product margin side.
Keith Bachman - BMO Capital Markets: Sorry Nick, just to be clear, so that, what I'm really trying to slice is, is that product margin in a number of different ways. Is pricing in there as one of the variables, and then I promise I'll cede the floor?
Nicholas R. Noviello - SVP of Finance and Global Controller: So what's in there is certainly Thailand is in there, and we're building that in. In addition to that, is a customer mix and an OEM mix. Those are the big drivers that are going to be built into that and are built into the product margin guidance for the third quarter.
Nicholas R. Noviello - SVP of Finance and Global Controller: Pricing from a point of view material pricing to us particularly disk drives that’s factored in. Products pricing to end users that our expectation is that’s not going to be materially different than what we saw this quarter.
Operator: Kaushik Roy, Merriman Capital.
Kaushik Roy - Merriman Capital: Tom, can you comment on the use of Flash we know you use Flash Cache as well as SSDs but can you comment on your offering for may be PCI SSDs in the servers.
Tom Georgens - President CEO: We kind of dropped the Flash our of our commentary because Flash is bundled into more and more of our systems. It's just becoming an integral part of these types of arrays, and the ability to use Flash and ATA drive in lieu of higher cost, enterprise class drives. Clearly drives the cost point that's very, very competitive and has driven up adoption. So the fact that they are bundled in and not exactly tied to customer preference makes it hard to talk about Flash adoption but I would venture to get certainly on the 6000 and the majority of the 3000 that’s an integral part of the solution. In terms of where we go from here, I think you continue to see innovation on Flash site from NetApp both inside the array and outside the array. I don’t want to pre-announce any products so I don’t think that I think for the planning horizon the model that you guys are trying to put out for Q3 I think you should expect our Flash strategy to be substantially the way it is. As far as PCI Flash products you need to be clear on what opportunity is there. I think for us things that are going to represent permanent storage we want to bring in to our data management methodology. So that’s clearly our interest. As far as flash based PCI boards as a revenue opportunity on a standalone basis, that's not nearly as interesting to us, but as a vehicle to sell software and broaden our footprint, clearly that's the vector that we'll be pushing.
Operator: Brian Freed, Wunderlich Securities.
Brian Freed - Wunderlich Securities: A real quick question on ONTAP 8.1, first, is it currently shipping as a GA product or is it still a release candidate on the FAS6000 and 3000 product family? Related to that, can you talk anything about what you're seeing from a win rate perspective? Are you seeing any visible signs of improvement, particularly in the scale-out NAS?
Tom Georgens - President CEO: From a 2000, in every unit item out of factory. So, it's basically the standard operating system that we ship. For the 3000, the 6000 is still obviously an option. They're shipping actually prior version of ONTAP 8 as a default, and they can actually ship a 7.x for some of the models also. So, in terms of win rates, particularly around scale-out NAS, it isn't just about 8.1, we are certainly competing with cluster node and that technology with the existing functionality of 8.x. I think what 8.1 brings to us is not only the performance that you saw, the new operating system on the new platform clearly is compelling. So, what it also does is it reduces the trade-off necessary of trading off clustering versus the premium software features. So, many of the premium software features in our standard version of ONTAP are now fully clusterable, and from that perspective, obviously, the product has much broader appeal, not just in scale-out NAS but really around traditional business applications. We really have very, very rich data management, which is not typical of products in traditional business applications, and then clustering to basically give tremendous flexibility in both scale of performance, of capacity, and also clustering is a key enabling technology of true non-stop operation. So from our perspective, the scale on NAS is just about one datapoint. The real focus of our 8.x journey, is effectively to bring clustering and putting themselves with features into the traditional business applications area, which have been relatively modest from an innovation perspective for a long period of time.
Operator: Richard Gardner, Citigroup.
Richard Gardner - Citigroup: Tom, sorry to beat a dead horse, but I did want to go back to the issues and the 9 accounts. On the one hand, it sounds like it's either macro or company specific driven, but you also suggested that some of these accounts are on the ascendency with NetApp and have decided to put plans on hold and it sounds like there might be – maybe a situation where you are displacing a competitor and those customers have decided to slowdown their adoption of NetApp technology. So I guess what I am really asking is, how much of this really is company specific and macro and how much of that is due to competitive dynamics in these accounts?
Tom Georgens - President CEO: I also want to be clear, I want to go back to my first answer. The real dynamic here is not the overall fundamental health of those accounts, it's the performance of those accounts this quarter, against our expectations of their performance this quarter that we had 90 days ago. So there are clearly some accounts that, that might be problematic growth accounts for company specific reasons, and we knew that going in, and those weren't factored in, and those might be accounts that might be tough for us to drive growth over time, whether gain share on them or not. On the other hand, these are accounts where we had higher expectations than what they did, which isn't to say that they have broken or they are damaged or they were losing ground. Some of these accounts, are accounts that we made a lot of progress. And they all did spend money. It's just a question of not as much. So I think from that perspective, I've realized that it's ultimately not leading to a satisfactory answer, you keep coming back to it. But I'd say that overall -- the point is, is that the major accounts in general, being a proxy for the broader environment, has certainly seen pressure, both from a pricing perspective and a demand perspective. And I think that those accounts being large, as they stop and go, have a much bigger impact on our business. So those nine accounts had a disproportionate amount of our business relative to our expectation, which isn't to say that we are in trouble with any of them. Like I said, I think the competitive pressure is really only relevant in one. And they aren't necessarily the nine worst accounts, because clearly we have accounts that we know are going to be problematic, and certainly sectors that are going to be problematic. But those were already factored into our forecast. I just want to be clear is that we only know – it sounds like we only have nine accounts that we're not happy with. I think these accounts will be very strong for us going forward, and there will be other accounts that are not on this list that we know are problematic, and that was factored to our guidance, and it is continued to be factored into our guidance going forward.
Operator: Scott Craig, Bank of America Merrill Lynch.
Scott Craig - Bank of America Merrill Lynch: Just a clarification on the guidance. I think, I heard you say that you're assuming a pickup in the major accounts. Maybe just clarify that? Then secondly, if that pickup doesn't happen, Nick, what are you guys prepared to do on the OpEx line and what can you do to sort of mitigate some of a potential revenue shortfall, with the continued slowdown?
Nicholas R. Noviello - SVP of Finance and Global Controller: Just in terms of your comment on pickup in major accounts. First of all, again we go through an account planning and build a view of where major accounts are going to go this coming quarter. Similarly, what Tom has said, there wasn't lot of growth built into last quarter. So we're not expecting a lot this coming quarter. We do a bottoms-up, that's built in, and that's how we've kind of come up with the guidance on those. On the OpEx side of the sense and really back to the question of operating margin, the operating margin shortfall is really reflected in the gross margin shortfall, and the gross margin shortfall is driven by the cost pressure that we believe is going to come, and we're seeing a little bit of, in terms of drive situation that's out there. So that's built into product gross margins. That flows through to the overall operating margin line and I made reference before to the OpEx as a percentage of revenue as basically flat. So the expense structure, we've managed pretty well.
Tom Georgens - President CEO: I think going forward, to kind of – if we were trying to crank back on operating expenses, it would be all the usual things. It would be programs, it would be hiring and things of that nature. If you look at this quarter similar to last quarter, we came in over the top on the EPS side, and clearly, the revenue didn't quite come up to our forecast in either case. So we're quite cognizant of that. So the issue that we are trying to solve here obviously, is we're trying to drive growth as opposed to deal with operating expense. On the other hand, with some uncertainty you had, both macroeconomically and also with the Thailand flooding, that we need to be careful about where the top line is going and therefore we were prudent this particular quarter. So we still hired 300 something people. It's not like we were sitting idle when we buy, but the balance that we need to have going forward is, how do we modulate the spending in proportion to the business. But I also wanted to be clear, as I said earlier, is the impact of the Thailand flood we expect to be temporary, and I'm not going to modulate operating expense too much on that, because A, it's going to be hard to predict, and I hate to just kind of jerk the organization around, around a set of datapoints that are changing every day.
Operator: Maynard Um, UBS.
Maynard Um - UBS: I think you more broadly addressed this issue, but I was hoping if you could be a little bit more direct. Are there any changes within your customer base around the way they are thinking about their storage architectures or their technologies? I'm curious just given kind of EMCs commentary that its Isilon product has been displacing, what they say NAS vendor that couldn't scale for general purpose needs. Can you just help kind of clear the air there, what you're seeing in the market from that standpoint?
Tom Georgens - President CEO: I think specifically on the Isilon case. I mean, certainly we see them. We see them certainly replacing Celerra, we certainly see them agitating in our accounts. I think when we think about Isilon, clearly they were targeting us before EMC bought them, and certainly, that has not let up. As a proximate cause in these accounts, like I said, the accounts that are on the ascendency, that suddenly stopped buying or paused for a period of time, that wasn't an intercept to the business by a competitive activity. Certainly, if that was a threat, it would have been factored into the forecast 90 days ago. Things like that don't happen that quickly. As far as Isilon itself, if you look at the value points that it has around NAS performance, and they have a value point, it has really about manageability of large content pools. Now, from a straight performance perspective, in fact objectively measured, clearly the E-Series for high-performance computing, it's clearly much higher performance. Certainly, the benchmark that we just did around SPEC NFS around NAS performance and NAS scalability, at dramatically less hardware. But I think from a performance perspective, NetApp is more than able to hold its own, in fact has a compelling leadership position there. On the general question of manageability, that's kind of a tough thing we have objectively benchmarked. But if you look at where we are going with that, now with 8.1, the marriageable or the premium features which don't exist in that particular product, and therefore makes it difficult to sell into traditional business applications. And also kind of the merger, where we are heading with the Bycast acquisition and object oriented stuff, effectively going to be bringing the functionality, both Atmos and in Isilon together if you will. So I feel good about our roadmap. I think clearly, from a performance perspective, NetApp has really clearly retaken the high ground, and I think from a manageability perspective, obviously that's a little bit harder to objectively measure, but I think you will see much better functionality from NetApp and continued competitiveness on that front. So I guess, where I see Isilon, some of the premium side of the business around performance and key scientific applications, more than comfortable with our stance there. In terms of large content repository pools, kind of lower value data, that's primarily a manageability play and you will certainly hear more from NetApp, more from 8.1 and the future releases. So from us, do we see them, yeah. Well, they are part and parcel of the dynamics of the major accounts. Certainly we see them, but they were not the primary cause of what we saw from 90 days ago.
Operator: Brent Bracelin, Pacific Crest.
Brent Bracelin - Pacific Crest: One quick clarification for Nick, and then a question for Tom. Nick, on the gross margin, obviously the guide down here implies close to 350 basis point product margin decline. Should we think about the vast majority of that assumption being tied to higher drive costs and temporary in nature?
Nicholas R. Noviello - SVP of Finance and Global Controller: Two points there to keep in mind, and yes it's pretty close in terms of that sequential decline in product gross margins. The two points are first, while you are going to have a product and customer mix including the OEM and heavier OEM that happens in the calendar third quarter of every year. That's impacting part of it, and then the Thailand drives are impacting the other part of it. That makes up the basic three point change, and decline in the product gross margin?
Brent Bracelin - Pacific Crest: That's helpful. Tom, my question for you is less about the nine major accounts and more about the direct sales as a whole, on an absolute basis down two consecutive quarters, lowest absolute level since October of 2009. You obviously have a new software release, 8.1, the low-end refresh. Do you think we're bottoming here on the direct side? Obviously, the commentary that there is going to be a heavier OEM E-Series mix, suggests maybe this isn't the bottom. What's your general sense? Is there a pipeline of new customers that could drive or rebound going forward? Help us understand the direct sales opportunities that you see now? Are we close to a bottom? Are we seeing the bottom and what gives you confidence that that you can grow that business going forward?
Tom Georgens - President CEO: One thing I would – I guess the one question I would put is that, don't assume that fulfillment model for end customers is static. So the fact that some of our big accounts may choose to go through a channel partner, or go through an integrator, or the system integrator is now moving more hardware through their business. So the same involvement of our sales reps might actually have a different fulfillment model. And I think that's in play here too. The flipside to that argument that I would also argue is, don't assume that our channel business has zero touch from our direct sales organization. In some cases, I wish it was more independent, but our direct sales organization is actively involved in a lot of accounts. So I think our direct selling motion is clearly creating demand, and the question is whether they fulfill it directly through NetApp or they prefer to go to a third party, in a lot of cases, that's the customer choice. So, we don't actually measure demand creation by channel. So, I wouldn't read into that the direct sales force numbers are necessarily indicative of lower direct sales force productivity.
Brent Bracelin - Pacific Crest: Okay, that's fair enough. We'll discount the overall direct sales force business but it's hard to discount the branded business that's slowing down overall. So, I guess, do you feel like 8.1 can help drive your acceleration branded overall?
Tom Georgens - President CEO: I think clearly 8.1 is – and the entire 8.x family, it's really revolutionary when it comes to storage for data center environments, the ability to bring true clustering and this premium feature set I think will help. Obviously, the 2000 will help as well. Clearly, it's not uncommon for us to see pickups in demand. Certainly, the last product release was remarkably successful in terms of conversion of customer demand. So, I expect the 2000 to pick up as well. So, from an overall branded business, like I said, I think the other thing that you need to put in context is just what you believe about the macro environment. So, I think the year-over-year growth numbers are all interesting, but I think we're dealing with a different macro environment. Obviously, NetApp has got other elements of the portfolio now that we can rely upon for growth. I think if you go back to a sequential number, I think that NetApp sequential product performance is actually pretty darn good this quarter than nine accounts or the major accounts in general notwithstanding. I think 5% sequential growth, and even despite everything else that's going on, 4% sequential growth from here, if we sustain that for the next couple of years – or I should say, if we can sustain that through a difficult period, I think that would be pretty good for us, and I think that might be a share gaining position.
Operator: Andrew Nowinski, Piper Jaffray.
Andrew Nowinski - Piper Jaffray: Could you just comment on – a lot of these sites the more of slow down on the fed sector during the month of October that Dell called out last night, and then looking into the next 12 months, aside from the obvious looming budget cuts, do you anticipate any headwinds or new headwinds from a competitive perspective, now that EMC has qualified the VNX and is now on more GSA list?
Tom Georgens - President CEO: On the federal side, clearly, that's been very, very successful for us. We're number one in market share position. Obviously, a lot of speculation on that particular business. I think, all things considered, over an extended period of time, a lot of other companies that talk about weakness in that area, well NetApp business continuing with momentum. So, that strong sequential growth in that business last quarter, we had growth year-over-year. So, with all the headlines, I think we have to be pretty pleased with the overall performance. Did I say that October would slow down – I don't think – first of all, I wouldn't overplay our granularity in that regard. One thing that happens in October is we see a lot of the systems integrator business that they actually win before the fiscal year ends. It takes a little while to roll through to us, but I wouldn't say that we saw anything in October that made us any more or less pessimistic in what we saw in September, when the deals were actually closing.
Steve Gomo - VP, CFO: I'd just add, as far as last quarter was concerned, remember that in the Fed business also, we have contracts that are in existence today, we own the contracts and what we're seeing, I think a little bit of slowdown, but not as many POs perhaps. People had anticipated we would receive – I think it's tied more to the fiscal situation in the United States than it is to anything else.
Tom Georgens - President CEO: I think on the question of VNX, in general, the VNX has not been that much of a change in the dynamic in many accounts. The VNXe in terms of EMC's channel incentives, is something that we've seen more of. Certainly, if you look at the performance of our volume segments, clearly that's been the strongest part of our portfolio. So I don't think they have slowed us down much, but nonetheless, I'd say that VNXe is something that we see particularly because of that channel push. And I think that's been something that's generated more discussion within NetApp than actually the VNX itself. I think the VNX itself is -- I think has been afflicting more pain on Dell, than it has been inflicting on NetApp.
Operator: We have run out of time for questions. I will now turn the call back over to management for closing remarks.
Tom Georgens - President CEO: Thank you, operator. Just one last thing, before we wrap up is I wanted to bring out that, we are quite aware of a number of press articles about NetApp products being deployed in Syria by a systems integrator named Area. The one thing I want to be very-very clear about this, is I want to show people on the call, our customers, our partners, our employees that we absolutely do not support the sale of NetApp equipment to Syria. I'm not here to suggest that we found a legal way to achieve an objective to sell product to a banned country. We have no intention of doing that, and we're just as disturbed when the product is in a banned country as anybody else. The other thing is that NetApp produces storage products. We don’t produce the applications that are being talked about in this particular article; and our products have been deployed in this solution and in its very generic way, and that NetApp does not produce this application or participate in this development at all. The last thing, I probably want to point out is that NetApp has proactively reached out to the government and we've offered our full assistance in reviewing the matter, sharing any information that we have about the situation, and ultimately get to the facts. At this point, we don't know even whether the story is true, or acting as if it were, and taking all the appropriate precautions. So I can assure you that this is a situation that, that we did not actively seek out. We did not choose to sell to the Syrian government, we do not deal with the Syrian government and we are not looking away to circumvent U.S. law to sell to the Syrian government. We have no interest in providing product to a banned country. I just wanted to make sure that was clear. So with that, I'd like to thank you for your time today and your interest in NetApp, and we will see you all in 90 days.
Operator: Thank you ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.