Highlights From NTAP's Q2 Conference Call: Guides Above for Q3 Revenues

November 19, 2009 9:28 AM EST

NetApp, Inc. (NASDAQ: NTAP) reports 2010 Q2 adjusted EPS of $0.37, 7 cents better than the analyst estimate of $0.30. Revenue for the quarter was $910 million, which compares to the estimate of $880.30 million. Shares look to open 3-4% higher.

Highlights From NTAP's Q2 Conference Call:

• Sees Q309 sales of $935 million, versus the $920.9 million consensus.
  
• (CFO) Revenue for the second quarter was $910 million, up 9% sequentially and nearly flat compared to Q2 of last year.
  
• Foreign currency effects increased our sequential results by just under one percentage point and decreased our year-over-year growth by just over one percentage point.
  
• Product revenue was up 10% sequentially and down 8% year over year to $525 million. Products represented 58% of total revenue. Included in product revenue is add-on software, which was 15% of total revenue.
  
• Revenue from software, entitlements, and maintenance, which is a deferred revenue element, was $170 million or 19% or total revenue. Software E&M was up 3% sequentially and up 11% year over year.
  
• Revenue from services was $215 million and 24% of total revenue, up 11% sequentially and up 14% over Q2 of last year.
  
• Revenue from maintenance support contracts is a deferred revenue element and comprised about 63% of our services revenue this quarter. In Q2, it increased 7% sequentially and 20% year over year.
  
• The professional services component increased 16% sequentially and was up 3% year over year. On a non-GAAP basis, consolidated gross margin was a record 67.5% of revenue this quarter.
  
• Revenue from deferred elements comprised about 40% of our total revenue compared to about 33% in Q2 last year. These deferred revenue elements carry a very high margin. Non-GAAP product gross margins were up 6.2 percentage points sequentially to 63%.
  
• Non-GAAP service margins increased to 54.4%, also exceeding expected levels because of a jump in professional services utilization rates. Non-GAAP software E&M gross margins were up just slightly to 98.2%.
  
• Turning to non-GAAP expenses, our OpEx increased 3% sequentially and was up 1% year over year, totaling $459 million or 50.5% of revenue.
  
• Our head count at the end of the quarter was 8,105, an increase of 63 people.
  
• Non-GAAP income from operations was up 74% sequentially and 53% year over year to $155 million or 17% of revenue in Q2.
  
• Non-GAAP net income before taxes was $155 million or 17% of revenue. Our non-GAAP effective tax rate remains at 16%.
  
• Moving to our cash flow performance, our cash from operations was $267 million, up 29% from Q2 last year.
  
• Capital expenditures were about $23 million this quarter, down from $25 million last quarter.
  
• Turning to the balance sheet, our Q2 cash and short-term investments totaled nearly $3 billion, for a net increase in cash and short-term investments of $293 million over Q1. At the end of Q2, our cash and short-term investments held in the US were 49% of the balance.
  
• The total deferred revenue balance of $1.7 billion reflects a sequential increase of approximately $7.3 million this quarter and a 9% increase in the balance year over year.
  
• With respect to DSO, accounts receivable days sales outstanding were 32 days this quarter compared to 39 days last quarter and 36 days in Q2 last year. Q2 collections were extremely strong, resulting in an accounts receivable balance that is 93% current, which is also a record.
  
• Inventory turns were approximately 20 turns, the same as achieved in Q1 and up from the 18 turns in Q2 of last year.
  
• We are forecasting third quarter non-GAAP OpEx to decline modestly to about the 445 to $455 million range subject to adjustment based upon what we see happening in the economy and in our pipeline. As a result, our non-GAAP operating profit should return to roughly 16% in Q3.
  
• We expect non-GAAP earnings per share to be between $0.36 and $0.37 per share. (Consensus is $0.36)
  
• (COO) Total revenue generated by the Americas was up 3% sequentially and down 4% from Q2 of last year, contributing 55% of total revenue. Within this, our public sector team had a record quarter, up 32% sequentially and up 1% year over year, producing 16% of total revenue.
  
• Led by a stellar performance in Germany, where we also have number one market share, Europe had its second strongest quarter ever, up 21% sequentially and up 10% year over year to 35% of total revenue. Asia-Pac was up 3% sequentially and down 7% year over year for a total of 10% of revenue.
  
• All major geographies were up sequentially and on a constant currency basis, we were up about 1% year over year in a quarter where most major competitors were down double digits.
  
• Direct revenue was 33% of total revenue this quarter, up 14% sequentially and flat year over year. Our indirect channel contributed 67%, up 6% sequentially and also flat year over year.
  
• The top 100 accounts increased in the mix this quarter, accounting for about 44% of total revenue, a little higher than previous quarters.
  
• (Q&A) With the quarter results coming in meaningfully over the guidance provided in early October, I was just wondering if you could talk about linearity in the quarter. Was there a late surge of demand that surprised you? (A)This is Steve here. Yes, it was a little stronger than we had anticipated in those last three weeks. We were doing really well right up to the Analyst Day. And to be fair, we didn't know if it was going to continue at the rate it had, particularly given that the fed's business ended the month end of September. But the commercial business really finished very, very strong. And we actually I think ended up revenuing about $220 million during those last three weeks. So yes, we were a little surprised at how strong it was.
  
• You've commented in the past that you had priced maybe a little bit more aggressively than you needed to, and it seems like better pricing helped gross margin this quarter. Does that pricing strategy still hold? I mean you made some comments about maybe pricing a little bit more aggressively to drive growth. Can you talk about that a little bit? (A)Yes, I'd say I think at 67 points of gross margin, I think the discipline that we put in the system around discounting where we've had some very frank coversations with the sales organization and communicated to them the impact of more discipline I think has clearly paid off. On the last call, we were high in gross margin also, higher than we thought, and we indicated that we would do some more aggressive pricing in certain situations. I don't think we want to price more broadly unless that discipline dissipates. But I think that we were committed to aggressively pursuing some deals and we did that. But nonetheless, the numbers remain strong. I think Steve talked about the components, the product mix and the life, obviously the role of the deferreds. But all in all, I think we did in fact pursue aggressively a number of deals, but the overall price margin - gross margin remains strong. So all in all, I think the value proposition is clearly resonating and it all starts with that. It's defending the price and supporting the price in the face of the customer. I think we've done a really good job there. And even though we have indeed pursued some very, very aggressive deals, the aggregate gross margin remains strong. (A)As I mentioned in the guidance that we gave you for the third quarter, David, we expect the margin to recede a little bit from the high water mark we just hit. And part of the reason for that is we're going to be giving some of those cost savings that we think are fundamental or long term if you will. We're going to be passing those through to our customers.(A)The other thing is what we don't want to do is just broadly drop price, if that's what you're getting at. We're clearly not going to do that. On the other hand, there are incentive programs that we can run with our partners to generate demand, and those things will come at the cost of contra revenue, which will impact gross margin. But those are the things that we have in mind to stimulate demand at this point as opposed to a broad pricing change.
  
• Could you talk a little more about the OpEx? Just given the substantial increase in your SAN exposure, should we think about R&D potentially going up as the complexity of some of those solutions with some of your customers maybe requires more R&D in terms of new products down the road? (A)I wouldn't go there. I don't think that the growth of our SAN business is going to impact our R&D investment. Clearly we've been investing a lot of R&D in our SAN business to drive the functionality. So I think we feel good about our competitive position but I think overall the mix of SAN versus NAS - we have an integrated architecture so the vast majority of the features - I should say unified architecture, so the vast majority of the features are common to both. As a result, I think the strength of SAN I think has to do with the previous investments we've made to drive the competitiveness of the product. And I think just as important is sales force confidence. I think the sales force is very confident leading with a product now. So I think if anything, the R&D investment will stabilize in that dimension as we made the progress that we have.
  
• Steve, I wanted to go back to gross margin if I could on products in particular. You had about a 10% sequential increase in revenues for products, and yet I think your costs of goods sold, even on a dollar basis, was down sequentially. And I just want to try to understand more what was the key drivers there, and then what changes as we look at the next couple quarters. Was there any kind of one-time events in there either on a materials basis or otherwise? I just wanted to try to get a little more color on the product gross margin specifically. (A)Let me - I'll try and quantify some of the commentary that I had in the script there, Keith. So to start with the big items, probably material costs themselves were the biggest issue. This has to do with the timing of when we receive a cost increase versus when we can pass it on to our customers. So that was about a two percentage point favorable benefit going from Q1 to Q2. The configurations we saw this quarter were very rich and really across the board, across all segments, and up and down the line for the product line, for that matter. And remember, V-Series had one of its strongest quarters ever. It was very large in the mix, and the V-Series has a very, very favorable gross margin structure.

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