NetApp, Inc. (NTAP) Q4 2011 Earnings Report, Transcript and Summary

Welcome to the NetApp Fourth Quarter and Fiscal Year 2011 Conference Call. My name is John, and I'll be your operator for today's call. [Operator Instructions] Please note that this conference is being recorded. I will now turn the call over to Ms. Tara Dhillon. Ms. Dhillon, you may begin.

Good afternoon, everyone. Thank you for joining us. With me on today's call are our CEO, Tom Georgens; and our CFO, Steve Gomo. 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. Concurrent with today's press release, a supplemental commentary we published contains many of the metrics we previously provided during our live call, as well as an analysis of the impact of the accounting change, in order to provide you with additional time for review of the data and allow us to focus on more strategic commentary and perspective from our CEO and CFO during this call. As a reminder, during today's call we will make forward-looking statements and projections, including our financial outlook for Q1, our expectations regarding our future market share, the benefits of our recent product introductions, our recent acquisition of the Engenio external storage systems business and our partnerships 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 from our projections are detailed in our accompanying press release, which we have filed on an 8-K with the SEC, as well as in 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 under the newly adopted accounting standards 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. To see the analysis of the impact of the accounting change on our FY '11 quarterly and annual results, please refer to Page 3 of our supplemental commentary and for a complete recast consolidated statement of operations, refer to Page 14 of the supplemental commentary or to the table on our website at investors.netapp.com. I'll now turn the call over to Steve for his thoughts. Steve?

Thanks, Tara. Good afternoon, everyone. From a financial performance standpoint, Q4 put an exclamation point on a very strong FY '11. Despite being hampered by supply constraints through the first half of the quarter, NetApp finished Q4 with solid revenue growth, record earnings per share and new record free cash flow generation. As you can see from our financial statements, NetApp also adopted the required new accounting standards for revenue recognition this quarter and recast the previous 3 quarters' financial statements under the new standards. As a result, the numbers I will reference for all periods in FY '11 and going forward reflect this new accounting methodology. The change in accounting treatment of revenue complicates the evaluation of our performance relative to the Q4 guidance we gave last quarter, which was for revenue to finish at $1.38 billion, plus or minus 2%. This guidance implies sequential revenue growth of 7% to 11%. With the adoption of the new accounting standards in Q4, the only apples-to-apples comparison we have to assess Q4's revenue performance is the actual 11% sequential revenue growth reported under the new methodology. This sequential growth rate corresponds to the high end of our guidance range for revenue. With this new methodology, it's important to remember that revenue value is neither created nor destroyed. There is simply a modest impact from the timing of when certain revenue elements are recognized. Because there is 0 revenue impact over the total life of a multi-element arrangement, our business model remains unchanged. Finally, with the adoption of the new rules, our revenue recognition is now comparable to all major competitors who have adopted this convention about a year ago. Turning now to our results. As I mentioned, total revenue grew 11% sequentially to $1.428 billion in Q4. More importantly, product revenue grew 14% sequentially to about $960 million, the second highest sequential growth rate in the past 5 years. Non-GAAP gross margins declined modestly to 65.5%, in line with our expectations. Product margins also finished the quarter in line with what we were expecting. Non-GAAP operating expenses increased 14% sequentially, up more than forecasted in Q3 due primarily to higher commission expenses, reflecting the strength of our core business. We ended Q4 with 454 net new employees, which does not include the folks we welcomed from Engenio as the transaction closed post Q4. As I highlighted earlier, the underlying business dynamics in Q4 were very strong. Our total units shipped were up 29% year-over-year despite material constraints through the middle of the quarter. The material constraints contributed to a back end loaded shipment profile which in turn, drove our accounts receivables days sales outstanding to 47 days. With the material supply constraints solved for Q1 FY '12, we are expecting a more linear shipment quarter and a reduction in DSO to the high 30s in Q1. One of the biggest highlights of the quarter was our cash generation. Despite the increase in accounts receivable DSOs, our strong net profit and large increase in deferred revenue yielded a near record $459 million in cash from operations, with free cash flow finishing at $386 million. Our cash and investments rose to $5.2 billion in Q4 and deferred revenue grew 21% year-over-year, up $243 million from last quarter. Our diluted share count declined by 2.7 million shares sequentially to about 404 million shares, driven primarily by the effect that a lower average quarterly stock price has on the accounting for our convertible notes and warrants. With the average closing price of $51.23 in Q4, approximately 15 million additional shares are included in the dilutive share count to account for the impact of the notes, and another 8 million additional shares account for the warrants sold as part of the original transaction. You may recall that 80% of the convertible notes are hedged, while the warrants were not 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 will find a table on our website which shows the impact on diluted share count for a range of stock prices. Looking forward, our target revenue range for Q1 is $1.5 billion, plus or minus 3%, which implies approximately 2% to 8% sequential growth and 26% to 34% year-over-year growth. This guidance includes revenue from the Engenio business. Consolidated non-GAAP gross margins are expected to finish Q1 at just over 62%, as the OEM business from Engenio is now included in our results. We anticipate that non-GAAP operating margins will finish at about 18% to 18.5%. Dilutive share count will likely continue to be significantly impacted by the accounting for convertible notes and warrants. We expect dilutive share count to rise to roughly 410 million shares in Q1, which includes about 16 million shares from the convertible debt and 9 million shares from the warrant. Recall that the favorable impact of the note hedges is not included as an offset, bringing our earnings per share estimates to approximately $0.52 to $0.57 per share. Bear in mind, as we told you when the acquisition was announced, the first quarter EPS includes about $0.01 dilution due to the consolidation of the Engenio business. Since we cannot accurately predict what the average stock price will be for the full quarter, the dilutive share count was calculated using the $52.98 average share price from the first 10 business days of this quarter. If we were to adjust the share count for the convertible bond hedge, that would add about $0.02 to the EPS guidance. It should be noted that we are expecting our blended consolidated non-GAAP effective tax rate to increase to 18.5% in FY '12. The vast majority of this increase reflects our expectation that the distribution of pretax profits will shift slightly next year, such that a greater proportion of pretax profits will be realized in the U.S. and subject to a higher corporate tax rate. The primary drivers of this shift are our core business, where the U.S. is growing faster than our international business, and the consolidation of the Engenio business, which has a higher concentration of pretax profits in the U.S. To summarize, we are very pleased with the strong growth in our product revenue despite the supply constraints in the first half of the quarter. The strength of our business model is evident with record revenues, record earnings per share and near record cash from operations. We plan to continue to prudently invest in growing our business while at the same time generating strong free cash flow. At this point, I'll turn it over to Tom for his perspective. Tom?

Thanks, Steve, and good afternoon, everyone. The NetApp team delivered a very strong close to our fiscal year. With a record number of deals over $1 million and a record number of deals over $5 million, our Q4 results demonstrated our continued momentum in the market and expanded presence in some of the largest data centers around the world. NetApp's innovation leadership continues to be the yardstick by which all other storage vendors are measured and our November product announcements further enhanced our competitive position, leading to our fastest uptake ever of new platforms. We continue to expand the most diversified channel and partner network in the industry, enabling the largest market share gains in our history. The associated supply chain issues experienced in Q3 were resolved during the quarter despite very strong demand and we ended Q4 with near record increases in cash and deferred revenue generation. Our platform refresh of the 3000 and 6000 family in November continued its strong momentum during Q4. The 6000 family saw units increase 86% sequentially and 64% year-over-year. The 3000 family grew 39% sequentially and 51% year-over-year. The 2000 family was up 11% year-over-year and down 4% sequentially, as some demand moved up to the newer 3200 platforms. The V-Series, which continues to be a compelling vehicle for enabling the introduction of Data ONTAP into new accounts, grew 37% sequentially and 35% year-over-year. In fairness, the 3000 compares were modestly assisted by ending backlog from last quarter due to parts availability issues. To be more specific, the supply constraints were on an I/O expansion module, a new capability of the 3000 family that enables the installation of additional feature cards. The major driver of this demand was the customer preference for additional Flash Cache modules which increased about 200% from Q4 of last year and are now attached to 2/3 of the 6200s and 1/3 of the 3200s. This is evidence of the rapid adoption of the Flash Cache and serial ATA drives as a compelling approach to optimizing price performance of storage systems as opposed to the administrative and operational complexity of storage tearing schemes. The last couple of quarters have seen virtually every storage competitor make announcements about the shipment and promise of new capabilities. From our perspective, the overwhelming majority of the messaging can be summarized with the simple phrase, "just like NetApp", as competitors attempt to address NetApp's innovation leadership in the areas of storage efficiency, virtualization, caching, flash integration and unified storage. While one can debate whether the first generation approaches that are inconsistently and incompatibly implemented across multiple platforms realistically narrow the gap, there no longer seems to be any debate about our innovation leadership. In addition to the innovation dimensions I already mentioned, other areas such as integrated data protection, where NetApp has now become the number one provider of replication software, deduplication for primary storage and secured multi-tenancy remain unchallenged in production environments and we have a roadmap of continued innovation well into the future. Recent competitor announcements notwithstanding, we remain confident in our competitive position, and our sustained market share gains confirm our success. From a geographic year-over-year growth perspective, EMEA grew 15%, Asia Pacific grew 21%, Americas grew 14% and the U.S. Public Sector an incredible 73%. As with prior quarters, the timing of shipments impacts these numbers and U.S. Public Sector is probably a bit overstated and the APAC and the Americas are understated. Nonetheless, our U.S. Public Sector business remains particularly robust as virtualization and cloud deployments remain a broad governmental priority. For full transparency, the year-over-year comparisons are slightly enhanced as last Q4 numbers were not adjusted for the mandatory new accounting regulations. Our reference to build the most diversified channels to market continued to have significant impact on the business in Q4, as our indirect business grew to a record 75% of revenue. Our distribution partners, Arrow and Avnet, grew 39% year-over-year to 31% of our total business. Our business with Fujitsu finished the year strongly with 18% growth over last Q4, and our newly acquired Engenio business expands and creates new OEM partnerships. Examples are Teradata in the data warehousing and analytics space and at the entry level and server test segments of the market, the IBM and Dell relationships will enable us to achieve product volumes in these price bands that cannot be attained through branded channels of standalone storage companies. Besides our channel partners, we have accelerated our alliance partner activity as well. Our Accenture relationship continues to expand, along with a significant number of jointly developed practices and solutions with other systems integrators around the world. Our SI relationships continue to thrive, as they know that NetApp strategy is to not compete with them for professional services and they also see NetApp becoming more relevant in their existing and targeted accounts. The strong collaboration with VMware and Cisco continues to create an ever-increasing number of joint business opportunities. The past few weeks have been particularly notable as more partners embraced FlexPod. With the recently announced FlexPod integrations with Citrix, Microsoft and SAP, as well as the Microsoft on NetApp and Hyper-V Cloud Fast Track program, NetApp continues to build out what we call the innovation stack, a tightly integrated set of best-of-breed hardware and software solutions. The NetApp innovation stack now provides customers the largest portfolio of best-of-breed solution offerings of any of our server or storage competitors. The completion of the Engenio acquisition brings an entirely new set of market and channel expansion opportunities for NetApp. Engenio develops a set of building blocks that can be combined with additional technologies to create a number of market solutions. The building blocks can be bundled with NetApp-owned or OEM IP to create solutions for workloads we have not previously served, as well as emerging workloads that will have very large storage requirements in the future. In addition, the building blocks can be bundled with the OEM partner's IP to create solutions that are brought to market in channels that we previously could not reach. Meanwhile, the positioning of Data ONTAP as the industry's premier platform for our traditional enterprise IT and technical computing markets remains unchanged for our direct sales team and our channel partners. Overall, we are off to a good start with Engenio as the high end has just been refreshed, the first NetApp solutions have been announced, we issued our first quotes and we have communicated our field engagement approach through our existing channels as we seek to expand our relationship with our new OEM partners. The recent few weeks have brought to a conclusion a number of items that have consumed a great deal of energy in Q4. We resolved the materials availability issues that impacted our Q3, we implemented the mandatory accounting changes and we closed the Engenio assets purchase. The closure of these items, in addition to the extreme intensity typical of a Q4, is indicative of the enhanced execution capabilities of the company. With these transitional items behind us, we can concentrate all of our efforts on gaining share in our core business and in deriving increasing value from the Engenio acquisition. As fiscal year 2011 comes to a close, we can take a minute, but no more than a minute, to reflect on a year of 30% revenue growth, the largest market share gains in our history, a 50% increase in million dollar accounts and the biggest new product launch in our history. I would like to thank the now more than 11,000 NetApp employees for all they have done for our customers, our shareholders, our partners, our community and each other to make these accomplishments possible. I would like to especially recognize our team in Japan for being an inspiration to all of us in their difficult times. Finally, I want to take the opportunity to welcome the Engenio group to the NetApp team, and I look forward to another year of records in fiscal year '12. We also look forward to spending time with the financial community at our Analyst Day on June 30 to help you gain a deeper understanding of our strategy, our financial picture and the scope of our competitive differentiation. At this point, I will open up the floor to questions. Please limit yourself to one so we may address as many people as possible during our remaining time. Thank you. Operator?

[Operator Instructions] Our first question comes from Ben Reitzes from Barclays.

Could you talk about Engenio in a little more detail? Are you still looking for $750 million in revenue for the fiscal year and the same margin impact for the year? And what are you including in the first quarter? And if I can slide in, can you just update, Tom, now that you have closed the deal, have you spoken to your server OEM customers and how do they feel about NetApp and Engenio?

Okay, so there's a lot of questions there, and Tom and I are kind of looking at each other who's going to answer what. Let me try with a couple of questions to start with. With respect to the information we gave you a couple of months ago when we announced the Engenio acquisition, nothing has changed. Indeed, we think that there's been about a 3-percentage point impact on our gross margins as a company as a result of the Engenio transaction and you see that in the first quarter. Our operating expenses are also going to be lower by about 2 percentage points as a percent of revenue. And our operating margin is probably about a point lower as a result of the transaction. So all of that is identical to what we told you with respect to the transaction.

Yes, I don't think we've seen anything different yet. As far as the OEMs go, clearly we've had conversations with them all along, and I think their stance is wait and see. I think they all have plans that they don't want to change, but they're waiting to see what we do because they'll change if they have to. So I think so far we've said all the right things and now it's up to us to prove that we're going to do all the right things. And I think if we do that, I think we will keep them on track and keep them on a trajectory that they're on. And I would say that for some of the OEMs, the NetApp channels and the other NetApp intellectual property actually creates opportunities for us to actually do more with them. So I think so far, I think our assumption is that we know what our intentions are and we expect them to stay on track and when we demonstrate our intentions with actual practice now that we actually own the business, I think that they'll see that we're going to back up our words and that the relationships that we currently have and the trajectory we're on will stay on track with some opportunities for upside around some of the newer deals.

Finally, Ben, I think you asked how much revenue we had included in the first quarter on behalf of Engenio. So we've assumed that there's going to be about $140 million, and we put a pretty wide band around that. We said plus or minus 10%. You should understand that Engenio is not going to be a standalone entity or managed as a separate entity. It's going to be completely integrated into NetApp. The engineering teams are managed by the same leadership team we have here, the sales teams, et cetera. So we're going to have Engenio kind of start to blur in to our operations. That said, if you look at the OEM business that Engenio brought with us, in the first quarter, it's going to be about $140 million, plus or minus 10%.

Our next question comes from Maynard Um from UBS.

Just a clarification, can you just help me with the math on Engenio? If it's a $0.01 dilutive, you gave the gross margins, but does that imply that the core operating margins are rising sequentially to around 20%? And then the question just on geographic and vertical areas, in particular geographies there were certain markets that you were not as strong in, where you had a small footprint in Europe and Asia. Just wondered if you can give an update on any progress there.

So as far as geographic, I'll take that one first. And I'll probably ask that we stick to one question going forward. As we go through the various different geographies, certainly Europe, Germany has been strong. Obviously the U.K., the government itself is undergoing a relatively significant austerity and some of the Southern European countries for NetApp have not been big markets for us historically. So I think some of the upheaval there has not been as impactful to us. And in fact, actually we had pretty good quarters in some of those. So part of my advice to the team is that when you've got more market share, the macroeconomics don't really matter very much. And I think we've been managed to grow and gain share in those segments despite the macro environment. So I think we're making progress there but if we had our traditional market share, I think that clearly that would have some impact on NetApp. But for us, we still see them as opportunities. And I sort of put Asia Pacific in the same category. I think we're pleased with the growth that we've been seeing with Asia Pacific all year. I think we're making some good progress but as a percentage of NetApp's revenue, Asia Pac isn't as high as where it needs to be, so I think that that's yet another opportunity for us. So I expect to see next year some significant growth in APAC, both in terms of our own penetration and also relative to the opportunity that at this point we're underpenetrated.

And then with respect to the margin question, so remember the 3% impact in the gross margin is unfavorable that's associated with Engenio, and the 2-percentage point improvement in operating expenses is a positive. The net effect there is to reduce the operating margin for the company, the consolidated company, by one percentage point. So all things being equal, you can add roughly a percentage point to the numbers we just guided you to if you wanted to look at the core.

Our next question comes from Brian Marshall from Gleacher & Co. Brian Marshall - Gleacher & Company, Inc.: Clearly there's been -- you've had tremendous success with your Flash Cache products and the attached rates that you've had on your raise. Question becomes with respect to storage and servers, clearly we're getting a lot more attention put on this marketplace going forward, your largest competitor talked about Project Lightning, et cetera. I was wondering if you had some thoughts there for us.

Yes, I think you meant Flash on servers. And yes, I think that there is a number of approaches to that. I think we certainly subscribe and said many times that Flash is going to change a lot of things, both around storage and servers. So I expect that there will be Flash in large quantities deployed in the servers. And I think there'll be various ways of utilizing it, some simply as a cache, some as effectively permanent storage or effectively like disk drives. So I think as time goes on, I think you'll see or continue to see innovation. You'll continue to see participation from NetApp in various different dimensions putting cache into these environments, I'm sorry, Flash into these environments. I expect Flash to be a big deal, and I think the Flash Cache has been very, very effective for us. And I think we've got aspirations to do more with it as time goes on and you'll see that come up from NetApp over the next couple of years.

Our next question comes from Aaron Rakers from Stifel, Nicolaus. Aaron Rakers - Stifel, Nicolaus & Co., Inc.: I want to dive a little bit deeper in the OEM side of the Engenio business. One of the names that you've obviously highlighted is Teradata. Can you help us understand the relationship there, the opportunity that exists for NetApp to really harvest that relationship? And then also talk about what kind of discussions you've had thus far, as well as with regard to the opportunity of selling the V-Series product on top of Engenio's installed base.

Yes, I think as far as Teradata goes, clearly they just came off an excellent quarter themselves and I think they have a lot of momentum and if you look at the data warehousing and analytics space, certainly it's getting a lot of airplay. And this is an opportunity for us to participate in that segment with the market leader. The other thing is unlike perhaps some of the other OEMs, I think there's a lot more partnership opportunity with Teradata, and that is we're not going to be in the analytics space. We're not going to compete with them. We have a broader channel and we've already had exploratory dialogue about what more can we do from a relationship perspective or on a go-to-market perspective. So I don't know what will come of that except to say that I think that Teradata and NetApp are very, very complementary in our technologies. I think we both have a lot of momentum and I think that together, we might be able to create some opportunities that we wouldn't be able to have without the Teradata relationship and Teradata would not have been able to have without -- with the previous LSI relationship. So I'm actually pretty optimistic about that one. Aaron Rakers - Stifel, Nicolaus & Co., Inc.: And as far as the V-Series opportunity, can you kind of give us a framework?

Yes, I think the V-Series opportunity first and foremost is -- there's a big installed base of Engenio platforms out there and the V-Series is already qualified with them. However, our initial thrust in that particular dimension clearly is not going to be in conflict with the OEMs. We're certainly not going to go after the IBM installed base, because clearly that would be detrimental to the relationship. I think we're in an important phase here. So I think the V-Series represents an opportunity to add value to that installed base, but we're going to do it in collaboration with the OEMs because to try to go around them I think would jeopardize all the OEM business and that's clearly not our intention now. Our intention is to keep the OEM business alive and well and thriving. So for a lot of them, the ability to add V-Series to their existing installed base is an opportunity to protect their installed base and add more value to their customers and reduce the risk of them being replaced by some joint competitor. So I'd say that the V-Series opportunity is not explicitly measured by the number of Engenio products that are out in the field. It's also going to be modulated by our level of cooperation with the OEMs, and at this point, our intention is not to go around them.

Our next question comes from Lou Miscioscia from Collins Stewart.

When you look at different revenue buckets that you had, U.S. commercial looked like it was a little bit below the corporate average. Maybe if you just give us a comment as to why that was the case and I guess as you look out to the new year, whether you think it will pick up and be at average or above the corporate average?

Yes. I'd say one of the things that impacts the actual revenue numbers is the timing of individual deals and what they had in backlog and when things come off reserves. So the actual revenue number is probably a bit more volatile than the bookings numbers overall. So from our perspective, I don't think we've got any reservations about the commercial business and the non-Federal business. I think they've been moving along quite well. And I think if you average them over several quarters, I think what you'll see is that their business is very, very strong. So overall, yes, it didn't work out that way but like I said, the U.S. Public Sector in all honesty at 73% is not indicative of that business level either. So we get some distortions on the shipment side. So I think the better way to look at the revenue split is over a smooth basis. I think if you do that, the U.S. commercial business actually looks quite robust.

Lou, I'll also add to that. I mentioned in my narrative portion that you could see a shift in pretax profits in the United States primarily because more of our pretax profits were going to be generated in the United States. That's because the U.S. businesses are growing slightly faster than the international businesses. The comps point may not be at any given quarter but over the course of next year, not only are we anticipating that but we're basing our tax assumptions on that as well.

Our next question comes from Amit Daryanani from RBC Capital Markets.

Just a question on the pricing dynamics. There's been a lot of concern, at least in the investors, about aggressive pricing in the industry. Your numbers probably don't imply that, but could you just probably talk about what are you seeing from a competitive pricing basis in the April quarter and how do you see that tracking to July?

I don't see it as any different, but that's not to say that it's -- I guess the term that you like to use is benign. It's a jungle out there and every deal is very competitive. And we'll see an entire range of opportunities from competitive takeouts which can be extremely competitive, to upgrades and things like that. So I would say there's no doubt that we do some very, very traditional deals. And in certain circumstances, we do some very, very, very aggressive deals. And our competition will do the exact same thing. So I would say the overall pricing environment is still very, very aggressive, still very, very competitive, but I don't think it's any different than it was 6 to 9 months ago.

Our next question comes from Richard Gardner from Citi.

I guess just a follow-up to that one, Tom, can you just give us your latest thoughts on the new midrange offering from EMC, the VNX, and whether that's having any sort of impact in the marketplace at all, whether it has had an impact on your win rates or it's causing customers to delay any other purchase decisions as they evaluate the new platform?

Well, I think fairly the results say that there's certainly not been any disruption to the business. When I look at the VNX, the VNX was a new product refresh and we also did our new product refresh. So I'd say that relative to the competitive balance between NetApp and EMC, relative to the VNX announcement and our announcement, I'd say to the first order is that basically nothing's really changed there. I think what it also does is it actually creates separation of us and EMC from the rest of the pack, but I don't think that the VNX changed the competitive dynamics vis-a-vis EMC -- vis-a-vis NetApp. So I still think they'll be an aggressive competitor. They'll be everywhere. They'll market aggressively. But I don't see that it's any different than it's been for the last period of time. But I do believe that the cadence of the independent providers, the EMC's and the NetApp's, is such that it's going to be more and more difficult for the rest of the storage industry to keep pace.

Our next question comes from Deepak Sitaraman from Crédit Suisse. Deepak Sitaraman - Crédit Suisse AG: Steve, can you talk us through the drivers of your product gross margin? And how much of an impacted mix, which seems to be skewed to the mid to high end that Q4 has? And I guess how should we think about that 61% product gross margin going forward? And just as a follow-up to that, relative to the 18% to 18.5% operating margin guidance for the first quarter, how should we think about the progression of your operating margins as we go through the year?

Okay, several questions, but I'll try to nail them all. First with respect to the sequential product growth, Q3 we reported that 61.5% and Q4 we reported 61%, and this is all apples-to-apples comparison. If you look at the delta there, we had expected about a half a point decline and indeed we saw it. The biggest single impact was in FX. FX was just not as favorable in the fourth quarter as it was in the third and we saw that coming. So that was based -- that was built into our forecast. So that's the single biggest thing. With respect to product mix and customer mix, there was almost no impact last quarter from that. It had a very, very small impact. Cost reductions and pricing adjustments were in line. So at the end of the day, it turned out to be primarily an impact due solely to the FX. Going forward, I think -- you can't quite see it because we've added the Engenio business, I don't expect a lot of change to our product margins going forward in our first quarter forecast. I think they're going to hang roughly right where they are. You always have to give me about half a point one way or the other, but I'd predict probably no change. And with respect to margins, I gave you the margin for the first quarter. I talked about the Engenio impact and at this point, we're not really going out any farther with respect to any guidance. We'll deal with that topic at the Analyst Day at the end of June.

Our next question comes from Bill Shope from Goldman Sachs.

Okay, great. I recognize that you guys just closed the Engenio acquisition. But if we kind of look forward, can you guys comment on how should we think about your pace of acquisitions? And I guess more importantly, how should we think about how M&A now fits into your longer-term strategy?

Well, I'd say this is one big win in a row so it hardly makes a trend, but we did a couple of small acquisitions. We did Akorri, we did Bycast before that and now we did this one. I think our position is essentially unchanged and that is when it's the right transaction at the right price and we think it's appropriately strategic that NetApp can execute on, then I think we'll move ahead. I think the small ones, the pace on those might just pick up a little bit just as we get bigger. But I think the big ones are going to be opportunistic. So I would say that compared to where we were, we have no greater appetite to do deals nor no lesser appetite to do deals. I think that's substantially unchanged.

Okay, fair enough.

Our next question comes from Brian Freed from Wunderlich.

Following up on your commentary around the tax rate, you mentioned your expectation for a higher growth rate in the U.S., but it seems a little counter to your peer group, at least in recent quarters. And given that you're a little bit underpenetrated by your own admission in APAC and Southern Europe, et cetera, can you talk a little bit about strategically why you would have the U.S. growing faster and why not invest more in some of the international markets?

Well, I think all your points are right about the penetration in the international, but I think it's also important to point out that our penetration opportunities are still very significant in the U.S. Plus, I think the U.S. PS [Public Sector] team is really doing well. You saw their growth. But I'll be the first to tell you that the 73% year-over-year growth they put up last quarter is probably not a realistic measurement of what's really happening. But if you took the average of the third quarter and the fourth quarter, I think the third quarter was up 6%, the fourth quarter was up 73%. You get to around -- you get north of 30% for sure and they've been chugging right along. The U.S. commercial team is doing extremely well, particularly penetrating new channels and developing those new channels, broadening out those new channels. All of that's adding to the U.S. growth. Europe as you know has been challenged a little bit, particularly Southern Europe, but even some of the bigger countries with the sovereign debt issues that are going on over there and some of the uncertainty, so we've probably been a little cautious in that area. We'll have to see how that all plays out. But basically, the U.S. is really cooking right now in both of our major organizations that are involved in the U.S.

Our next question comes from Keith Bachman from Bank of Montréal.

I wanted to ask a question about your relationship with IBM that's not related to Engenio and more specifically, if IBM's coming out with some unified storage platforms during the course of calendar year '11, do you think that would change the nature of their existing relationship with, say, the 2000 and 3000 existing NetApp series?

Well, I think independent of Engenio and independent of N Series, clearly I think we made it clear on this call that IBM has aspirations to have products in this space, and they've had that all along. And certainly all that's factored into the forecast that we gave. On the other hand, our observation with them is that the business is going to be a very, very opportunistic. The desire by their internal groups to develop their own products makes the positioning very, very complicated. And are we happy with the positioning? No. On the other hand, our engagement with IBM's customer facing groups, the people who actually have to put solutions in front of customers, that relationship is actually exceptionally strong. So I think that an approach to storage from a pure platform perspective and basically creating SAN products and NAS products and unified products in a very, very hardware point of view is interesting, but it's just recreating the fractured product line that's given us an opportunity to gain share. I think what's really important is actually creating solutions for customers. How do we solve virtualization, how do we solve database, how do we do virtual desktop, how do we build a cloud, how do we handle high bandwidth applications and the like. And I think that's where the software value proposition is really what separates us. So I think that there'll be a lot of motion with IBM around their existing products. But I also expect that there's still going to be a lot of customer facing demand for NetApp, and it's been that way for the last 5 years. I mean, it's really no different today. IBM has introduced products that are competitive with both Engenio and with the NetApp offerings over the years, yet this business still continues to grow, it still continues to be robust. So I think we understand. I think our eyes are wide open as are theirs. I think that internal groups are looking to compete and develop competitive products and if they truly are competitive and they truly can compete with our feature set both from a hardware and a software perspective, clearly demand will shift in that direction. But if we continue to out-innovate them and have a higher development gains and introduce products to market faster, then we'll preserve the business. It's no different. It all comes down to innovation and execution excellence. And it's been that way for the last 5 years and that's the nature of the OEM business.

Our next question comes from Eric Martinuzzi from Craig-Hallum.

Coming out of the Q3, you estimated your free cash flow percent at about 23%, maybe up to 24%. You obviously did well above that. You had a real strong 27% free cash flow for Q4. What's your expectation for Q1? Do we go back to kind of a more normalized rate there?

Yes. So every time I give you guys guidance with respect to free cash flow, I'm talking about an annual rate. That's because there's a seasonality to our free cash flow. We have massive accruals in the back half of the year, particularly with respect to commissions and with respect to the ICP, our incentive compensation plan. And then we pay -- in the first quarter, we always pay those down, the actual cash flows out. So the first quarter is always artificially low relative to where the year will finish and the next 3 quarters are always artificially high. That's why you have to look at the full year. I think we're at the very high end of the guidance range we gave you last time for this past year, and I think that this next year, I would use the same guidance range that I've used in the past. I will also provide information on Analyst Day of perhaps a new way to think about it, but it's not going to be a whole lot different. By the way, I might mention that if we had just had one day left of DSO this past quarter, we would have had record cash flow from operations, and every day of DSO is about $15 million, $15.5 million.

Okay, right. But even looking back over the last quarter, it was about 22%. Is that what you're saying going forward that's a good number to use? I know you said seasonally it's a lower number in the July quarter.

Yes. That's roughly, that's a pretty good number to use. Let me update you in June. For now, I would use the old chart I gave you about a year and a half ago.

Our next question comes from Katy Huberty from Morgan Stanley.

Tom, can you talk about the drivers behind the acceleration at the high end of storage systems, just given that there's an investor view out there that the high-end market is shrinking and yet both you and your biggest competitor have seen very strong results in that segment the last few quarters?

Well, I think one of them clearly is the fact that we just did a refresh of the platform, so I think that there's a set of customers that we have that are always going to go for the biggest and fastest thing. The other thing about the high end is that I don't necessarily support that language because it means a whole bunch of different things. The large systems that we build serve a bunch of purposes. Some of them are high-performance computing related around semiconductor and software development. Some of them are around mission-critical enterprise IT, but a lot of it is also around content repositories and very, very large drive counts. So all of those have got different dynamics around the high-end platform. The ones that are around enterprise IT and mission-critical applications, typical databases and things like that, those tend to have a longer evaluation cycle and come up with new platforms because they need to be evaluated and tested before they go into production. Some of the other markets, particularly around the content repository and around some of the performance sensitive, they tend to move to new platforms faster. So high-end computing in terms of data growth for mission-critical applications, I agree that that's a slow growth market. On the other hand, the need for large amounts of data that can be supported by these systems for other types of applications that demand large systems, I think those are growing quite rapidly. And that's why the traditional midrange and high end doesn't mean anything, because traditionally high end means things that are connected to mission-critical apps. But we're seeing a lot of demand from very, very large systems that are not mission-critical apps related that are looking for high drive count and high performance. And I think that part of the market is alive and well.

Our next question comes from Jayson Noland from Robert Baird. Jayson Noland - Robert W. Baird & Co. Incorporated: Question for Steve on the supply chain. Are you comfortable now that those constraints are behind us? And did that challenge push any revenue out into Q1?

Yes, I think we're -- let's put it this way, we're as confident as one can currently be with the state of the world the way it is that our supply problems are behind us. There is no impact on Q1 that we're projecting. That said, we've gone through a pretty rigorous analysis with our supply chain, both our own vendors and then our partners and their vendors. It's been a deep scrub. We've tried to identify all kinds of issues or any issues that are out there. We've also taken steps to where possible have backup vendors or secondary sources of product and supplies. We've, in several cases, bought ahead so that we can guarantee ourselves a certain supply. So we've done everything we can within reason to feel confident that we know of no impending supply issue coming out there. That said, some of this information on Japan continues to come out every day and we'll just have to standby. But as of right now, we think we're in pretty good shape. Jayson Noland - Robert W. Baird & Co. Incorporated: And did that push any revenue out, Steve?

No.

Our next question comes from Paul Mansky from Canaccord.

With respect to that 10.2 on the employee count you just gave us, can you tell us where did that stand the day after you closed on Engenio, and then where do you think that will be on July 31?

Well, we're over -- as I said we're over 11,000 now because of Engenio and we also hired, we continue to hire ourselves. So we're probably looking to add about -- we're probably looking to add on top of what we've already -- where we are today and Engenio is over 11,000, we're looking to add about 500 in the upcoming quarter.

Wow, okay. And just to clarify, I think last quarter you indicated that you were thinking about probably decelerating headcount growth on a kind of an organic basis after Engenio, at least in the first half of the fiscal year, is that correct?

Yes, and some of those are related to the Engenio business as well as we look to develop channels for the new products and work around the new products that we have and also fill some of the holes that they had in their organization. So some of those are in the core business and some of that is Engenio related also. The other thing that I'd add is that it's also new college grad season, so for us there's actually going to be a substantial amount of new college grads in the first quarter. So that's going to put a floor under -- that's basically going to have a baseline amount. I think that's probably in the 150 range of just new college grads.

Perfect, appreciate that.

Our next question comes from Glenn Hanus from Needham & Company. Glenn Hanus - Needham & Company, LLC: Just back on the integrating Engenio again, in terms of gross margin, Steve, you gave us overall 62%. But if I heard you right, you're saying the product margins stayed at 61%. Wouldn't that be down a couple of hundred basis points with integrating Engenio? Just trying to get at the product margin again there going forward.

Yes, the Engenio effect is virtually all in products. So the total impact, you could -- I think it's very safe to say that the total impact of Engenio on our gross margins, the consolidated gross margins are in the product section. Glenn Hanus - Needham & Company, LLC: Right. Okay, so it's not -- I thought I heard you say 61% going forward for the whole company in product, so it's...

No, I said -- I'm sorry, for the core product at 61%. Glenn Hanus - Needham & Company, LLC: Okay, okay. Just didn't quite hear that right then. All right.

Our next question comes from Chris Whitmore from Deutsche Bank.

I wanted to follow up on your comments around big deals. Have you seen a change in buying behaviors from your customers to larger average deal sizes? Or does this reflect the culmination of a year's worth of salespeople's activity and their fiscal year? Any color in terms of what's happening there?

Yes, I think it's fair that it's as much to do with selling behavior as it's much to do with buying behavior. As you understand, big-ticket items and enterprise sales, you spend a whole year cultivating deals to kind of pull them in at the end. I would say that those dynamics in the fourth quarter and that would be fair, the one year -- the $1 million and $5 million deals have been up all year long, so I think that's been generally a trend. I think the Q4 dynamics are kind of hard to read because they represent the culmination of a full year's worth of work. But all year long the amount of deals in those categories have been very, very strong. And just as a practical matter, the number of million-dollar accounts that NetApp has then grew 50% last year and that didn't all happen in the fourth quarter. So we certainly have the selling dynamics. There's a lot of money at stake. Customers are also expecting us to behave that way and use this as a time to consolidate purchasing power in hopes of getting better discounts and all the normal dynamics that go on. But I wouldn't say -- if there was a market trend underneath, then I'd say it was probably matched by the fact that it was all fourth quarter. But in general, the amount of large deals and the amount of million dollar accounts for NetApp has been going up and it's been going up for a long time.

And just to follow up, I wanted to ask about your go-to-market strategy for the Engenio high-end product. Can you just give us some color on your strategy there, number one. And then number two, is the product ready to aggressively go after that video and video surveillance market today, or do we need to wait for a period when you integrate existing NetApp IP into that system before it's competitive?

Well first and foremost, our plan is to market that product in its traditional form through the OEMs. So we're not going to bring any of the Engenio products on a stand-alone basis into any of our channels. That business is for our OEM partners. There may be an exception here and there around certain circumstances, but for the most part, the OEMs are going to be the primary vehicle for that technology. Now it's bundled with NetApp intellectual property like in V-Series or like storage grid or some of the things that we OEM at the solution level, those things that we will sell through our direct sales force and through our channel relationships there. But I want to be really clear is that we are not jeopardizing any of the positioning of Data ONTAP in our core markets. Data ONTAP is the core product. This is not going to overlap. It's not going to be available to either our direct or indirect, outside of either special circumstances or whether it's bundled with NetApp hardware. So as far as the high-end product is concerned, the companies that sell that, the various OEM partners that sell that continue to do that, assure that we're not going to be attacking them in their core business. So our focus is going to be on a set of new workloads that we talked about, whether it be Hadoop around the analytics space which we recently announced, and obviously full motion video. So as far as this being a new product, it's really the -- I kind of lose track myself. It's either the sixth generation or the seventh generation. So it's not a new architecture. It's not a new design. It's basically an evolution of existing design, substantially the same code base with new hardware underneath it. So I'm confident in the maturity of the design team and I'm confident in the maturity of the architecture. But I believe that this product is ready for the market, and in fact we're actively quoting it right now.

Our next question comes from Brent Bracelin from Pacific Crest Securities.

I wanted to take a step back and kind of look at the trends here as we think about the storage industry. We've seen pretty significant consolidation, I think about $12 billion worth of M&A in the last kind of 2, 3 years. I guess it's a surprise to me that fact that you saw a pretty material slowdown in the server OEMs storage-related business here in kind of the first quarter, clearly didn't see a slowdown in your business. We didn't see a slowdown -- a material slowdown in EMC's business. Why do you think you're seeing the change with the server OEMs? Give us an update on kind of competition, post-consolidation. Are there new opportunities out there are as they kind of try to bring to market a new product within the installed base that perhaps frees up repair/replace opportunity for you? Help us kind of understand what you're seeing and anything that relates to consolidation and competition.

You know I think there's a few ways of looking at it. Independent of the merits of any individual vendor, I think one of the issues that the server vendors have is that at the end of the day, nobody buys storage from a server vendor unless they buy their servers. So step number one, their ability to monetize their storage investments is throttled by the server market share. And the server market share is very volatile and very fluid and probably the least value add component of the stack. So as a result, I think that they're always going to be challenged from an investment point of view. And they've all lost a lot of ground. They've all lost a tremendous amount of market share. So they're effectively reloading by acquiring companies out there that actually have innovated. But I think the same old dynamics are still at play. And the ability to sustain that investment I still think is very much in doubt. So at the end of the day, I think companies like NetApp and EMC for that matter, especially I hate to say it, are actually going to be the ongoing innovators because I think we're going to be the only guys that are going to be able to sustain the level of investment to stay competitive. So what I see happening is the companies, the server guys are basically going to use the value proposition that's effectively one of integration, that they will basically come to the end users with a stack of hardware, software and services with a single support function and basically sell an integration -- integrated, easy to deploy solution. I think that'll be the value proposition they will promote. Now what the customers find is what they're gaining in integration, they're giving up in best of breed and they may be willing to accept that trade-off or not. And those that are willing to accept that trade-off is why the OEM business matters to us because there's still going to be a set of customers that they can't reach. For those that don't want to make the trade-off, then I think it's incumbent upon us to partner with other best-of-breed players in this industry, whether it be Cisco or Microsoft or VMware and you could see the list building. We talked about Citrix and there will be a number of other players out there, SAP, and Accenture around professional services. And the idea is that if we can come to the customer with something that is every bit as integrated with a common support on the back end and companies that can provide professional services on the front end, then the customer doesn't have to trade off best of breed for an integrated solution. They can get something that is actually even more integrated yet still best of breed, and I think that's the value proposition that we're pushing. So when we talk about FlexPod and EMC talks about Vblock, effectively, the target of those is to basically compete with the integration value proposition of the server OEMs because effectively, that's the only value proposition they have.

Our next question comes from Ittai Kidron from Oppenheimer. Ittai Kidron - Oppenheimer & Co. Inc.: I had a couple of questions. Steve, when you look at your first -- your July quarter guidance, if you strip out Engenio out of the revenue, it looks like you're modeling about a 5% sequential decline for your core business, which is worse than you've had in the last couple of years, so any color on that would be appreciated. And second, how should we think about the seasonality of your Engenio business going forward. If I remember correctly, they were part of LSI and if I remember correctly, LSI had a December year end. How did the year-end bonuses structure to the salespeople over there get changed such that the seasonality and the patterns in that business start matching your own core versus still mimic LSI's?

Yes, I'm glad you brought the question up about the sequential growth in the first quarter, because I meant to mention it earlier. If you look at consolidated revenue, the 5-year average growth in the first quarter is 4.8%. That's fourth quarter to first. If you look at what we're projecting here in our guidance, it's 4.8%. So it's identical. But I would not point you towards consolidated revenue because I think the deferred elements, which are really artifacts of history, distort it. I think what you have to look at is product revenue. And over the past 5 years, the 5-year average of product revenue transition from fourth to first, or sequential growth fourth to first, is down 10.7%. This guidance is down 7.5%. In fact, this is the second best quarter we're having in the past 5 years. It's the second best first quarter we're having in the past 5 years.

So kind of taking on the second question about the sales dynamics and superimposing our fiscal year on theirs is -- I think it's an interesting one and I think there are a few dynamics at play. And one of which is reflected in the guidance that we're giving this quarter. And that is we don't quite have it for the full quarter. We have it for 12 of the 13 weeks. And one of the things that we're not entirely sure of is are there any transitional idiosyncrasies that we're going to see on a onetime basis, whether it be the prior owner accelerating revenue, whether it be the sales reps having incentive to do one thing or the other or even the OEMs themselves trying to accelerate business into the prior periods to reduce execution risks. So I think that there's a fair amount of uncertainty around the Engenio business and that's kind of why we gave the guidance that we gave with the wide range around this quarter. So we'll see how that all plays out. So the OEM business, I think, is clearly going to be moderated or impacted by effectively the quarterly boundaries of the OEMs themselves. So IBM and NCR are on natural calendar boundaries, although Dell and some of the other players are not. And LSI was indeed on the calendar boundaries as well, so it kind of supported that. So I'm guessing is that our own commission and accelerator structure are going to distort it a little bit, but I still believe that at the end of the day, these products are not built to inventory. There's no channel stuffing. There's none of that going on. So I would expect the seasonality to stay substantially similar to the seasonality that they've previously seen because they'll be driven by the OEMs themselves. Now the NetApp branded component of that, which in the first quarter is not going to be very significant but will build over time, I would expect that element of the portfolio to actually move to our calendarization. Ittai Kidron - Oppenheimer & Co. Inc.: Okay, so if I may follow up on that, it sounds like you're suggesting Engenio, assuming that they follow on their own schedule, should have a stronger contribution in the -- I guess it's your January, your third fiscal quarter. Do you see any challenges in the fact that the salespeople over there would have about 6 quarters from the last time they had a year end till the next time they'll have an official NetApp year end?

Two things, one of them is I think that the first question around the Q3 is reasonable. In fact, if you look at our IBM OEM business now, in Q3, that's when they peak as a percentage of our revenue. And in the quarter we just finished is when they're at the bottom. And that's exactly what happened. I would expect that to stay the same. As far as the rest on their end on the OEM business, it's hard for them to generate near-term demand. They clearly focus on design wins and winning next generation platforms but driving close end demand is always a challenge to them. So the fact that they've gone this period of time, I don't think that's going to change the dynamic very much. A lot of their compensation scheme is related to design wins which are asynchronous to their quarterly boundaries.

At this point, we have reached our time limit. Ms. Dhillon, do you have any closing remarks?

Thank you, operator. I would just like to remind our callers today that our Financial Analyst Day has been rescheduled to June 30 in New York and the registration site is now open, so we ask for you to please register promptly. We've got some space limitation, and feel free to contact our IR team if you need the information. Thank you all for your time today. Good day.

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.