Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-Q

 

 

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended October 29, 2010

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission file number 0-27130

 

 

NetApp, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   77-0307520

(State or other jurisdiction of

incorporation or organization)

 

(IRS Employer

Identification No.)

495 East Java Drive,

Sunnyvale, California 94089

(Address of principal executive offices, including zip code)

Registrant’s telephone number, including area code:

(408) 822-6000

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer   x    Accelerated filer   ¨
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

Indicate by check mark whether the registrant is a shell company (a Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class

 

Outstanding at November 12, 2010

Common Stock   361,423,011

 

 

 


Table of Contents

TABLE OF CONTENTS

 

          Page No.  
PART I. — FINANCIAL INFORMATION   

Item 1.

  

Condensed Consolidated Financial Statements (Unaudited)

     3   
  

Condensed Consolidated Balance Sheets as of October 29, 2010 and April 30, 2010 (Unaudited)

     3   
  

Condensed Consolidated Statements of Operations for the Three and Six Month Periods Ended October 29, 2010 and October 30, 2009 (Unaudited)

     4   
  

Condensed Consolidated Statements of Cash Flows for the Six Month Periods Ended October 29, 2010 and October 30, 2009 (Unaudited)

     5   
  

Notes to Condensed Consolidated Financial Statements (Unaudited)

     6   

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     23   

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

     37   

Item 4.

  

Controls and Procedures

     39   
PART II. — OTHER INFORMATION   

Item 1.

   Legal Proceedings      40   

Item 1A.

   Risk Factors      40   

Item 2.

   Unregistered Sales of Equity Securities and Use of Proceeds      59   

Item 3.

   Defaults upon Senior Securities      59   

Item 4.

   Reserved      60   

Item 5.

   Other Information      60   

Item 6.

   Exhibits      60   

SIGNATURE

     61   

TRADEMARKS

© Copyright 2010 NetApp, Inc. All rights reserved. No portions of this document may be reproduced without prior written consent of NetApp, Inc. NetApp, the NetApp logo, Go further, faster, DataFabric, Data ONTAP, FAServer, FilerView, FlexCache, FlexClone, FlexShare, FlexVol, MultiStore, NearStore, Network Appliance, SecureShare, SnapDrive, SnapLock, SnapManager, SnapMirror, SnapRestore, Snapshot, SnapVault, and WAFL are trademarks or registered trademarks of NetApp, Inc. in the United States and/or other countries. Windows is a registered trademark of Microsoft Corporation. Linux is a registered trademark of Linus Torvalds. UNIX is a registered trademark of The Open Group. All other brands or products are trademarks or registered trademarks of their respective holders and should be treated as such.

 

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Table of Contents

PART I. FINANCIAL INFORMATION

 

Item 1. Condensed Consolidated Financial Statements (Unaudited)

NETAPP, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In millions)

(Unaudited)

 

     October 29, 2010     April 30, 2010  
ASSETS     

Current assets:

    

Cash and cash equivalents

   $ 1,771.1      $ 1,705.0   

Short-term investments

     2,610.4        2,019.0   

Accounts receivable, net of allowances of $1.8 and $1.6 at October 29 and April 30, 2010, respectively

     446.6        471.5   

Inventories

     84.7        112.9   

Other current assets

     218.3        228.7   
                

Total current assets

     5,131.1        4,537.1   

Property and equipment, net

     845.3        804.4   

Goodwill

     737.0        681.0   

Other intangible assets, net

     38.8        25.1   

Long-term investments and restricted cash

     69.8        72.8   

Other non-current assets

     415.8        374.0   
                

Total assets

   $ 7,237.8      $ 6,494.4   
                
LIABILITIES AND STOCKHOLDERS’ EQUITY     

Current liabilities:

    

Accounts payable

   $ 175.9      $ 184.6   

Accrued compensation and related benefits

     277.6        379.1   

Other current liabilities

     245.4        212.2   

Short-term deferred revenue

     1,135.6        1,135.1   
                

Total current liabilities

     1,834.5        1,911.0   

1.75% Convertible Senior Notes due 2013

     1,125.4        1,101.5   

Other long-term liabilities

     204.1        171.9   

Long-term deferred revenue

     866.4        779.5   
                

Total liabilities

     4,030.4        3,963.9   
                

Commitments and contingencies (Note 15)

    

Stockholders’ equity:

    

Common stock (465.6 and 451.6 shares issued at

    

October 29 and April 30, 2010)

     0.5        0.5   

Additional paid-in capital

     3,816.0        3,453.7   

Treasury stock at cost (104.3 shares at October 29 and April 30, 2010)

     (2,927.4     (2,927.4

Retained earnings

     2,307.3        2,000.9   

Accumulated other comprehensive income

     11.0        2.8   
                

Total stockholders’ equity

     3,207.4        2,530.5   
                

Total liabilities and stockholders’ equity

   $ 7,237.8      $ 6,494.4   
                

See accompanying notes to condensed consolidated financial statements.

 

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NETAPP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In millions, except per share amounts)

(Unaudited)

 

     Three Months Ended     Six Months Ended  
     October 29,
2010
    October 30,
2009
    October 29,
2010
    October 30,
2009
 

Revenues:

        

Product

   $ 780.0      $ 525.1      $ 1,500.8      $ 1,003.4   

Software entitlements and maintenance

     177.9        169.8        352.6        335.1   

Service

     249.5        215.1        491.8        409.5   
                                

Net revenues

     1,207.4        910.0        2,345.2        1,748.0   
                                

Cost of revenues:

        

Cost of product

     296.1        199.1        603.8        411.7   

Cost of software entitlements and maintenance

     3.5        3.1        6.9        6.2   

Cost of service

     106.7        101.1        209.0        200.9   
                                

Total cost of revenues

     406.3        303.3        819.7        618.8   
                                

Gross profit

     801.1        606.7        1,525.5        1,129.2   
                                

Operating expenses:

        

Sales and marketing

     382.8        300.8        737.0        602.3   

Research and development

     156.6        132.4        306.1        262.7   

General and administrative

     64.2        56.9        120.4        116.4   

Restructuring and other charges

     0.1        1.2        0.1        2.7   

Acquisition related (income) expense, net

     0.0        0.0        0.3        (41.1
                                

Total operating expenses

     603.7        491.3        1,163.9        943.0   
                                

Income from operations

     197.4        115.4        361.6        186.2   

Other expenses, net:

        

Interest income

     9.5        7.0        19.3        15.6   

Interest expense

     (18.6     (17.9     (37.2     (37.1

Other income (expense), net

     (1.4     1.5        0.8        0.4   
                                

Total other expenses, net

     (10.5     (9.4     (17.1     (21.1
                                

Income before income taxes

     186.9        106.0        344.5        165.1   

Provision for income taxes

     22.3        10.3        38.1        17.8   
                                

Net income

   $ 164.6      $ 95.7      $ 306.4      $ 147.3   
                                

Net income per share:

        

Basic

   $ 0.46      $ 0.28      $ 0.86      $ 0.44   
                                

Diluted

   $ 0.42      $ 0.27      $ 0.80      $ 0.43   
                                

Shares used in net income per share calculations:

        

Basic

     359.1        336.7        355.8        335.6   
                                

Diluted

     391.7        349.8        383.0        344.3   
                                

See accompanying notes to condensed consolidated financial statements.

 

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NETAPP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In millions)

(Unaudited)

 

     Six Months Ended  
     October 29, 2010     October 30, 2009  

Cash flows from operating activities:

    

Net income

   $ 306.4      $ 147.3   

Adjustments to reconcile net income to net cash provided by operating activities:

    

Depreciation and amortization

     82.3        85.2   

Stock-based compensation

     82.0        85.4   

Accretion of discount and issuance costs on notes

     25.9        25.3   

Unrealized losses on derivative activities

     6.7        0.0   

Deferred income taxes

     (29.6     (1.9

Tax benefit from stock-based compensation

     40.9        14.4   

Excess tax benefit from stock-based compensation

     (32.7     (1.4

Other non-cash items, net

     11.8        (2.2

Changes in assets and liabilities, net of acquisition of business:

    

Accounts receivable

     27.3        131.7   

Inventories

     28.2        0.3   

Other operating assets

     6.0        (1.1

Accounts payable

     (18.6     (16.9

Accrued compensation and other current liabilities

     (96.1     (140.1

Deferred revenue

     81.6        (14.2

Other operating liabilities

     19.9        (6.3
                

Net cash provided by operating activities

     542.0        305.5   
                

Cash flows from investing activities:

    

Purchases of investments

     (1,650.1     (883.2

Redemptions of investments

     1,055.3        780.8   

Purchases of property and equipment

     (83.5     (47.5

Acquisition of business, net of cash acquired

     (74.9     0.0   

Other investing activities, net

     0.0        3.6   
                

Net cash used in investing activities

     (753.2     (146.3
                

Cash flows from financing activities:

    

Issuance of common stock

     236.1        60.1   

Excess tax benefit from stock-based compensation

     32.7        1.4   

Payment on financing arrangements

     (2.0     0.0   
                

Net cash provided by financing activities

     266.8        61.5   
                

Effect of exchange rate changes on cash and cash equivalents

     10.5        13.9   

Net increase in cash and cash equivalents

     66.1        234.6   

Cash and cash equivalents:

    

Beginning of period

     1,705.0        1,494.2   
                

End of period

   $ 1,771.1      $ 1,728.8   
                

See accompanying notes to condensed consolidated financial statements.

 

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NETAPP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. The Company

Based in Sunnyvale, California, NetApp, Inc. (“we” or “the Company”) is a supplier of enterprise storage and data management software and hardware products and services. Our solutions help global enterprises meet major information technology challenges such as managing storage growth, assuring secure and timely information access, protecting data and controlling costs by providing innovative solutions that simplify the complexity associated with managing corporate data.

2. Condensed Consolidated Financial Statements

Fiscal Year — We operate on a 52- or 53-week fiscal year ending on the last Friday in April. In a 52-week fiscal year, each quarter includes 13 weeks of operations; in a 53-week fiscal year, the first quarter includes 14 weeks of operations and the second, third and fourth quarter include 13 weeks of operations. Fiscal 2010 was a 53-week year and fiscal 2011 is a 52-week year. As a result, the six months ended October 30, 2009 included 27 weeks compared to 26 weeks for the six months ended October 29, 2010.

Basis of Presentation — The accompanying unaudited condensed consolidated financial statements have been prepared by the Company, and reflect all adjustments consisting only of normal recurring adjustments which are, in the opinion of management, necessary for a fair presentation of our financial position, results of operations, and cash flows for the interim periods presented. The statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information and in accordance with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all information and footnotes required by GAAP for annual consolidated financial statements, and should be read in conjunction with the Company’s audited consolidated financial statements as of and for the fiscal year ended April 30, 2010 contained in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on June 18, 2010. The results of operations for the three and six month periods ended October 29, 2010 are not necessarily indicative of the operating results to be expected for the full fiscal year or future operating periods.

3. Significant Accounting Policies

There have been no significant changes in our significant accounting policies for the six month period ended October 29, 2010, as compared to the significant accounting policies described in our Annual Report on Form 10-K for the fiscal year ended April 30, 2010.

Recent Accounting Standards Not Yet Effective

In October 2009, the FASB amended the accounting standards for multiple deliverable revenue arrangements to:

 

  (i) provide updated guidance on how the deliverables in an arrangement should be separated, and how the consideration should be allocated;

 

  (ii) require an entity to allocate revenue in an arrangement using best estimate of selling prices (BESP) of deliverables if a vendor does not have vendor-specific objective evidence of selling price (VSOE) or third-party evidence of selling price (TPE);

 

  (iii) eliminate the use of the residual method and requires an entity to allocate revenue using the relative selling price method; and

 

  (iv) expand the disclosure requirements to provide both qualitative and quantitative information about the significant judgments made in applying the revised guidance and subsequent changes in those judgments that may significantly affect the timing or amount of revenue recognition.

In addition, in October 2009, the FASB amended the accounting standards for revenue recognition to exclude tangible products containing software components and non-software components that function together to deliver the tangible product’s essential functionality from the scope of the software revenue recognition guidance. The revised revenue recognition accounting standards are effective for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 and shall be applied on a prospective basis. Earlier application is permitted. We are required to adopt this standard at the beginning of fiscal 2012, which begins on April 30, 2011. We are assessing the impact of the new accounting standards on our financial position and results of operations.

 

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NETAPP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

In July 2010, the FASB issued an accounting standard that is intended to improve the disclosures that an entity provides about the credit quality of its financing receivables and the related allowance for credit losses. As a result of these amendments, an entity is required to disaggregate by portfolio segment or class certain existing disclosures and provide certain new disclosures about its financing receivables and related allowance for credit losses. The disclosures as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. We do not expect the new standard to have a material impact on our financial statements.

Use of Estimates — The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Such estimates include, but are not limited to, revenue recognition, reserve and allowances; inventory valuation and purchase order accruals; valuation of goodwill and intangibles; restructuring reserves; product warranties; self-insurance; stock-based compensation; loss contingencies; investment impairments; income taxes, and fair value measurements. Actual results could differ from those estimates.

4. Statements of Cash Flows

Supplemental cash flows and noncash investing and financing activities are as follows (in millions):

 

     Six Months Ended  
     October 29, 2010      October 30, 2009  

Noncash Investing and Financing Activities:

     

Acquisition of property and equipment on account

   $ 36.4       $ 7.1   

Acquisition of property and equipment through long-term financing

   $ 12.6       $ 0.0   

Supplemental Cash Flow Information:

     

Income taxes paid, net of refunds

   $ 11.8       $ 15.6   

Interest paid

   $ 11.3       $ 11.1   

5. Business Combinations

We recognize identifiable assets acquired and the liabilities assumed at their acquisition date fair values. Goodwill as of the acquisition date is measured as the excess of consideration transferred over the net of the acquisition date fair values of the assets acquired and the liabilities assumed. While we use our best estimates and assumptions as a part of the purchase price allocation process to accurately value assets acquired and liabilities assumed at the acquisition date, our estimates are inherently uncertain and subject to refinement. As a result, during the measurement period, which may be up to one year from the acquisition date, we record adjustments to the assets acquired and liabilities assumed, with the corresponding offset to goodwill to the extent that we identify adjustments to the preliminary purchase price allocation. Upon the conclusion of the measurement period or final determination of the values of assets acquired or liabilities assumed, whichever comes first, any subsequent adjustments are recorded to our Consolidated Statements of Operations.

Bycast Acquisition

On May 13, 2010, NetApp completed its acquisition of Bycast Inc. (Bycast), a privately held company headquartered in Vancouver, Canada. Bycast develops and sells software designed to manage petabyte-scale, globally distributed repositories of images, video and records for enterprises and service providers. The acquisition extends our position in unified storage by adding an object-based storage software offering, which simplifies the task of large-scale storage and improves the ability to search and locate data objects.

We acquired 100% of the outstanding shares of Bycast for a purchase price of $80.5 million in cash, including $13.1 million which was placed in an escrow account to secure Bycast’s obligations under certain indemnity provisions. Subject to any claims for indemnity, the escrow funds will be released 18 months from the closing date of the acquisition. In addition, we assumed all of the then outstanding options to purchase Bycast common stock, and converted those into options to purchase approximately 0.2 million shares of our common stock. The results of operations of Bycast are included in our Condensed Consolidated Statements of Operations beginning May 13, 2010, the closing date of the acquisition.

 

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NETAPP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

The following table summarizes the purchase price (in millions):

 

Cash

   $ 80.5   

Fair value of vested options assumed

     3.3   
        

Total initial purchase price

   $ 83.8   
        

The fair value of the assumed options was determined using a Black-Scholes valuation model.

The purchase price as shown in the table above was allocated to Bycast’s net tangible and intangible assets based on various fair value estimates and analyses, including work performed by third-party valuation specialists (in millions):

 

Cash

   $ 5.7   

Tangible assets

     3.8   

Deferred revenue and other liabilities

     (1.4

Identified intangible assets

     23.6   

Deferred income taxes

     (3.9

Goodwill

     56.0   
        

Total purchase price

   $ 83.8   
        

Goodwill is not deductible for income tax purposes.

Adjustments may be made to the allocation of the purchase price during the measurement period to reflect adjustments to deferred taxes related to the acquisition. The identified intangible assets, which are amortized on a straight-line basis over their estimated useful lives, consisted of the following (in millions, except useful life):

 

            Useful Life (Years)  

Developed technology

   $ 18.0         5   

Customer relationships

     4.7         3   

Trademarks and trade names

     0.7         5   

Other

     0.2         2   
           

Total identified intangible assets

   $ 23.6      
           

Pro forma results of operations have not been presented because the acquisition was not material to our results of operations.

Termination of Proposed Merger with Data Domain, Inc.

In July 2009, a proposed merger between us and Data Domain, Inc. (Data Domain) was terminated by Data Domain’s Board of Directors and, pursuant to the terms of the agreement, Data Domain paid us a $57.0 million termination fee. We incurred $15.9 million of incremental third-party costs relating to the terminated merger transaction during the same period, resulting in a net amount of $41.1 million which is included in acquisition related (income) expense, net in the consolidated statement of operations.

6. Goodwill and Purchased Intangible Assets

Goodwill and identified intangible assets are summarized as follows (in millions):

 

     October 29, 2010      April 30, 2010  
     Gross      Accumulated
Amortization
    Net      Gross      Accumulated
Amortization
    Net  

Goodwill

   $ 737.0         $ 737.0       $ 681.0         $ 681.0   

Identified Intangible Assets:

               

Existing technology

   $ 93.1       $ (63.3   $ 29.8       $ 75.1       $ (55.5   $ 19.6   

Trademarks/tradenames

     7.1         (4.8     2.3         6.4         (4.3     2.1   

Customer contracts/relationships

     17.1         (10.4     6.7         12.2         (8.8     3.4   
                                                   

Total identified intangible assets

   $ 117.3       $ (78.5   $ 38.8       $ 93.7       $ (68.6   $ 25.1   
                                                   

 

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NETAPP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

Amortization expense for identified intangible assets is summarized below (in millions):

 

     Three Months Ended      Six Months Ended      Statement of
Operations
Classifications
 
     October 29,
2010
     October 30,
2009
     October 29,
2010
     October 30,
2009
    

Existing technology

   $ 3.3       $ 4.3       $ 7.7       $ 9.0         Cost of product revenues   

Trademarks/tradenames

     0.3         0.3         0.6         0.6         Sales and marketing   

Customer contracts/relationships

     0.8         0.6         1.6         1.2         Sales and marketing   
                                      
   $ 4.4       $ 5.2       $ 9.9       $ 10.8      
                                      

As of October 29, 2010, future amortization expense related to identifiable intangible assets was as follows (in millions):

 

Fiscal Year

   Amount  

Remainder of 2011

   $ 6.7   

2012

     12.6   

2013

     10.3   

2014

     4.4   

2015 and thereafter

     4.8   
        

Total

   $ 38.8   
        

7. Balance Sheet Detail

Cash and cash equivalents (in millions):

 

     October 29, 2010      April 30, 2010  

Cash

   $ 189.8       $ 187.8   

Cash equivalents

     1,581.3         1,517.2   
                 
   $ 1,771.1       $ 1,705.0   
                 

Inventories (in millions):

 

     October 29, 2010      April 30, 2010  

Purchased components

   $ 8.9       $ 9.4   

Work-in-process

     0.1         0.2   

Finished goods

     75.7         103.3   
                 

Total

   $ 84.7       $ 112.9   
                 

Other current assets (in millions):

 

     October 29, 2010      April 30, 2010  

Deferred tax assets

   $ 65.8       $ 69.6   

Prepaid expenses and other current assets

     149.2         157.0   

Short-term restricted cash

     3.3         2.1   
                 
   $ 218.3       $ 228.7   
                 

 

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NETAPP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

Property and equipment (in millions):

 

     October 29, 2010     April 30, 2010  

Land

   $ 204.7      $ 204.7   

Buildings and building improvements

     402.0        394.8   

Leasehold improvements

     76.0        73.7   

Computer, production, engineering and other equipment and software

     684.4        628.6   

Furniture

     55.7        63.2   

Construction-in-process

     62.1        37.0   
                
     1,484.9        1,402.0   

Accumulated depreciation and amortization

     (639.6     (597.6
                
   $ 845.3      $ 804.4   
                

Long-term investments and restricted cash (in millions):

 

     October 29, 2010      April 30, 2010  

Auction rate securities

   $ 66.2       $ 69.0   

Nonmarketable securities

     1.3         1.4   

Restricted cash

     2.3         2.4   
                 
   $ 69.8       $ 72.8   
                 

Other non-current liabilities (in millions):

 

     October 29, 2010      April 30, 2010  

Liability for uncertain tax positions

   $ 126.0         122.4   

Warranty

     15.0         13.7   

Other

     63.1         35.8   
                 
   $ 204.1       $ 171.9   
                 

8. Financial Instruments and Fair Value

The accounting guidance for fair value measurements provides a framework for measuring fair value on either a recurring or nonrecurring basis whereby inputs, used in valuation techniques, are assigned a hierarchical level. The following are the hierarchical levels of inputs to measure fair value:

Level 1: Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets.

Level 2: Inputs reflect quoted prices for identical assets or liabilities in markets that are not active; quoted prices for similar assets or liabilities in active markets; inputs other than quoted prices that are observable for the assets or liabilities; or inputs that are derived principally from or corroborated by observable market data by correlation or other means.

Level 3: Unobservable inputs reflecting our own assumptions incorporated in valuation techniques used to determine fair value. These assumptions are required to be consistent with market participant assumptions that are reasonably available.

We consider an active market to be one in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis, and view an inactive market as one in which there are few transactions for the asset or liability, the prices are not current, or price quotations vary substantially either over time or among market makers. Where appropriate, our own or the counterparty’s non-performance risk is considered in determining the fair values of liabilities and assets, respectively.

 

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NETAPP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

Investments

The following is a summary of investments at October 29, 2010 and April 30, 2010 (in millions):

 

     October 29, 2010      April 30, 2010  
     Cost      Gross Unrealized     Estimated
Fair
Value
     Cost      Gross Unrealized     Estimated
Fair
Value
 
      Gains      Losses           Gains      Losses    

Corporate bonds

   $ 1,805.5       $ 13.5       $ (0.5   $ 1,818.5       $ 1,128.1       $ 3.4       $ (1.8   $ 1,129.7   

Auction rate securities

     70.2         0.5         (4.5     66.2         71.6         0.7         (3.3     69.0   

U.S. agency securities

     664.6         0.9         (0.1     665.4         775.4         1.7         (0.1     777.0   

U.S. treasuries

     5.0         0.1         0.0        5.1         41.5         0.4         0.0        41.9   

Commercial paper

     474.6         0.0         (0.1     474.5         215.9         0.0         0.0        215.9   

Municipal bonds

     1.5         0.0         0.0        1.5         1.5         0.0         0.0        1.5   

Certificates of deposit

     80.1         0.0         0.0        80.1         159.0         0.0         0.0        159.0   

Money market funds

     1,146.6         0.0         0.0        1,146.6         1,211.2         0.0         0.0        1,211.2   

Equity funds

     17.9         0.0         0.0        17.9         12.6         0.0         0.0        12.6   

Investment in privately-held companies

     1.3         0.0         0.0        1.3         1.4         0.0         0.0        1.4   
                                                                     

Total investments

     4,267.3         15.0         (5.2     4,277.1         3,618.2         6.2         (5.2     3,619.2   
                                                                     

The following table presents the contractual maturities of our debt investments as of October 29, 2010 (in millions):

 

Debt Investment Maturities

   Cost      Fair
Value
 

Due in one year or less

   $ 1,131.7       $ 1,133.2   

Due in one through five years

     1,899.6         1,911.9   

Due in five through ten years

     0.0         0.0   

Due after ten years*

     70.2         66.2   
                 
   $ 3,101.5       $ 3,111.3   
                 

 

* Consists of auction rate securities which have contractual maturities of greater than 10 years.

 

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NETAPP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

Fair Value of Financial Instruments

The following table summarizes our financial assets and liabilities measured at fair value on a recurring basis as of October 29, 2010 (in millions):

 

     Total      Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs
(Level 3)
 
           
           
           
           

Assets

           

Corporate bonds

   $ 1,818.5       $ 0.0       $ 1,818.5       $ 0.0   

Auction rate securities

     66.2         0.0         0.0         66.2   

U.S. agency securities

     665.4         0.0         665.4         0.0   

U.S. treasuries

     5.1         5.1         0.0         0.0   

Commercial paper

     474.5         0.0         474.5         0.0   

Municipal bonds

     1.5         0.0         1.5         0.0   

Certificates of deposit

     80.1         0.0         80.1         0.0   

Money market funds

     1,146.6         1,146.6         0.0         0.0   

Equity funds

     17.9         17.9         0.0         0.0   

Investment in privately-held companies

     1.3         0.0         0.0         1.3   
                                   

Total

   $ 4,277.1       $ 1,169.6       $ 3,040.0       $ 67.5   
                                   

Liabilities

           

Foreign currency contracts

   $ 7.7       $ 0.0       $ 7.7       $ 0.0   
                                   

Reported as (in millions):

 

     Total      Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs

(Level 3)
 

Assets

           

Cash equivalents

   $ 1,581.3       $ 1,146.6       $ 434.7       $ 0.0   

Short-term investments

     2,610.4         5.1         2,605.3         0.0   

Other current assets

     2.3         2.3         0.0         0.0   

Long-term investments

     67.5         0.0         0.0         67.5   

Other non-current assets

     15.6         15.6         0.0         0.0   
                                   

Total

   $ 4,277.1       $ 1,169.6       $ 3,040.0       $ 67.5   
                                   

Liabilities

           

Other current liabilities

   $ 7.7       $ 0.0       $ 7.7       $ 0.0   
                                   

The unrealized losses on our available-for-sale investments in corporate bonds, U.S. agency securities and commercial paper were caused by market value declines as a result of the recent economic environment, as well as fluctuations in market interest rates. Because the decline in market value is attributable to changes in market conditions and not credit quality, and because we neither intend to sell nor are likely to be required to sell these investments prior to a recovery of par value, we do not consider these investments to be other-than temporarily impaired at October 29, 2010.

 

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NETAPP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

As of October 29, 2010 and April 30, 2010, we had auction rate securities (ARSs) with a par value of $72.3 million and $73.8 million, respectively, and an estimated fair value of $66.2 million and $69.0 million, respectively, which are classified as long-term investments. All of our ARSs are backed by pools of student loans guaranteed by the U.S. Department of Education. As of October 29, 2010, we recorded cumulative net temporary losses of $4.0 million within Accumulated Other Comprehensive Income (AOCI). We estimated the fair value for each individual ARS using an income (discounted cash flow) approach that incorporates both observable and unobservable inputs to discount the expected future cash flows. Based on our ability to access our cash and other short-term investments, our expected operating cash flows, and our other sources of cash, we do not intend to sell these investments prior to recovery of value. We will continue to monitor our ARS investments in light of the current debt market environment and evaluate our accounting for these investments.

The table below provides a reconciliation of activities related to our Level 3 financial assets for the six months ended October 29, 2010 (in millions).

 

     Six Months Ended
October 29, 2010
 
     Auction Rate Securities     Private Equity Fund  

Beginning balance

   $ 69.0      $ 1.4   

Total unrealized losses included in other comprehensive income

     (1.4     0.0   

Purchases, sales and settlements, net

     (1.4     (0.1
                

Ending balance

   $ 66.2      $ 1.3   
                

9. Financing Arrangements

1.75% Convertible Senior Notes Due 2013

On June 10, 2008, we issued $1,265.0 million aggregate principal amount of 1.75% Convertible Senior Notes due 2013 (the Notes). The Notes are unsecured, unsubordinated obligations of the Company. Interest is payable in cash semi-annually at a rate of 1.75% per annum. The Notes will mature on June 1, 2013 unless repurchased or converted in accordance with their terms prior to such date. The Notes may be converted, under the conditions specified in the indenture governing the Notes, based on an initial conversion rate of approximately 31.40 shares of common stock per $1,000 principal amount of Notes (which represents an initial effective conversion price of the Notes of approximately $31.85 per share), subject to adjustment as described in the indenture governing the Notes. For at least 20 trading days during the 30 consecutive trading days ended September 30, 2010, our common stock price exceeded the conversion threshold price of $41.41 per share set forth for these Notes. Accordingly, the notes are convertible at the holder’s option through December 31, 2010. Upon conversion of any Notes, we will deliver cash up to the principal amount of the Notes and, with respect to any excess conversion value greater than the principal amount of the Notes, shares of our common stock.

As of October 29, 2010, we had not issued any shares related to the Notes. Based on the closing price of our common stock of $53.25 on October 29, 2010, the if-converted value of our Notes exceeded their principal amount by approximately $850.0 million.

The following table reflects the carrying value of our convertible debt (in millions):

 

     October 29, 2010     April 30, 2010  

1.75% Convertible Notes Due 2013

   $ 1,265.0      $ 1,265.0   

Less: Unamortized discount

     (139.6     (163.5
                

Net carrying amount of Notes

   $ 1,125.4      $ 1,101.5   
                

 

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NETAPP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

The following table presents the amount of interest expense recognized at an effective interest rate of 6.31% relating to both the contractual interest coupon and the amortization of the discount and issuance costs (in millions):

 

     Three Months Ended      Six Months Ended  
     October 29, 2010      October 30, 2009      October 29, 2010      October 30, 2009  

Contractual coupon interest expense

   $ 5.5       $ 5.5       $ 11.0       $ 11.4   

Amortization of debt discount

     12.0         11.2         23.9         23.3   

Amortization of issuance costs

     1.0         1.0         2.0         2.0   
                                   

Total interest expense recognized

   $ 18.5       $ 17.7       $ 36.9       $ 36.7   
                                   

The following table reflects the remaining debt discount and issuance cost as of October 29, 2010 (in millions):

 

Remaining debt discount

   $ 139.6   

Remaining issuance costs

   $ 12.1   

Remaining life of the Notes (years)

     2.6   

Note Hedges and Warrants

Concurrent with the issuance of the Notes, we purchased Note hedges and sold warrants. The separate Note hedge and warrants transactions are structured to reduce the potential future economic dilution associated with the conversion of the Notes.

 

   

Note Hedges. As of October 29, 2010 and April 30, 2010, we have transactions with counterparties to buy up to approximately 31.8 million shares, subject to anti-dilution adjustments, of our common stock at a price of $31.85 per share, subject to adjustment. The Note hedge transactions will expire at the earlier of (1) the last day on which any Notes remain outstanding and (2) the scheduled trading day immediately preceding the maturity date of the Notes.

 

   

Warrants. As of October 29, 2010 and April 30, 2010, we have outstanding warrants for others to acquire, subject to anti-dilution adjustments, 39.7 million shares of our common stock at an exercise price of $41.28 per share, subject to adjustment, on a series of days commencing on September 3, 2013. Upon exercise of the warrants, we have the option to deliver cash or shares of our common stock equal to the difference between the then market price and the strike price of the warrants.

As of October 29, 2010 we are subject to potential dilution on the approximately 20% unhedged portion of our Notes upon conversion, if on the date of conversion, the per-share market price of our common stock exceeds the conversion price of approximately $31.85.

Fair Value of Notes

As of October 29, 2010, the approximate fair value of the principal amount of our Notes, which includes the debt and equity components, was approximately $2.2 billion, or 174% of the face value of the Notes, based upon quoted market information.

Other Long-Term Financing Arrangements

The following presents the amounts due under other long-term financing arrangements (in millions):

 

     October 29, 2010      April 30, 2010  

Current portion of other long-term financing arrangements

   $ 4.1       $ 0.0   

Non-current portion of long-term financing arrangements

     6.5         0.0   
                 
   $ 10.6       $ 0.0   
                 

 

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NETAPP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

10. Stockholders’ Equity

Stock Options

A summary of the combined activity under our stock option plans and agreements is as follows (in millions, except for per share information and term):

 

     Numbers
of Shares
    Weighted
Average
Exercise
Price
     Weighted
Average
Remaining
Contractual
Term (Years)
     Aggregate
Intrinsic
Value
 

Outstanding at April 30, 2010

     35.2      $ 23.02         

Options granted

     2.1        39.50         

Options assumed in acquisition

     0.2        16.56         

Options exercised

     (10.2     21.86         

Option forfeitures and cancellations

     (0.6     35.93         
                

Outstanding at October 29, 2010

     26.7        24.42         4.52       $ 770.1   
                

Vested and expected to vest as of October 29, 2010

     25.3      $ 24.25         4.45       $ 732.8   

Exercisable at October 29, 2010

     14.8      $ 23.21         3.67       $ 443.7   

Additional information related to our stock options is summarized below (in millions, except per share information):

 

     Three Months Ended      Six Months Ended  
     October 29,
2010
     October 30,
2009
     October 29,
2010
     October 30,
2009
 

Weighted-average fair value per share granted

   $ 15.21       $ 9.70       $ 13.70       $ 8.14   

Weighted-average fair value per share of options assumed in acquisition

     N/A         N/A       $ 21.15         N/A   

Intrinsic value of options exercised

   $ 104.1       $ 12.4       $ 214.6       $ 16.5   

Proceeds received from the exercise of stock options

   $ 97.3       $ 27.4       $ 224.9       $ 40.3   

Fair value of options vested

   $ 26.5       $ 35.9       $ 54.5       $ 81.9   

There was $94.2 million of total unrecognized compensation expense as of October 29, 2010 related to options. The unrecognized compensation expense will be amortized on a straight-line basis over a weighted-average remaining period of 2.5 years.

The following table summarizes activity related to our RSUs (in millions, except the fair value):

 

     Numbers of
Shares
    Weighted Average
Grant Date
Fair Value
 

Outstanding at April 30, 2010

     9.0      $ 23.93   

RSUs granted

     1.5        41.64   

RSUs vested

     (1.4     19.23   

RSU forfeitures and cancellations

     (0.4     24.87   
          

Outstanding at October 29, 2010

     8.7        27.82   
          

RSUs are converted into common stock upon the release to the employees or directors upon vesting. Upon the vesting of restricted stock, we primarily require the use of the net share settlement approach and withhold a portion of the shares to cover the applicable taxes and decrease the shares issued to the employee by a corresponding value. The number and the value of the shares netted for employee taxes are summarized in the table below (in millions):

 

     Three Months Ended      Six Months Ended  
     October 29, 2010      October 30, 2009      October 29, 2010      October 30, 2009  

Shares withheld for taxes

     0.0         0.0         0.5         0.3   

Fair value of shares withheld

   $ 1.1       $ 0.5       $ 19.6       $ 5.7   

 

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NETAPP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

As of October 29, 2010, there was $161.7 million of total unrecognized compensation expense related to RSUs. The unrecognized compensation expense will be amortized on a straight-line basis over a weighted-average remaining vesting period of 2.6 years.

Employee Stock Purchase Plan — Under the Employee Stock Purchase Plan (ESPP), employees are entitled to purchase shares of our common stock at 85% of the fair market value at certain specified dates over a two-year period. Additional information related to our purchase rights issued under the ESPP is summarized below (in millions, except per share information):

 

     Three and Six Months Ended  
     October 29, 2010      October 30, 2009  

Weighted-average fair value per right granted

   $ 11.79       $ 7.07   

Shares issued under the ESPP

     2.8         2.5   

Weighted average price of shares issued

   $ 11.08       $ 10.38   

Stock-Based Compensation Expense

Stock-based compensation expense included in the condensed consolidated statements of operations for the three and six month periods ended October 29, 2010 and October 30, 2009, respectively, are as follows (in millions):

 

     Three Months Ended      Six Months Ended  
     October 29, 2010      October 30, 2009      October 29, 2010      October 30, 2009  

Cost of product revenues

   $ 0.8       $ 0.5       $ 1.7       $ 1.7   

Cost of service revenues

     3.1         2.9         7.0         7.4   

Sales and marketing

     17.3         15.7         37.9         39.7   

Research and development

     9.2         7.9         20.3         20.6   

General and administrative

     7.3         6.2         15.1         16.0   
                                   

Total stock-based compensation expense

   $ 37.7       $ 33.2       $ 82.0       $ 85.4   
                                   

The following table summarizes stock-based compensation expense associated with each type of award (in millions):

 

     Three Months Ended     Six Months Ended  
     October 29, 2010      October 30, 2009     October 29, 2010      October 30, 2009  

Employee stock options

   $ 13.0       $ 11.1      $ 25.9       $ 40.5   

RSUs and restricted stock awards

     18.0         13.7        37.8         30.5   

ESPP

     6.7         8.7        18.3         14.8   

Change in amounts capitalized in inventory

     0.0         (0.3     0.0         (0.4
                                  

Total stock-based compensation expense

   $ 37.7       $ 33.2      $ 82.0       $ 85.4   
                                  

For the six month periods ended October 29, 2010 and October 30, 2009, total income tax benefits associated with employee stock transactions and recognized in stockholders’ equity were $40.9 million and $14.4 million, respectively.

Valuation Assumptions

The fair value of each award is estimated on the date of grant using the Black-Scholes option pricing model, assuming no expected dividends and the following weighted average assumptions:

 

     Stock Options  
     Three Months Ended     Six Months Ended  
     October 29, 2010     October 30, 2009     October 29, 2010     October 30, 2009  

Expected term in years

     4.8        4.7        4.8        4.2   

Risk-free interest rate

     1.40     2.39     1.95     2.27

Volatility

     37     41     37     43

 

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NETAPP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

     ESPP  
     Three Months Ended    Six Months Ended  
     October 29,
2010
   October 30,
2009
   October 29,
2010
    October 30,
2009
 

Expected term in years

   N/A    N/A      1.2        1.3   

Risk-free interest rate

   N/A    N/A      0.46     0.63

Volatility

   N/A    N/A      39     45

 

N/A – No new employee purchase rights were granted under the ESPP during the three month periods ended October 29, 2010 and October 30, 2009.

Stock Repurchase Program

Since the May 13, 2003 inception of our stock repurchase program through October 29, 2010, we have repurchased a total of 104.3 million shares of our common stock at an average price of $28.06 per share, for an aggregate purchase price of $2.9 billion. As of October 29, 2010, our Board of Directors had authorized the repurchase of up to $4.0 billion of common stock under this stock repurchase program, and $1.1 billion remains available under these authorizations. The stock repurchase programs may be suspended or discontinued at any time.

During the six month period ended October 29, 2010, we did not repurchase any shares of our common stock under the stock repurchase program.

Comprehensive Income

The components of accumulated other comprehensive income, net of related tax effects, were as follows (in millions):

 

     October 29, 2010     April 30, 2010  

Accumulated translation adjustments

   $ 5.4      $ 1.2   

Accumulated unrealized gain on available-for-sale investments

     7.3        0.9   

Accumulated unrealized gain (loss) on derivatives qualifying as cash flow hedges

     (1.7     0.7   
                

Total accumulated other comprehensive income

   $ 11.0      $ 2.8   
                

The components of comprehensive income were as follows:

 

    Three Months Ended     Six Months Ended  
    October 29, 2010     October 30, 2009     October 29, 2010     October 30, 2009  

Net income

  $ 164.6      $ 95.7      $ 306.4      $ 147.3   

Change in currency translation adjustments

    3.7        0.4        4.2        2.8   

Change in unrealized gain on available-for-sale investments, net of related tax effect

    4.3        1.7        6.4        8.6   

Change in unrealized gain (loss) on derivatives qualifying as cash flow hedges

    (1.9     0.8        (2.4     0.2   
                               

Comprehensive income

  $ 170.7      $ 98.6      $ 314.6      $ 158.9   
                               

 

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NETAPP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

11. Derivatives and Hedging Activities

We use derivative instruments to manage exposures to foreign currency risk. The maximum length of time over which forecasted foreign denominated revenues are hedged is six months. The notional value of our outstanding currency forward contracts that were entered into to hedge forecasted foreign denominated sales and our balance sheet monetary asset and liability exposures consisted of the following (in millions):

 

     October 29, 2010      April 30, 2010  

Cash Flow Hedges

     

Euro

   $ 123.7       $ 81.0   

British Pound Sterling

     25.1         18.9   

Balance Sheet Contracts

     

Euro

     186.7         232.6   

British Pound Sterling

     68.8         57.0   

Canadian Dollar

     19.3         28.1   

Australian Dollar

     30.1         23.0   

Other

     50.3         43.6   

Put Option (Euro)

     14.8         0.0   

As of October 29, 2010 and April 30, 2010, the fair value of our short-term foreign currency contracts was not material. Certain of these contracts are designed to hedge our exposure to foreign monetary assets and liabilities and are not accounted for as a hedging activity. Accordingly, changes in fair value of these instruments are recognized in earnings during the period of change. Net deferred gains and losses relating to changes in fair value of our foreign currency contracts that are accounted for as cash flow hedges were not material for any period presented. We did not recognize any gains and losses in earnings due to hedge ineffectiveness for any period presented. The amount of net losses recorded in AOCI as of October 29, 2010 was not material.

12. Income Taxes

Our effective tax rate for the periods presented was as follows:

 

     Six Months Ended  
     October 29,
2010
    October 30,
2009
 

Effective tax rate

     11.1     10.8

Our effective tax rate reflects the impact of a significant amount of our earnings being taxed in foreign jurisdictions at rates below the U.S. statutory tax rate. As of October 29, 2010, we had $139.5 million of unrecognized tax benefits. We have recorded $126.0 million in other long-term liabilities, of which $113.4 million, if recognized, would affect our provision for income taxes.

We are currently undergoing federal income tax audits in the United States and several foreign tax jurisdictions. The rights to some of our intellectual property (“IP”) are owned by certain of our foreign subsidiaries, and payments are made between U.S. and foreign tax jurisdictions relating to the use of this IP in a qualified cost sharing arrangement. In recent years, several other U.S. companies have had their foreign IP arrangements challenged as part of IRS examinations, which has resulted in material proposed assessments and/or litigation with respect to those companies. Effective September 27, 2007, the IRS’s Large and Mid-Sized Business Division (“LMSB”) released a Coordinated Issues Paper (“CIP”) with respect to qualified cost sharing arrangements (“CSAs”). Specifically, this CIP provides guidance to IRS personnel concerning methods that may be applied to evaluate the arm’s length charge (buy-in payment) for internally developed (pre-existing), as well as acquisition-related, intangible property that is made available to a qualified CSA.

 

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NETAPP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

During fiscal year 2009, we received Notices of Proposed Adjustments from the IRS in connection with a federal income tax audit of our fiscal 2003 and 2004 tax returns. We filed a protest with the IRS in response to the Notices of Proposed Adjustments and subsequently received a rebuttal from the IRS examination team in response to our protest. We are currently in discussions with the IRS Appeals office for further administrative review. The Notices of Proposed Adjustments in this audit focus primarily on issues of the timing and the amount of income recognized and deductions taken during the audit years and on the level of cost allocations made to foreign operations during the audit years.

The IRS recently commenced the examination of our fiscal 2005 through 2007 federal income tax returns, and the California Franchise Tax Board has begun the examination of our fiscal 2007 and 2008 California income tax returns. The scope of each of the IRS and California Franchise Tax Board examinations is unclear at this time.

If upon the conclusion of these audits, the ultimate determination of taxes owed in the U.S. is for an amount in excess of the tax provision we have recorded in the applicable period or subsequently reserved for, the overall tax expense and effective tax rate could be adversely impacted in the period of adjustment. It is reasonably possible the Company will reach a final settlement with the IRS on the 2003 — 2004 audit within the next six months.

On September 17, 2010, the Danish tax authorities issued a decision concluding that distributions declared in 2005 and 2006 from the Company’s indirect Danish subsidiary to the subsidiary’s immediate parent affiliate, for which the Company has not paid or accrued any taxes, are subject to Danish at-source dividend withholding tax. The Company does not believe that the Danish subsidiary was liable to withhold tax at source on the distributions and has appealed this assessment decision with the Danish National Tax Tribunal.

13. Net Income per Share

The following is a calculation of basic and diluted net income per share for the periods presented (in millions):

 

     Three Months Ended      Six Months Ended  
     October 29,
2010
     October 30,
2009
     October 29,
2010
     October 30,
2009
 

Numerator:

           

Net income

   $ 164.6       $ 95.7       $ 306.4       $ 147.3   
                                   

Denominator:

           

Weighted average common shares outstanding

     359.1         336.7         355.8         335.7   

Weighted average common shares outstanding subject to repurchase

     0.0         0.0         0.0         (0.1
                                   

Shares used in basic computation

     359.1         336.7         355.8         335.6   

Weighted average common shares outstanding subject to repurchase

     0.0         0.0         0.0         0.1   

Dilutive potential shares related to employee equity award plans

     15.9         13.1         15.7         8.6   

Dilutive impact of assumed conversion of Notes

     12.4         0.0         9.4         0.0   

Dilutive impact of warrants

     4.3         0.0         2.1         0.0   
                                   

Shares used in diluted computation

     391.7         349.8         383.0         344.3   
                                   

Net Income per Share:

           

Basic

   $ 0.46       $ 0.28       $ 0.86       $ 0.44   
                                   

Diluted

   $ 0.42       $ 0.27       $ 0.80       $ 0.43   
                                   

The following employee equity awards have been excluded from the diluted net income per share calculations, as their effect would have been antidilutive (in millions):

 

     Three Months Ended      Six Months Ended  
     October 29, 2010      October 30, 2009      October 29, 2010      October 30, 2009  

Options and RSUs

     2.1         20.3         3.7         31.0   

 

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NETAPP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

Dilutive shares outstanding during the three and six month periods ended October 30, 2009 do not include any effect resulting from warrants or any effect resulting from assumed conversion of the Notes, as their impact would have been anti-dilutive. The Note hedges (as described in Note 9) are not included for purposes of calculating earnings per share as their effect would be anti-dilutive. The Note hedges, if exercised upon conversion of the Notes, are expected to reduce approximately 80% of the dilutive effect of the Notes when our stock price is above $31.85 per share.

14. Segment, Geographic, and Significant Customer Information

We operate in one reportable industry segment: the design, manufacturing, marketing, and technical support of high-performance networked storage solutions. The Company conducts business globally and is primarily managed on a geographic basis. Our management reviews financial information presented on a consolidated basis, accompanied by disaggregated information it receives from its internal management system about revenues by geographic region, based on the location from which the customer relationship is managed, for purposes of allocating resources and evaluating financial performance. We do not allocate costs of revenues, research and development, sales and marketing, or general and administrative expenses to our geographic regions in this internal management system because management does not review operations or operating results, or make planning decisions, below the consolidated entity level.

Summarized revenues by geographic region for the three and six month periods ended October 29, 2010 and October 30, 2009, based on the our internal management system and as utilized by our Chief Executive Officer, who is considered our Chief Operating Decision Maker (CODM), is as follows (in millions):

 

     Three Month Ended      Six Month Ended  
     October 29,
2010
     October 30,
2009
     October 29,
2010
     October 30,
2009
 

Americas (United States, Canada and Latin America)*

   $ 741.1       $ 510.5       $ 1,375.0       $ 993.3   

Europe, Middle East and Africa

     349.9         306.1         733.2         573.0   

Asia Pacific and Japan

     116.4         93.4         237.0         181.7   
                                   

Net revenues

   $ 1,207.4       $ 910.0       $ 2,345.2       $ 1,748.0   
                                   

 

* Sales to the United States accounted for $668.3 million and $460.8 million, respectively, in the three month periods ended October 29, 2010 and October 30, 2009, and $1,233.5 million and $899.8 million, respectively, of Americas’ revenues in the six month periods ended October 29, 2010 and October 30, 2009.

The majority of our assets, excluding cash, cash equivalents and investments and accounts receivable, as of October 29, 2010 and April 30, 2010 were attributable to our U.S. operations. Our total cash, cash equivalents and investments held outside of the United States in various foreign subsidiaries was $2.0 billion and $1.7 billion as of October 29, 2010 and April 30, 2010, respectively, and the remaining $2.5 billion and $2.1 billion at the respective period ends was held in the United States.

With the exception of property and equipment, we do not identify or allocate our long-lived assets by geographic area. The following table presents property and equipment information for geographic areas based on the physical location of the assets (in millions):

 

     October 29, 2010      April 30, 2010  

United States

   $ 777.7       $ 735.0   

International

     67.6         69.4   
                 

Total property and equipment

   $ 845.3       $ 804.4   
                 

No more than ten percent of property and equipment was located in any single foreign country.

International sales to single foreign countries which accounted for ten percent or more of net revenues were as follows (in millions):

 

     Three Months Ended      Six Months Ended  
     October 29, 2010      October 30, 2009      October 29, 2010      October 30, 2009  

Germany

   $ 127.7       $ 105.5       $ 261.8       $ 184.8   

 

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NETAPP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

Sales to customers, who are our distributors, which accounted for ten percent or more of net revenues were as follows (in millions):

 

     Three Months Ended      Six Months Ended  
     October 29, 2010      October 30, 2009      October 29, 2010      October 30, 2009  

Arrow Electronics, Inc.

   $ 211.7       $ 107.4       $ 392.0       $ 200.9   

Avnet, Inc.

     186.2         100.7         310.2         195.5   

The following customers accounted for ten percent or more of net accounts receivable (in millions):

 

     October 29, 2010      April 30, 2010  

Arrow Electronics, Inc.

   $ 42.5       $ 48.7   

15. Commitments and Contingencies

Lease Commitments

Future annual minimum lease payments under all noncancelable facilities and equipment operating leases with an initial term in excess of one year as of October 29, 2010 totaled $254.3 million.

Purchase Orders and Other Commitments

In the normal course of business we make commitments to our third party contract manufacturers, to manage manufacturer lead times and meet product forecasts, and to other parties, to purchase various key components used in the manufacture of our products. We establish accruals for estimated losses on purchased components for which we believe it is probable that they will not be utilized in future operations. To the extent that such forecasts are not achieved, our commitments and associated accruals may change. We had $126.2 million in non-cancelable purchase commitments with our contract manufacturers as of October 29, 2010. In addition, we recorded a liability for firm non-cancelable and unconditional purchase commitments with contract manufacturers for quantities in excess of our future demand forecasts through a charge to product cost of sales. As of October 29, 2010 and April 30, 2010, such liability amounted to $3.5 million and $3.8 million, respectively, and is included in other current liabilities in the consolidated balance sheets.

In addition to commitments with contract manufacturers and component suppliers, we have open purchase orders and contractual obligations associated with our ordinary course business for which we have not received goods or services. We had $30.1 million in capital purchase commitments and $337.1 million in other purchase commitments as of October 29, 2010.

Product Warranties

We provide customers a warranty on software of ninety days and a warranty on hardware of three years. Following is an analysis of our warranty reserves (in millions):

 

     Three Months Ended     Six Months Ended  
     October 29,
2010
    October 30,
2009
    October 29,
2010
    October 30,
2009
 

Beginning balance

   $ 32.1      $ 40.3      $ 31.9      $ 42.3   

Expense accrued during the period

     7.0        2.3        12.9        7.6   

Warranty costs incurred

     (5.6     (6.7     (11.3     (14.0
                                

Ending balance

   $ 33.5      $ 35.9      $ 33.5      $ 35.9   
                                

 

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NETAPP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

Financing Guarantees

We have both nonrecourse and recourse lease financing arrangements with third-party leasing companies through new and preexisting relationships with customers. In addition, from time to time we provide guarantees for a portion of other financing arrangements under which we could be called upon to make payments to our third-party funding companies in the event of nonpayment by end-user customers. Under the terms of the nonrecourse leases, we do not have any continuing obligations or liabilities to the third-party leasing companies. Under the terms of the recourse leases, which are generally three years or less, we remain liable for the aggregate unpaid remaining lease payments to the third-party leasing companies in the event of end-user customer default. These arrangements are generally collateralized by a security interest in the underlying assets. Where we provide a guarantee, we defer the revenues associated with the end-user financing arrangement in accordance with our revenue recognition policies. As of October 29, 2010, the maximum guaranteed payment contingencies under our financing arrangements totaled approximately $75.8 million; and the related deferred revenue and cost of revenues totaled approximately $78.7 million and $9.1 million, respectively. To date, we have not experienced material losses under our lease financing programs or other financing arrangements.

Legal Contingencies

We are subject to various legal proceedings and claims which may arise in the normal course of business. No accrual has been recorded as of October 29, 2010, as the outcome of these legal matters is currently not determinable.

On September 5, 2007, we filed a patent infringement lawsuit in the Eastern District of Texas seeking compensatory damages and a permanent injunction against Sun Microsystems (Sun). On October 25, 2007, Sun filed a counter claim against us in the Eastern District of Texas seeking compensatory damages and a permanent injunction. On October 29, 2007, Sun filed a second lawsuit against us in the Northern District of California asserting additional patents against us. The Texas court granted a joint motion to transfer the Texas lawsuit to the Northern District of California on November 26, 2007. On March 26, 2008, Sun filed a third lawsuit in federal court that extends the patent infringement charges to storage management technology we acquired in January 2008. In January 2010, Oracle Corporation acquired Sun. In September 2010, the lawsuits were dismissed without prejudice.

On October 13, 2010, Amalgamated Bank (as trustee of the Longview Largecap 500 Index Fund and the Longview Largecap 500 Index Veba Fund) filed a derivative lawsuit on behalf of NetApp, Inc. and NetApp U.S. Public Sector, Inc. in the Superior Court of the State of California, Santa Clara County. The lawsuit names 15 current and former NetApp directors as defendants, alleging breach of fiduciary duty and wasting of corporate assets. The lawsuit alleges that the defendants failed to implement and oversee internal controls to ensure that we complied with legal requirements in its General Services Administration (GSA) contracting activities, and that this purported failure of oversight required us to incur significant costs in defending and settling a dispute with the United States of America regarding these past GSA contracting activities. The complaint seeks disgorgement of salaries and other compensation from the defendants and seeks additional unspecified damages. We and the defendants have filed demurrers seeking to have the lawsuit dismissed.

 

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Table of Contents
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act), and is subject to the safe harbor provisions set forth in the Exchange Act. Forward-looking statements usually contain the words “estimate,” “intend,” “plan,” “predict,” “seek,” “may,” “will,” “should,” “would,” “could,” “anticipate,” “expect,” “believe,” or similar expressions and variations or negatives of these words. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. All forward-looking statements, including but not limited to, statements about:

 

   

our future financial and operating results;

 

   

our business strategies;

 

   

management’s plans, beliefs and objectives for future operations, research and development;

 

   

economic and industry trends or trend analyses;

 

   

product introductions, development, enhancements and acceptance;

 

   

acquisitions and joint ventures, growth opportunities, investments and legal proceedings;

 

   

competitive positions;

 

   

future cash flows and cash deployment strategies;

 

   

short-term and long-term cash requirements, including anticipated capital expenditures;

 

   

our anticipated tax rate;

 

   

the dilutive effect of our convertible notes and associated warrants on our earnings per share;

 

   

the conversion, maturation or repurchase of the convertible notes;

 

   

compliance with laws, regulations and debt covenants;

 

   

the continuation of our stock repurchase program; and

 

   

the impact of completed acquisitions

are inherently uncertain as they are based on management’s current expectations and assumptions concerning future events, and they are subject to numerous known and unknown risks and uncertainties. Therefore, our actual results may differ materially from the forward-looking statements contained herein. Factors that could cause actual results to differ materially from those described herein include, but are not limited to:

 

   

acceptance of, and demand for, our products, including our recently announced new product introductions;

 

   

our ability to increase our customer base, market share and revenue;

 

   

the general economic environment and the growth of the storage markets;

 

   

the amount of orders received in future periods;

 

   

our ability to ship our products in a timely manner;

 

   

our ability to achieve anticipated pricing, cost, and gross margins levels;

 

   

our ability to successfully manage our backlog and increase revenue;

 

   

our ability to successfully execute on our strategy;

 

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Table of Contents

 

   

our ability to successfully introduce new products;

 

   

our ability to maintain the quality of our hardware, software and services offerings;

 

   

our ability to adapt to changes in market demand;

 

   

demand for our services and support;

 

   

our ability to identify and respond to significant market trends and emerging standards;

 

   

the impact of industry consolidation;

 

   

our ability to successfully manage our investment in people, process, and systems;

 

   

our ability to maintain our partner, supplier and contract manufacturer relationships;

 

   

the ability of our suppliers and contract manufacturers to meet our requirements;

 

   

the ability of our competitors to introduce new products that compete successfully with our products;

 

   

our ability to grow direct and indirect sales and to efficiently utilize global service and support;

 

   

variability in our gross margins;

 

   

our ability to sustain and/or improve our cash and overall financial position;

 

   

our cash requirements and terms and availability of financing;

 

   

valuation and liquidity of our investment portfolio;

 

   

our ability to finance business acquisitions, construction projects and capital expenditures through cash from operations and/or financing;

 

   

the results of our ongoing litigation, tax audits, government audits and inquiries; and

 

   

those factors discussed under “Risk Factors” elsewhere in this Quarterly Report on Form 10-Q.

Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof and are based upon information available to us at this time. These statements are not guarantees of future performance. We disclaim any obligation to update information in any forward-looking statement. Actual results could vary from our forward looking statements due to foregoing factors as well as other important factors, including those described in the Risk Factors included on page 40.

Overview

Net revenues for the three month period ended October 29, 2010 were $1,207.4 million, up $297.4 million, or 33%, from the comparable period in the prior year. Net revenues for the six month periods ended October 29, 2010 were $2,345.2 million, up $597.2 million, or 34%, from the comparable period in the prior year. Improved revenue performance in the first three and six months of fiscal 2011 was the result of strong demand for our storage efficiency and data management solutions, with increases in revenues across all geographies. Gross margin percentages remained relatively flat during the three and six month periods ended October 29, 2010, respectively, compared to the same periods in the prior year.

Sales and marketing, research and development, and general and administrative expenses for the three month period ended October 29, 2010 totaled $603.6 million, up 23% from the prior year and for the six month period ended October 29, 2010 totaled $1,163.5 million, up 19% from the prior year. The increase is primarily due to an 18% and 14% increase in average headcount, respectively, and higher levels of incentive compensation and commission expense. Salary and related expenses for the six months ended October 29, 2010 were favorably impacted by having 26 weeks in that period compared to 27 weeks in the same period of the prior year.

 

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Table of Contents

Critical Accounting Estimates and Policies

Our discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of such statements requires us to make estimates and assumptions that affect the reported amounts of revenues and expenses during the reporting period and the reported amounts of assets and liabilities as of the date of the financial statements. Our estimates are based on historical experience and other assumptions that we consider to be appropriate in the circumstances. However, actual future results may vary from our estimates.

We believe the accounting policies discussed under Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the fiscal year ended April 30, 2010 are significantly affected by critical accounting estimates and that they are both highly important to the portrayal of our financial condition and results and require difficult management judgments and assumptions about matters that are inherently uncertain. There have been no material changes to the critical accounting policies and estimates as filed in such report.

New Accounting Standards

See Note 3 of the accompanying condensed consolidated financial statements for a full description of new accounting pronouncements, including the respective expected dates of adoption and effects on results of operations and financial condition.

Results of Operations

The following table sets forth certain condensed consolidated statements of operations data as a percentage of net revenues for the periods indicated:

 

     Three Months Ended     Six Months Ended  
     October 29,
2010
    October 30,
2009
    October 29,
2010
    October 30,
2009
 

Revenues:

        

Product

     64.6     57.7     64.0     57.4

Software entitlements and maintenance

     14.7        18.7        15.0        19.2   

Service

     20.7        23.6        21.0        23.4   
                                

Net revenues

     100.0        100.0        100.0        100.0   

Cost of revenues:

        

Cost of product

     24.5        21.9        25.7        23.5   

Cost of software entitlements and maintenance

     0.3        0.3        0.3        0.4   

Cost of service

     8.9        11.1        9.0        11.5   
                                

Gross profit

     66.3        66.7        65.0        64.6   
                                

Operating expenses:

        

Sales and marketing

     31.7        33.1        31.4        34.5   

Research and development

     13.0        14.5        13.1        15.0   

General and administrative

     5.3        6.3        5.1        6.7   

Restructuring and other charges

     —          0.1        —          0.2   

Acquisition related (income) expense, net

     —          —          —          (2.4
                                

Total operating expenses

     50.0        54.0        49.6        54.0   
                                

Income from operations

     16.3        12.7        15.4        10.6   

Other expenses, net:

        

Interest income

     0.7        0.7        0.8        0.8   

Interest expense

     (1.5     (2.0     (1.5     (2.1

Other income (expense), net

     (0.1     0.2        —          0.1   
                                

Total other expenses, net

     (0.9     (1.1     (0.7     (1.2
                                

Income before income taxes

     15.4        11.6        14.7        9.4   

Provision for income taxes

     1.8        1.1        1.6        1.0   
                                

Net income

     13.6     10.5     13.1     8.4
                                

 

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Table of Contents

Discussion and Analysis of Results of Operations

Net Revenues — Our net revenues for the three and six month periods ended October 29, 2010 and October 30, 2009 were as follows (in millions, except percentages):

 

     Three Months Ended     Six Months Ended  
     October 29,
2010
     October 30,
2009
     %
Change
    October 29,
2010
     October 30,
2009
     %
Change
 

Net revenues

   $ 1,207.4       $ 910.0         33   $ 2,345.2       $ 1,748.0         34

Net revenues increased by $297.4 million, or 33%, for the three month period ended October 29, 2010 from the comparable period in the prior year, and for the six month period ended October 29, 2010, increased $597.2 million, or 34%, from the comparable period in the prior year. The increase in our net revenues for both periods was primarily related to an increase in product revenues, which comprised 65% and 64% of net revenues in the three and six month periods ended October 29, 2010, respectively, compared to 58% and 57% in the three and six month periods ended October 30, 2009, respectively.

Sales through our indirect channels represented 72% and 70% of net revenues for the three and six month periods ended October 29, 2010, respectively, and represented 67% and 68% of net revenues for the three and six month periods ended October 30, 2009, respectively.

The following table sets forth sales to customers, who are distributors, who accounted for 10% or more of revenues (in millions, except percentages):

 

     Three Months Ended     Six Months Ended  
     October 29,
2010
     % of
Revenues
    October 30,
2009
     % of
Revenues
    October 29,
2010
     % of
Revenues
    October 30,
2009
     % of
Revenues
 

Arrow Electronics, Inc.

   $ 211.7         18   $ 107.4         12   $ 392.0         17   $ 200.9         11

Avnet, Inc.

     186.2         15     100.7         11     310.2         13     195.5         11

Product Revenues (in millions, except percentages):

 

     Three Months Ended     Six Months Ended  
     October 29,
2010
     October 30,
2009
     %
Change
    October 29,
2010
     October 30,
2009
     %
Change
 

Product revenues

   $ 780.0       $ 525.1         49   $ 1,500.8       $ 1,003.4         50

Product revenues increased by $254.9 million, or 49%, for the three month period ended October 29, 2010, and increased by $497.4 million, or 50%, for the six month period ended October 29, 2010, from the comparable periods in the prior year. Our configured systems are comprised of bundled hardware and software products. Configured systems unit volume increased by 77% for each of the three and six month periods ended October 29, 2010 compared to the prior year, with the largest increase in smaller systems. Total configured system revenue increased by $182.7 million and $376.0 million for the three and six month periods ended October 29, 2010, respectively, compared to the prior year, with the largest increase in medium-sized systems.

 

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During the three month period ended October 29, 2010, large, medium-sized and smaller systems generated approximately 18%, 59% and 23% of configured systems revenues, respectively, compared to approximately 23%, 58% and 19%, respectively in the prior year. Average selling prices (ASPs) declined during the three month period ended October 29, 2010 due primarily to lower ASPs per unit in smaller systems, as well as a shift in unit mix towards smaller systems. During the six month period ended October 29, 2010, large, medium-sized and smaller systems generated approximately 22%, 55% and 23% of configured systems revenues, respectively, compared to approximately 22%, 58% and 20%, respectively in the prior year. During the six months ended October 29, 2010, ASP declined due primarily to lower ASPs per unit in smaller systems, partially offset by an increase in ASPs per unit in medium-sized systems as well as a shift in unit mix towards medium-sized systems.

In addition, our net add-on hardware, software and other product revenues accounted for a $72.1 million and a $121.5 million increase for the three and six month periods ended October 29, 2010 from the comparable periods in the prior year, primarily due to customers increasing the capacity and/or functionality of their storage systems.

Our systems are highly configurable to respond to customer requirements in the open systems storage markets that we serve. This wide variation in customer configurations can significantly impact revenues, cost of revenues, and gross profit performance. Price changes, foreign currency rates, unit volumes, customer mix and product configuration can also impact revenues, cost of revenues and gross profit performance. Disks are a significant component of our storage systems. Industry disk pricing continues to fall every year, and we pass along those price decreases to our customers while working to maintain relatively constant profit margins on our disk drives. While our sales price per terabyte continues to decline, improved system performance, increased capacity and software to manage this increased capacity have an offsetting impact on product revenues.

Software Entitlements and Maintenance Revenues (in millions, except percentages):

 

     Three Months Ended     Six Months Ended  
     October 29,
2010
     October 30,
2009
     %
Change
    October 29,
2010
     October 30,
2009
     %
Change
 

Software entitlements and maintenance revenues

   $ 177.9       $ 169.8         5   $ 352.6       $ 335.1         5

Software entitlements and maintenance, or SEM, revenues increased by $8.1 million, or 5%, and $17.5 million, or 5%, for the three and six month periods ended October 29, 2010, respectively, from the comparable periods in the prior year. These increases were the result of an increase in the aggregate contract value of the installed base under SEM contracts, which is recognized as revenue ratably over the terms of the underlying contracts.

Service Revenues (in millions, except percentages):

 

     Three Months Ended     Six Months Ended  
     October 29,
2010
     October 30,
2009
     %
Change
    October 29,
2010
     October 30,
2009
     %
Change
 

Service revenues

   $ 249.5       $ 215.1         16   $ 491.8       $ 409.5         20

Service revenues include hardware maintenance, professional services and educational and training services. Service revenues increased by $34.4 million, or 16%, and $82.3 million, or 20%, for the three and six month periods ended October 29, 2010, respectively, from the comparable periods in the prior year. Hardware maintenance contract revenues increased 22% for each of the three and six month periods ended October 29, 2010, respectively, from the comparable periods in the prior year, as a result of an increase in the installed base under service contracts and the timing of recognition of the related revenue. Professional services and educational and training services revenues increased 6% and 16% for the three and six month periods ended October 29, 2010, respectively, compared to the prior year.

Revenues by Geographic Area (in millions, except percentages):

 

     Three Months Ended     Six Months Ended  
     October 29,
2010
     October 30,
2009
     %
Change
    October 29,
2010
     October 30,
2009
     %
Change
 

Americas (primarily the United States)

   $ 741.1       $ 510.5         45   $ 1,375.0       $ 993.3         38

Europe, Middle East and Africa (EMEA)

     349.9         306.1         14     733.2         573.0         28

Asia Pacific and Japan (APAC)

     116.4         93.4         25     237.0         181.7         30
                                        

Net revenues

   $ 1,207.4       $ 910.0         $ 2,345.2       $ 1,748.0      

 

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Sales to the United States accounted for 90% of Americas’ revenues in each of the three month periods ended October 29, 2010 and October 30, 2009, and 90% and 91% of Americas’ revenues in the six month periods ended October 29, 2010 and October 30, 2009, respectively. Sales to Germany accounted for 11% and 12% of net revenues for the three month periods ended October 29, 2010 and October 30, 2009, respectively, and for 11% of net revenues for each of the six month periods ended October 29, 2010 and October 30, 2009, respectively.

Cost of Revenues

Our cost of revenues consists of three elements: (1) cost of product revenues, which includes the costs of manufacturing and shipping of our storage systems, amortization of purchased intangible assets, inventory write-downs, and warranty costs; (2) cost of software maintenance and entitlements, which includes the costs of providing software entitlements and maintenance and third party royalty costs, and (3) cost of service, which reflects costs associated with providing support center activities for hardware, global support partnership programs, professional services and educational and training services.

Our gross profits are impacted by a variety of factors including pricing and discount practices, product configuration, channel sales mix, revenue mix and product material costs. Service gross profit is also typically impacted by factors such as changes in the size of our installed base of products, as well as the timing of support service initiations and renewals, and incremental investments in our customer support infrastructure. If our shipment volumes, product and services mix, average selling prices and pricing actions that impact our gross profit are adversely affected, whether by economic uncertainties or for other reasons, our gross profit could decline.

Cost of Product Revenues (in millions, except percentages):

 

     Three Months Ended     Six Months Ended  
     October 29,
2010
     October 30,
2009
     %
Change
    October 29,
2010
     October 30,
2009
     %
Change
 

Cost of product revenues

   $ 296.1       $ 199.1         49   $ 603.8       $ 411.7         47

Cost of product revenues increased by $97.0 million, or 49%, and by $192.1 million, or 47%, for the three and six month periods ended October 29, 2010, respectively, from the comparable periods in the prior year. The change was comprised of the following elements (in percentage points of the total change):

 

     Three Months Ended
Fiscal 2010 to Fiscal 2011
Percentage Points
     Six Months Ended
Fiscal 2010 to Fiscal 2011
Percentage Points
 

Materials costs

     44         44   

Excess and obsolete inventory

     1         —     

Warranty

     2         1   

Manufacturing overhead

     1         1   

Other

     1         1   
                 

Total change

     49         47   
                 

In each of the three and six month periods ended October 29, 2010, the increase in materials cost reflects a 77% increase in configured systems unit volume and an increase in unit costs of large systems, partially offset by lower per unit costs in smaller systems due to favorable materials pricing, which we expect to continue. Average materials costs per unit were favorably impacted by a shift in mix to smaller systems in the three months ended October 29, 2009, but were unfavorably impacted by a shift towards medium-sized systems in the six months ended October 29, 2009. Our cost of product revenues was unfavorably impacted by:

 

  (i) an increase of $57.8 million and $123.5 million in material costs related to increased volumes in the three and six month periods ended October 29, 2010, respectively,

 

  (ii) an increase of $4.7 million and $5.3 million in warranty expenses in the three and six month period ended October 29, 2010, respectively,

 

  (iii) an increase of $34.5 million and $63.3 million in costs of hardware add-ons and other product costs in the three and six month period ended October 29, 2010, respectively,

 

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Cost of product revenues represented 38% of product revenue for each of the three month periods ended October 29, 2010 and October 30, 2009, respectively, and represented 40% and 41% of product revenue for the six month periods ended October 29, 2010 and October 30, 2009, respectively. The overall reduction of costs as a percentage of revenues for the six month periods ended October 29, 2010 was the result of per unit materials cost reductions outpacing sales price reductions.

Cost of Software Entitlements and Maintenance Revenues (in millions, except percentages):

 

     Three Months Ended     Six Months Ended  
     October 29,
2010
     October 30,
2009
     %
Change
    October 29,
2010
     October 30,
2009
     %
Change
 

Cost of software entitlements and maintenance revenues

   $ 3.5       $ 3.1         13   $ 6.9       $ 6.2         11

Cost of SEM revenues increased by $0.4 million, or 13%, and $0.7 million, or 11%, for the three and six month periods ended October 29, 2010, respectively, from the comparable periods in the prior year due to an increase in field service engineering costs. Cost of SEM revenues represented 2% of SEM revenues for each of the three month periods ended October 29, 2010 and October 30, 2009, and for each of the six month periods ended October 29, 2010 and October 30, 2009.

Cost of Service Revenues (in millions, except percentages):

 

     Three Months Ended     Six Months Ended  
     October 29,
2010
     October 30,
2009
     %
Change
    October 29,
2010
     October 30,
2009
     %
Change
 

Cost of service revenues

   $ 106.7       $ 101.1         6   $ 209.0       $ 200.9         4

Cost of service revenues increased by $5.6 million, or 6%, and increased by $8.1 million, or 4%, for the three and six month periods ended October 29, 2010, respectively, from the comparable periods in the prior year primarily due to increased warranty costs associated with higher sales volumes. Costs represented 43% and 47% of service revenues for the three month periods ended October 29, 2010 and October 30, 2009, respectively, and represented 43% and 49% of service revenues for the six month periods ended October 29, 2010 and October 30, 2009, respectively.

Operating Expenses

Sales and Marketing, Research and Development, and General and Administrative Expenses

Compensation costs comprise the largest component of operating expenses. Included in compensation costs are salaries and related benefits, stock-based compensation costs and employee incentive compensation plan costs. Compensation costs included in operating expenses increased approximately $52.6 million, or 20%, and $72.8 million, or 13%, during the three and six month periods ended October 29, 2010, respectively, compared to the comparable periods in the prior year, primarily due to:

 

  (i) an increase in salaries, benefits and other compensation related costs due to an increase in average headcount, primarily in sales, marketing and engineering functions, of $42.7 million and $62.0 million for the three and six month periods ended October 29, 2010, respectively,

 

  (ii) an increase in incentive compensation expense reflecting stronger operating performance and increased headcounts of $5.9 million and $13.7 million during the three and six month periods ended October 29, 2010, respectively, and

 

  (iii) an increase in stock based compensation of $4.0 million for the three month periods ended October 29, 2010, and a decrease of $2.9 million for the six month periods ended October 29, 2010.

In addition, sales and marketing expenses reflected an increase in commissions expense of $6.0 million and $17.8 million during the three and six month periods ended October 29, 2010, respectively, reflecting stronger sales performance compared to the same periods of the prior year.

Sales and Marketing (in millions, except percentages):

 

     Three Months Ended     Six Months Ended  
     October 29,
2010
     October 30,
2009
     %
Change
    October 29,
2010
     October 30,
2009
     %
Change
 

Sales and marketing expenses

   $ 382.8       $ 300.8         27   $ 737.0       $ 602.3         22

 

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Table of Contents

Sales and marketing expense consists primarily of compensation costs, commissions, outside services, allocated facilities and IT costs, advertising and marketing promotional expense, and travel and entertainment expense, and increased $82.0 million, or 27%, and $134.7 million, or 22%, for the three and six month periods ended October 29, 2010, respectively, from the comparable period in the prior year. This change was comprised of the following elements (in percentage points of the total change):

 

     Three Months Ended
Fiscal 2010 to Fiscal 2011
Percentage Points
     Six Months Ended
Fiscal 2010 to Fiscal 2011
Percentage Points
 

Salaries

     6         5   

Incentive plan compensation

     1         1   

Stock based compensation

     1         —     

Other compensation and benefit costs

     3         2   

Commissions

     2         3   

Outside services

     5         4   

Advertising and marketing promotional expense

     3         2   

Travel and entertainment

     1         1   

Facilities and IT support costs

     3         2   

Other

     2         2   
                 

Total change

     27         22   
                 

The increase in salaries and related expenses reflects an increase in average sales and marketing headcount of 17% and 13% for the three and six month periods ended October 29, 2010, respectively, compared to the same periods in the prior year.

Research and Development (in millions, except percentages):

 

     Three Months Ended     Six Months Ended  
     October 29,
2010
     October 30,
2009
     %
Change
    October 29,
2010
     October 30,
2009
     %
Change
 

Research and development expenses

   $ 156.6       $ 132.4         18   $ 306.1       $ 262.7         17

Research and development expense consists primarily of compensation costs, allocated facilities and IT costs, depreciation and amortization, prototypes, non-recurring engineering, or NRE charges and other outside services costs. Research and development expenses increased $24.2 million, or 18%, and $43.4 million, or 17%, for the three and six month periods ended October 29, 2010, respectively, from the comparable periods in the prior year. This change was comprised of the following elements (in percentage points of the total change):

 

     Three Months Ended
Fiscal 2010 to Fiscal 2011
Percentage Points
     Six Months Ended
Fiscal 2010 to Fiscal 2011
Percentage Points
 

Salaries

     8         6   

Incentive plan compensation

     1         2   

Stock based compensation

     1         —     

Travel and entertainment

     1         1   

Facilities and IT support costs

     3         3   

NRE charges

     —           1   

Outside services

     1         1   

Equipment and software related costs

     1         1   

Other

     2         2   
                 

Total change

     18         17   
                 

 

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The increase in salaries and related expenses reflects an increase in average engineering headcount of 23% and 18% for the three and six month periods ended October 29, 2010, respectively, compared to the same periods in the prior year.

General and Administrative (in millions, except percentages):

 

     Three Months Ended     Six Months Ended  
     October 29,
2010
     October 30,
2009
     %
Change
    October 29,
2010
     October 30,
2009
     %
Change
 

General and administrative expenses

   $ 64.2       $ 56.9         13   $ 120.4       $ 116.4         3

General and administrative expense consists primarily of compensation costs, professional and corporate legal fees, recruiting expenses, and allocated facilities and IT costs. General and administrative expenses increased $7.3 million, or 13%, and $4.0 million, or 3%, for the three and six month periods ended October 29, 2010, respectively, from the comparable periods in the prior year. This change was comprised of the following elements (in percentage points of the total change):

 

     Three Months Ended
Fiscal 2010 to Fiscal 2011
Percentage Points
    Six Months Ended
Fiscal 2010 to Fiscal 2011
Percentage Points
 

Salaries

     3        1   

Incentive plan compensation

     2        2   

Stock based compensation

     2        (1

Other compensation and benefits costs

     2        1   

Professional and corporate legal fees

     (1     (2

IT costs

     3        1   

Other

     2        1   
                

Total change

     13        3   
                

Restructuring and Other Charges (in millions, except percentages):

 

     Three Months Ended     Six Months Ended  
     October 29,
2010
     October 30,
2009
     %
Change
    October 29,
2010
     October 30,
2009
     %
Change
 

Restructuring and other charges

   $ 0.1       $ 1.2         (92 )%    $ 0.1       $ 2.7         (96 )% 

In each of the three and six month periods ended October 30, 2009, we recorded restructuring expense of $1.2 million and $2.7 million, respectively, primarily related to adjustments to future lease commitments and employee severance costs associated with our fiscal 2009 restructuring plan.

Acquisition Related (Income) Expense, Net (in millions, except percentages):

 

     Three Months Ended     Six Months Ended  
     October 29,
2010
     October 30,
2009
     %
Change
    October 29,
2010
     October 30,
2009
    %
Change
 

Acquisition related (income) expense, net

   $ 0.0       $ 0.0         0   $ 0.3       $ (41.1     NM   

 

NM — Not meaningful

In the six month period ended October 29, 2010, we incurred $0.3 million of costs associated with our acquisition of Bycast Inc. In the six month period ended October 30, 2009, we received a $57.0 million termination fee related to the terminated merger transaction with Data Domain Corporation, partially offset by $15.9 million of incremental third-party costs.

 

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Table of Contents

Other Income and Expense

Interest Income (in millions, except percentages):

 

     Three Months Ended     Six Months Ended  
     October 29,
2010
     October 30,
2009
     %
Change
    October 29,
2010
     October 30,
2009
     %
Change
 

Interest income

   $ 9.5       $ 7.0         36   $ 19.3       $ 15.6         24

The increase in interest income for the three and six month periods ended October 29, 2010 compared to the comparable periods in the prior year was primarily due to higher levels of investments in fiscal 2011.

Interest Expense (in millions except percentages):

 

     Three Months Ended     Six Months Ended  
     October 29,
2010
    October 30,
2009
    %
Change
    October 29,
2010
    October 30,
2009
    %
Change
 

Interest expense

   $ (18.6   $ (17.9     4   $ (37.2   $ (37.1     0

Interest expense was relatively flat for the three and six month periods ended October 29, 2010, compared to the comparable periods in the prior year. We recognized incremental non-cash interest expense from the amortization of debt discount and issuance costs relating to our convertible notes (the Notes) of $13.0 million and $25.9 million, during the three and six month periods ended October 29, 2010, respectively, and $12.2 million and $25.3 million, for the three and six month periods ended October 30, 2009, respectively. The coupon interest expense related to the Notes was $5.5 million and $11.0 million for the three and six month periods ended October 29, 2010, respectively, and $5.5 million and $11.4 million for the three and six month periods ended October 30, 2009, respectively.

Other Income (Expenses), Net (in millions, except percentages):

 

     Three Months Ended     Six Months Ended  
     October 29,
2010
    October 30,
2009
    %
Change
    October 29,
2010
    October 30,
2009
    %
Change
 

Realized gain (loss) on investments, net

   $ (0.1   $ 2.8        NM      $ 2.6      $ 2.7        (4 )% 

Other expenses, net

     (1.3     (1.3     0     (1.8     (2.3     (22 )% 
                                    

Other income (expense), net

   $ (1.4   $ 1.5        NM      $ 0.8      $ 0.4        100

 

NM — Not meaningful

Other income (expense), net for the three and six month periods ended October 29, 2010 included $0.1 million of net loss and $2.6 million of net gains on investment, respectively. Other expenses for the three and six month periods ended October 29, 2010 included $2.4 million and $2.7 million, respectively, in net losses on foreign currency transactions and related hedging activities, compared to $1.5 million and $3.5 million for the three and six month periods ended October 30, 2009, respectively.

Provision for Income Taxes (in millions, except percentages):

 

     Three Months Ended     Six Months Ended  
     October 29,
2010
     October 30,
2009
     %
Change
    October 29,
2010
     October 30,
2009
     %
Change
 

Provision for income taxes

   $ 22.3       $ 10.3         117   $ 38.1       $ 17.8         114

The increase in the provision for income taxes for the six month period ended October 29, 2010 was primarily due to a 109% increase in income before income taxes from the comparable period in the prior year. Our effective tax rate for the six month period ended October 29, 2010 was 11.1%, compared to an effective tax rate of 10.8% for the six month period ended October 30, 2009. Our effective tax rate reflects our corporate legal entity structure and the global nature of our business with a significant amount of our profits generated and taxed in foreign jurisdictions at rates below the U.S. statutory tax rate.

 

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Liquidity and Capital Resources

The following sections discuss our principal liquidity requirements, as well as our sources and uses of cash flows on our liquidity and capital resources. The principal objectives of our investment policy are the preservation of principal and maintenance of liquidity. We attempt to mitigate default risk by investing in high-quality investment grade securities, limiting the time to maturity and by monitoring the counter-parties and underlying obligors closely. We believe our cash equivalents and short-term investments are liquid and accessible. We are not aware of any significant deterioration in the fair value of our cash equivalents or investments from the values reported as of October 29, 2010.

Liquidity Sources, Cash Requirements

Our principal sources of liquidity as of October 29, 2010 consisted of approximately $4.5 billion in cash, cash equivalents and short-term and long-term investments, as well as cash we expect to generate from operations.

Cash, cash equivalents and investments consist of the following:

 

     October 29, 2010      April 30, 2010  

Cash and cash equivalents

   $ 1,771.1       $ 1,705.0   

Short-term investments

     2,610.4         2,019.0   

Long-term investments and restricted cash

     69.8         72.8   
                 

Total cash, cash equivalents and investments

   $ 4,451.3       $ 3,796.8   
                 

As of October 29, 2010, $2.5 billion of cash, cash equivalents and investments were held in the United States, while $2.0 billion were held in foreign countries. Our principal liquidity requirements are primarily to meet our working capital needs, support ongoing business activities, fund research and development, meet capital expenditure needs, invest in critical or complementary technologies, and to service our debt and synthetic leases.

Key factors that could affect our cash flows include changes in our revenue mix and profitability, as well as our ability to effectively manage our working capital, in particular, accounts receivable and inventories. Based on our current business outlook, we believe that our sources of cash will satisfy our working capital needs, capital expenditures, investment requirements, stock repurchases, contractual obligations, commitments, interest payments on our Notes and other liquidity requirements associated with operations and meet our cash requirements for at least the next 12 months. However, in the event our liquidity is insufficient, we may be required to further curtail spending and implement additional cost saving measures and restructuring actions. We cannot be certain that we will continue to generate cash flows at or above current levels or that we will be able to obtain additional financing, if necessary, on satisfactory terms, if at all.

Our investment portfolio, including auction rate securities, has been and will continue to be exposed to market risk due to trends in the credit and capital markets. We continue to closely monitor current economic and market events to minimize our market risk on our investment portfolio. Based on our ability to access our cash and short-term investments, our expected operating cash flows, and our other potential sources of cash, we do not anticipate that the lack of liquidity of these investments will impact our ability to fund working capital needs, capital expenditures, acquisitions or other cash requirements. We intend to and believe that we have the ability to hold these investments until the market recovers. If current market conditions deteriorate, we may be required to record additional charges to earnings in future periods.

Capital Expenditure Requirements

We expect to fund our capital expenditures, including our commitments related to facilities and equipment operating leases and internal use software development projects, over the next few years through existing cash, cash equivalents, investments and cash generated from operations. The timing and amount of our capital requirements cannot be precisely determined at this time and will depend on a number of factors including future demand for products, changes in the network storage industry, hiring plans and our decisions related to financing our facilities requirements. We expect that our existing facilities and those being developed in Sunnyvale, California; Research Triangle Park, North Carolina; and worldwide are adequate for our requirements over at least the next two years and that additional space will be available as needed. We expect to incur approximately $155.0 million related to capital projects for the remaining six months of fiscal year 2011.

 

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Table of Contents

Cash Flows

As of October 29, 2010, our cash and cash equivalents and short-term and long-term investments increased by $0.7 billion from April 30, 2010 to $4.4 billion. The increase was primarily a result of cash provided by operating activities and issuances of common stock related to employee stock option exercises and purchases under the employee stock purchase plan, partially offset by $74.9 million net cash paid in connection with the acquisition of Bycast Inc. and $83.5 million in capital expenditures. We derive our liquidity and capital resources primarily from our cash flow from operations and from working capital. Days sales outstanding as of October 29, 2010 decreased to 34 days, compared to 37 days as of April 30, 2010, primarily due to improvements in shipment linearity. Working capital increased by $0.7 billion to $3.3 billion as of October 29, 2010, compared to $2.6 billion as of April 30, 2010, primarily due to an increase in cash, cash equivalents and short-term investments of $0.7 billion.

Cash Flows from Operating Activities

During the six month period ended October 29, 2010, we generated cash from operating activities of $542.0 million. The primary sources of cash from operations consisted of net income of $306.4 million, adjusted by non-cash stock-based compensation expense of $82.0 million and depreciation and amortization expense of $82.3 million. Significant changes in assets and liabilities impacting operating cash flows included a decrease in accrued compensation and other current liabilities of $96.1 million, primarily attributable to employee payouts related to fiscal year 2010’s commissions and incentive compensation plans, partially offset by an increase in deferred revenue of $81.6 million.

We expect that cash provided by operating activities may fluctuate in future periods as a result of a number of factors, including fluctuations in our operating results, shipment linearity, accounts receivable collections performance, inventory and supply chain management, tax benefits from stock-based compensation, and the timing and amount of compensation and other payments.

Cash Flows from Investing Activities

Capital expenditures for the six month period ended October 29, 2010 were $83.5 million. We paid $594.8 million for net purchases and redemptions of our investments for the six month period ended October 29, 2010. During the six month period ended October 29, 2010, we completed our acquisition of Bycast Inc. for total cash payments of $74.9 million, net of cash acquired.

Cash Flows from Financing Activities

We received $266.8 million from financing activities for the six month period ended October 29, 2010, which primarily consisted of $236.1 million of proceeds from employee equity award plans, net of shares withheld for taxes, and $32.7 million of excess tax benefit from stock-based compensation.

Net proceeds from the issuance of common stock related to employee participation in employee equity award programs have historically been a significant component of our liquidity. The extent to which our employees exercise stock options or participate in our ESPP program generally increases or decreases based upon changes in the market price of our common stock. As a result, our cash flow resulting from the issuance of common stock in connection with these programs and related tax benefits will vary.

Stock Repurchase Program

Since the May 13, 2003 inception of our stock repurchase program through October 29, 2010, our Board of Directors has authorized the repurchase of up to $4.0 billion of common stock under such stock repurchase program. At October 29, 2010, $1.1 billion remains available under these authorizations. The stock repurchase program may be suspended or discontinued at any time.

Convertible Notes

As of October 29, 2010, we had $1.265 billion principal amount of 1.75% Convertible Senior Notes due 2013 (the Notes). The Notes will mature on June 1, 2013, unless earlier repurchased or converted. As of October 29, 2010, the Notes have not been repurchased or converted. We also have not received any shares under the related Note hedges or delivered cash or shares under the related warrants.

 

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Table of Contents

Contractual Obligations

The following summarizes our contractual obligations, and commitments at October 29, 2010 and the effect such obligations are expected to have on our liquidity and cash flows in future periods (in millions):

 

     2011     2012     2013     2014     2015     Thereafter     Total  

Off-balance sheet commitments:

              

Office operating lease payments

   $ 14.4      $ 26.5      $ 21.0      $ 17.4      $ 15.8      $ 21.2      $ 116.3   

Real estate lease payments (1)

     1.6        3.2        92.3        0.0        0.0        0.0        97.1   

Less: sublease income

     (0.8     (1.4     (1.4     (1.1     (1.0     (0.5     (6.2

Equipment operating lease payments

     14.3        15.3        8.5        2.5        0.2        0.1        40.9   

Purchase commitments with contract manufacturers (2)

     117.6        3.6        3.6        1.2        0.2        0.0        126.2   

Capital expenditures

     12.1        18.0        0.0        0.0        0.0        0.0        30.1   

Other purchase obligations (3)

     116.2        112.1        72.7        19.3        13.6        3.2        337.1   
                                                        

Total off balance sheet commitments

     275.4        177.3        196.7        39.3        28.8        24.0        741.5   

Long-term financing arrangements

     2.2        4.5        4.5        0.0        0.0        0.0        11.2   

1.75% Convertible Notes (4)

     11.1        22.1        22.1        1,276.1        0.0        0.0        1,331.4   

Uncertain tax positions (5)

                 126.0   
                                                        

Total

   $ 288.7      $ 203.9      $ 223.3      $ 1,315.4      $ 28.8      $ 24.0      $ 2,210.1   
                                                        

Other Commercial Commitments:

              

Letters of credit

   $ 3.1      $ 0.9      $ 0.1      $ 0.0      $ 0.0      $ 0.8      $ 4.9   
                                                        

Some of the figures we include in this table are based on management’s estimates and assumptions about these obligations, including their duration, the possibility of renewal or termination, anticipated actions by management and third parties and other factors. Because these estimates and assumptions are necessarily subjective, our actual future obligations may vary from those reflected in the table. We expect to fund our contractual obligations and other commitments in the table above through existing cash, cash equivalents, investments, and cash generated from operations or obtain additional financing, if necessary.

 

 

(1) Included in real estate lease payments pursuant to four financing arrangements with BNP Paribas LLC (BNPPLC) are (i) lease commitments of $1.6 million in the remainder of fiscal year 2011; $3.2 million in fiscal 2012; and $2.1 million in fiscal 2013, which are based on either the LIBOR rate at October 29, 2010 plus a spread or a fixed rate for terms of five years, and (ii) at the expiration or termination of the lease, a supplemental payment obligation equal to our minimum guarantee of $90.2 million in the event that we elect not to purchase or arrange for sale of the buildings.
(2) Contract manufacturer commitments consist of obligations for on hand inventories and non-cancelable purchase order with our contract manufacturer. We record a liability for firm, noncancelable, and nonreturnable purchase commitments for quantities in excess of our future demand forecasts, which is consistent with the valuation of our excess and obsolete inventory. As of October 29, 2010, the liability for these purchase commitments in excess of future demand was approximately $3.5 million and is recorded in other current liabilities.
(3) Purchase obligations represent an estimate of all open purchase orders and contractual obligations in the ordinary course of business, other than commitments with contract manufacturers and suppliers, for which we have not received the goods or services. Purchase obligations do not include contracts that may be cancelled without penalty. Although open purchase orders are considered enforceable and legally binding, the terms generally allow us the option to cancel, reschedule, and adjust our requirements based on our business needs prior to the delivery of goods or performance of services.
(4) Included in these amounts are obligations related to the $1.265 billion principal amount of 1.75% Notes due 2013 (see Note 9 of the accompanying condensed consolidated financial statements). Estimated interest payments for the Notes are $66.4 million for the remainder of fiscal 2011 through fiscal 2014.
(5) As of October 29, 2010, our liability for uncertain tax positions was $126.0 million, which due to the uncertainty of the timing of future payments, are presented in the total column on a separate line in this table.

 

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As of October 29, 2010, we have four leasing arrangements (Leasing Arrangements 1, 2, 3 and 4) with BNPPLC which requires us to lease certain of our land to BNPPLC for a period of 99 years and to lease approximately 0.6 million square feet of office space for our headquarters in Sunnyvale, which had an original cost of $149.6 million. Under these leasing arrangements, we pay BNPPLC minimum lease payments, which vary based on LIBOR plus a spread or a fixed rate on the costs of the facilities on the respective lease commencement dates. We make payments for each of the leases for a term of five years. We have the option to renew each of the leases for two consecutive five-year periods upon approval by BNPPLC. Upon expiration (or upon any earlier termination) of the lease terms, we must elect one of the following options: (i) purchase the buildings from BNPPLC at cost; (ii) if certain conditions are met, arrange for the sale of the buildings by BNPPLC to a third party for an amount equal to at least 85% of the costs (residual guarantee), and be liable for any deficiency between the net proceeds received from the third party and such amounts; or (iii) pay BNPPLC supplemental payments for an amount equal to at least 85% of the costs (residual guarantee), in which event we may recoup some or all of such payments by arranging for a sale of each or all buildings by BNPPLC during the ensuing two-year period. The following table summarizes the costs, the residual guarantee, the applicable LIBOR plus spread or fixed rate at October 29, 2010 and the date we began to make payments for each of our leasing arrangements (in millions):

 

Leasing

Arrangements

               Cost                   Residual
         Guarantee        
    

LIBOR plus

Spread or

Fixed Rate

  

Lease

Commencement

Date

  

        Term        

1

   $ 48.5       $ 41.2       3.69%    January 2008    5 years

2

     80.0         68.0       0.81%    December 2007    5 years

3

     10.5         8.9       3.67%    December 2007    5 years

4

     10.6         9.0       3.69%    December 2007    5 years

As of October 29, 2010, we estimated that the fair value of the properties under synthetic lease was $36.9 million less than their aggregate residual guarantees. We are accruing for this deficiency over the remaining terms of the respective leases.

Legal Contingencies

On September 5, 2007, we filed a patent infringement lawsuit in the Eastern District of Texas seeking compensatory damages and a permanent injunction against Sun Microsystems (Sun). On October 25, 2007, Sun filed a counter claim against us in the Eastern District of Texas seeking compensatory damages and a permanent injunction. On October 29, 2007, Sun filed a second lawsuit against us in the Northern District of California asserting additional patents against us. The Texas court granted a joint motion to transfer the Texas lawsuit to the Northern District of California on November 26, 2007. On March 26, 2008, Sun filed a third lawsuit in federal court that extends the patent infringement charges to storage management technology we acquired in January 2008. In January 2010, Oracle Corporation acquired Sun. In September 2010, the lawsuits were dismissed without prejudice.

On October 13, 2010, Amalgamated Bank (as trustee of the Longview Largecap 500 Index Fund and the Longview Largecap 500 Index Veba Fund) filed a derivative lawsuit on behalf of NetApp, Inc. and NetApp U.S. Public Sector, Inc. in the Superior Court of the State of California, Santa Clara County. The lawsuit names 15 current and former NetApp directors as defendants, alleging breach of fiduciary duty and wasting of corporate assets. The lawsuit alleges that the defendants failed to implement and oversee internal controls to ensure that we complied with legal requirements in its General Services Administration (GSA) contracting activities, and that this purported failure of oversight required us to incur significant costs in defending and settling a dispute with the United States of America regarding these past GSA contracting activities. The complaint seeks disgorgement of salaries and other compensation from the defendants and seeks additional unspecified damages. We and the defendants have filed demurrers seeking to have the lawsuit dismissed.

In addition, we are subject to various legal proceedings and claims which have arisen or may arise in the normal course of business. While the outcome of these legal matters is currently not determinable, we do not believe that any current litigation or claims will have a material adverse effect on our business, cash flow, operating results, or financial condition.

Off-Balance Sheet Arrangements

During the ordinary course of business, we provide standby letters of credit or other guarantee instruments to third parties as required for certain transactions initiated either by us or our subsidiaries. As of October 29, 2010, our financial guarantees of $4.9 million that were not recorded on our balance sheet consisted of standby letters of credit related to workers’ compensation, a customs guarantee, a corporate credit card program, foreign rent guarantees and surety bonds, which were primarily related to self-insurance.

 

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We use derivative instruments to manage exposures to foreign currency risk. Our primary objective in holding derivatives is to reduce the volatility of earnings and cash flows associated with changes in foreign currency. The program is not designated for trading or speculative purposes. Currently, we do not enter into any foreign exchange forward contracts to hedge exposures related to firm commitments or nonmarketable investments. Our major foreign currency exchange exposures and related hedging programs are described below:

 

   

We utilize monthly foreign currency forward and options contracts to hedge exchange rate fluctuations related to certain foreign monetary assets and liabilities.

 

   

We use currency forward contracts to hedge exposures related to forecasted sales denominated in certain foreign currencies. These contracts are designated as cash flow hedges and in general closely match the underlying forecasted transactions in duration.

As of October 29, 2010, our notional value of foreign exchange forward and foreign currency option contracts totaled $518.8 million. We do not believe that these derivatives present significant credit risks, because of the short term maturity of the outstanding contracts at any point in time, the counterparties to the derivatives consist of major financial institutions, and we manage the notional amount of contracts entered into with any one counterparty. Other than the risk associated with the financial condition of the counterparties, our maximum exposure related to foreign currency forward and option contracts is limited to the premiums paid. See Note 11 of the accompanying condensed consolidated financial statements for more information related to our hedging activities.

In the ordinary course of business, we enter into recourse lease financing arrangements with third-party leasing companies and from time to time provide guarantees for a portion of other financing arrangements under which we could be called upon to make payments to the third-party funding companies in the event of nonpayment by end-user customers. See Note 15 of the accompanying condensed consolidated financial statements for more information related to these financing arrangements.

We enter into indemnification agreements with third parties in the ordinary course of business. Generally, these indemnification agreements require us to reimburse losses suffered by the third party due to various events, such as lawsuits arising from patent or copyright infringement. These indemnification obligations are considered off-balance sheet arrangements under accounting guidance.

We have commitments related to four lease arrangements with BNPPLC for approximately 0.6 million square feet of office space for our headquarters in Sunnyvale, California (as further described above under “Contractual Obligations”). Our future minimum lease payments and residual guarantees under these real estate leases will amount to a total of $97.1 million as discussed in above in “Contractual Obligations”.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We are exposed to market risk related to fluctuations in interest rates, market prices, and foreign currency exchange rates. We use certain derivative financial instruments to manage these risks. We do not use derivative financial instruments for speculative or trading purposes. All financial instruments are used in accordance with management-approved policies.

Market Risk and Market Interest Risk

Investment and Interest Income — As of October 29, 2010, we had available-for-sale investments of $2.7 billion. Our investment portfolio primarily consists of investments with original maturities at the date of purchase of greater than three months, which are classified as available-for-sale. These investments, consisting primarily of corporate bonds, commercial paper, U.S. agency securities, U.S. Treasuries, and certificates of deposit, are subject to interest rate and interest income risk and will decrease in value if market interest rates increase. A hypothetical 10 percent increase in market interest rates from levels at October 29, 2010 would cause the fair value of these available-for-sale investments to decline by approximately $2.4 million. Volatility in market interest rates over time will cause variability in our interest income. We do not use derivative financial instruments in our investment portfolio.

Our investment policy is to limit credit exposure through diversification and investment in highly rated securities. We further mitigate concentrations of credit risk in our investments by limiting our investments in the debt securities of a single issuer and by diversifying risk across geographies and type of issuer. We actively review, along with our investment advisors, current investment ratings, company specific events and general economic conditions in managing our investments and in determining whether there is a significant decline in fair value that is other-than-temporary. We will monitor and evaluate the accounting for our investment portfolio on a quarterly basis for additional other-than-temporary impairment charges.

 

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We are also exposed to market risk relating to our auction rate securities due to uncertainties in the credit and capital markets. As of October 29, 2010, we recorded cumulative unrealized loss of $4.5 million, offset by $0.5 million of unrealized gains related to these securities. The fair value of our auction rate securities may change significantly due to events and conditions in the credit and capital markets. These securities/issuers could be subject to review for possible downgrade. Any downgrade in these credit ratings may result in an additional decline in the estimated fair value of our auction rate securities. Changes in the various assumptions used to value these securities and any increase in the markets’ perceived risk associated with such investments may also result in a decline in estimated fair value.

If current market conditions deteriorate, or the anticipated recovery in market values does not occur, we may be required to record additional unrealized losses in other comprehensive income (loss) or other-than-temporary impairment charges to earnings in future quarters. We intend, and have the ability, to hold these investments until the market recovers. We do not believe that the lack of liquidity relating to our portfolio investments will impact our ability to fund working capital needs, capital expenditures or other operating requirements.

Lease Commitments — As of October 29, 2010, one of our four lease arrangements with BNPPLC is based on a floating interest rate. The minimum lease payments will vary based on LIBOR plus a spread. All of our leases have an initial term of five years, and we have the option to renew these leases for two consecutive five-year periods upon approval by BNPPLC. A hypothetical 10 percent increase in market interest rate from the level at October 29, 2010 would increase our lease payments on this one floating lease arrangement under the initial five-year term by an immaterial amount. We do not currently hedge against market interest rate increases.

Convertible Notes — In June 2008, we issued $1.265 billion in aggregate principal amount of 1.75% Convertible Senior Notes due 2013 (the “Notes”), of which $1.017 billion was allocated to debt and $0.248 billion was allocated to equity. Holders may convert the Notes prior to maturity upon the occurrence of certain circumstances, including, but not limited to:

 

   

during the five business day period after any five consecutive trading day period in which the trading price of the Notes for each day in this five consecutive trading day period was less than 98% of an amount equal to (i) the last reported sale price of our common stock multiplied by (ii) the conversion rate on such day;

 

   

during any calendar quarter if the last reported sale price of our common stock for 20 or more trading days in a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter exceeds 130% of the applicable conversion price in effect for the Notes on the last trading day of such immediately preceding calendar quarter; or

 

   

upon the occurrence of specified corporate transactions under the indenture for the Notes.

The Notes are convertible into the right to receive cash in an amount up to the principal amount and shares of our common stock for the conversion value in excess of the principal amount, if any, at an initial conversion rate of 31.4006 shares of common stock per $1,000 principal amount of Notes, subject to adjustment as described in the indenture governing the Notes, which represents an initial conversion price of approximately $31.85 per share.

Concurrent with the issuance of the Notes, we entered into convertible Note hedge transactions and separately, warrant transactions, to reduce the potential dilution from the conversion of the Notes and to mitigate any negative effect such conversion may have on the price of our common stock. In fiscal 2010, we terminated the hedge transaction with a counterparty to 20% of our Note hedges as a result of the bankruptcy filing by Lehman Brothers OTC Derivatives Inc., which constituted an event of default under the Note hedge. Because we have decided not to replace the hedge, we are subject to potential dilution on the 20% unhedged portion of our Notes upon conversion if on the date of conversion the per-share market price of our common stock exceeds the conversion price of $31.85.

For at least 20 trading days during the 30 consecutive trading days ended September 30, 2010, our common stock price exceeded the conversion threshold price of $41.41 per share set forth for these Notes. Accordingly, the Notes are convertible at the holder’s option through December 31, 2010. Based on the closing price of our common stock of $53.25 on October 29, 2010, the if-converted value of our Notes exceeded their principal amount by approximately $850.0 million.

The fair value of our Notes is subject to interest rate risk, market risk and other factors due to the convertible feature. Generally, the fair value of Notes will increase as interest rates fall and/or our common stock price increases, and decrease as interest rates rise and/or our common stock price decreases. The interest and market value changes affect the fair value of our Notes, but do not impact our financial position, cash flows, or results of operations due to the fixed nature of the debt obligations. We do not carry the Notes at fair value, but present the fair value of the principal amount of our Notes for disclosure purposes. As of October 29, 2010, the principal amount of our Notes, which consists of the combined debt and equity components, was $1.265 billion, and the total estimated fair value of such was $2.2 billion based on the closing trading price of $174 per $100 of our Notes as of that date.

 

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Foreign Currency Exchange Rate Risk and Foreign Exchange Forward Contracts

We hedge risks associated with foreign currency transactions to minimize the impact of changes in foreign currency exchange rates on earnings. We utilize forward and option contracts to hedge against the short-term impact of foreign currency fluctuations on certain assets and liabilities denominated in foreign currencies. All balance sheet hedges are marked to market through earnings every period. We also use foreign exchange forward contracts to hedge foreign currency forecasted transactions related to forecasted sales transactions. These derivatives are designated as cash flow hedges under accounting guidance for derivatives and hedging. For cash flow hedges outstanding at October 29, 2010, the time-value component is recorded in earnings while all other gains or losses were included in other comprehensive income.

We do not enter into foreign exchange contracts for speculative or trading purposes. In entering into forward and option foreign exchange contracts, we have assumed the risk that might arise from the possible inability of counterparties to meet the terms of their contracts. We attempt to limit our exposure to credit risk by executing foreign exchange contracts with creditworthy multinational commercial banks. All contracts have a maturity of less than one year.

The following table provides information about our currency forward and option contracts outstanding on October 29, 2010 (in millions):

 

     October 29, 2010  

Currency

   Local Currency
Amount
     Notional Contract
Amount (USD)
     Fair Value
(USD)
 

Forward Contracts:

        

Euro

     223.4       $ 310.4       $ 311.3   

British Pound Sterling

     58.7         93.9         94.1   

Canadian Dollar

     19.6         19.3         19.2   

Australian Dollar

     30.9         30.1         30.2   

Other

     N/A         50.3         50.4   

Option Contracts:

        

Euro

     11.0       $ 14.8       $ 0.0   

 

Item 4. Controls and Procedures

Disclosure controls are controls and procedures designed to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), such as this Quarterly Report on Form 10-Q, is recorded, processed, summarized, and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures are also designed to ensure that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

Under the supervision and with the participation of our management, including our CEO and CFO, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as of October 29, 2010, the end of the fiscal period covered by this Quarterly Report on Form 10-Q (the “Evaluation Date”). Based on this evaluation, our CEO and CFO concluded as of the Evaluation Date that our disclosure controls and procedures were effective such that the information relating to NetApp, including its consolidated subsidiaries, required to be disclosed in its Securities and Exchange Commission (“SEC”) reports (i) is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to NetApp management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings

On September 5, 2007, we filed a patent infringement lawsuit in the Eastern District of Texas seeking compensatory damages and a permanent injunction against Sun Microsystems (Sun). On October 25, 2007, Sun filed a counter claim against us in the Eastern District of Texas seeking compensatory damages and a permanent injunction. On October 29, 2007, Sun filed a second lawsuit against us in the Northern District of California asserting additional patents against us. The Texas court granted a joint motion to transfer the Texas lawsuit to the Northern District of California on November 26, 2007. On March 26, 2008, Sun filed a third lawsuit in federal court that extends the patent infringement charges to storage management technology we acquired in January 2008. In January 2010, Oracle Corporation acquired Sun. In September 2010, the lawsuits were dismissed without prejudice.

On October 13, 2010, Amalgamated Bank (as trustee of the Longview Largecap 500 Index Fund and the Longview Largecap 500 Index Veba Fund) filed a derivative lawsuit on behalf of NetApp, Inc. and NetApp U.S. Public Sector, Inc. in the Superior Court of the State of California, Santa Clara County. The lawsuit names 15 current and former NetApp directors as defendants, alleging breach of fiduciary duty and wasting of corporate assets. The lawsuit alleges that the defendants failed to implement and oversee internal controls to ensure that we complied with legal requirements in its General Services Administration (GSA) contracting activities, and that this purported failure of oversight required us to incur significant costs in defending and settling a dispute with the United States of America regarding these past GSA contracting activities. The complaint seeks disgorgement of salaries and other compensation from the defendants and seeks additional unspecified damages. We and the defendants have filed demurrers seeking to have the lawsuit dismissed.

 

Item 1A. Risk Factors

The following risk factors and other information included in this Quarterly Report on Form 10-Q should be carefully considered. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we presently deem less significant may also impair our business operations. Please see page 23 of this Quarterly Report on Form 10-Q for a discussion of the forward-looking statements that are qualified by these risk factors. If any of the events or circumstances described in the following risk factors actually occurs, our business, operating results, and financial condition could be materially adversely affected.

Our operating results may be adversely affected by uncertain economic and market conditions.

We are subject to the effects of general global economic and market conditions. Challenging economic conditions worldwide or in certain geographic regions have from time to time contributed to slowdowns in the computer, storage, and networking industries at large, as well as the information technology (“IT”) market, resulting in:

 

   

Reduced demand for our products as a result of constraints on IT related spending by our customers;

 

   

Increased price competition for our products from competitors;

 

   

Deferment of purchases and orders by customers due to budgetary constraints or changes in current or planned utilization of our systems;

 

   

Risk of excess and obsolete inventories;

 

   

Risk of supply constraints:

 

   

Excess facilities costs;

 

   

Higher overhead costs as a percentage of revenues;

 

   

Negative impacts from increased financial pressures on customers, distributors and resellers;

 

   

Negative impacts from increased financial pressures on key suppliers or contract manufacturers; and

 

   

Potential discontinuance of product lines or businesses and related asset impairments.

Any of the above mentioned factors could have a material and adverse effect on our business and financial performance.

 

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Our quarterly operating results may fluctuate, which could adversely impact our common stock price.

We believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indicators of future performance. Our operating results have in the past, and will continue to be, subject to quarterly fluctuations as a result of numerous factors, some of which may contribute to more pronounced fluctuations during times of economic volatility. These factors include, but are not limited to, the following:

 

   

Fluctuations in demand for our products and services, in part due to changes in general economic conditions and specific economic conditions in the storage and data management market;

 

   

A shift in federal government spending patterns;

 

   

Changes in sales and implementation cycles for our products and reduced visibility into our customers’ spending plans and associated revenues;

 

   

The level of price and product competition in our target product markets;

 

   

The impact of economic uncertainty on our customers’ budgets and IT spending capacity;

 

   

Our ability to maintain appropriate inventory levels and purchase commitments;

 

   

Our reliance on a limited number of suppliers, and industry consolidation in our supply base, which could subject us to periodic supply-and-demand, price rigidity, and quality issues with our components;

 

   

The timing of bookings, the cancellation of significant orders and the management of our backlog;

 

   

Product configuration and mix;

 

   

The extent to which our customers renew their service and maintenance contracts with us;

 

   

Seasonality, such as our historical seasonal decline in revenues in the first quarter of our fiscal year and seasonal increase in revenues in the second quarter of our fiscal year, with the latter due in part to the impact of the U.S. federal government’s September 30 fiscal year end on the timing of its orders;

 

   

Linearity, such as our historical intraquarter bookings and revenue pattern in which a disproportionate percentage of each quarter’s total bookings and related revenue occur in the last month of the quarter;

 

   

Announcements and introductions of, and transitions to, new products by us or our competitors;

 

   

Deferrals of customer orders in anticipation of new products or product enhancements introduced by us or our competitors;

 

   

Our ability to develop, introduce, and market new products and enhancements in a timely manner;

 

   

Our levels of expenditure on research and development and sales and marketing programs;

 

   

Our ability to effectively manage our operating expenses;

 

   

Adverse movements in foreign currency exchange rates in the countries in which we do business;

 

   

The dilutive impact of our $1.265 billion of 1.75% convertible senior notes due June 2013 (the “Notes”) and related warrants on our earnings per share;

 

   

Excess or inadequate facilities;

 

   

Actual events, circumstances, outcomes and amounts differing from judgments, assumptions, and estimates used in determining the values of certain assets (including the amounts of valuation allowances), liabilities, and other items reflected in our consolidated financial statements;

 

   

Disruptions resulting from new systems and processes as we continue to enhance and scale our system infrastructure; and

 

   

Future accounting pronouncements and changes in accounting rules, such as the increased use of fair value measures, changes in accounting standards related to revenue recognition, lease accounting, and financial instruments and the potential requirement that U.S. registrants prepare financial statements in accordance with International Financial Reporting Standards (IFRS).

Due to such factors, operating results for a future period are difficult to predict, and, therefore, prior results are not necessarily indicative of results to be expected in future periods. Any of the foregoing factors, or any other factors discussed elsewhere herein, could have a material adverse effect on our business, results of operations, and financial condition. It is possible that in one or more quarters our results may fall below our forecasts and the expectations of public market analysts and investors. In such event, the trading price of our common stock would likely decrease.

 

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Our revenue for a particular period is difficult to forecast, and a shortfall in revenue may harm our business and our operating results.

Our revenues for a particular period are difficult to forecast, especially in times of economic uncertainty. Our revenues are also difficult to forecast because the storage and data management market is rapidly evolving, and our sales cycle varies substantially from customer to customer. New or additional product introductions also increase the complexities of forecasting revenues.

We derive a majority of our revenues in any given quarter from orders booked in the same quarter. Bookings typically follow intraquarter seasonality patterns weighted toward the back end of the quarter. If we do not achieve bookings in the latter part of a quarter consistent with our quarterly targets, our financial results will be adversely impacted. Additionally, due to the complexities associated with revenue recognition, we may not accurately forecast our non-deferred and deferred revenues, which could adversely impact our results of operations.

We use a “pipeline” system, a common industry practice, to forecast bookings and trends in our business. Sales personnel monitor the status of potential business and estimate when a customer will make a purchase decision, the dollar amount of the sale and the products or services to be sold. These estimates are aggregated periodically to generate a bookings pipeline. Our pipeline estimates may prove to be unreliable either in a particular quarter or over a longer period of time, in part because the “conversion rate” of the pipeline into revenues varies from customer to customer, can be difficult to estimate, and requires management judgment, and also because customers’ purchasing decisions are subject to delay, reduction or cancellation. Small deviations from our forecasted conversion rate may result in inaccurate plans and budgets and could materially and adversely impact our business or our planned results of operations.

Economic uncertainties have caused, and may in the future again cause, consumers, businesses and governments to defer purchases in response to tighter budgets, credit, decreased cash availability and declining customer confidence. Accordingly, future demand for our products could differ from our current expectations.

We have experienced periods of alternating growth and decline in revenues and operating expenses. If we are not able to successfully manage these fluctuations, our business, financial condition and results of operations could be significantly impacted.

Changing market conditions and economic uncertainty create a challenging operating environment for our business. It is critical that we maintain appropriate alignment between our cost structure and our expected growth and revenues, while at the same time, continue to make strategic investments for future growth.

Our expense levels are based in part on our expectations as to future revenues, and a significant percentage of our expenses are fixed. We have a limited ability to quickly or significantly reduce our fixed costs, and if revenue levels are below our expectations, operating results will be adversely impacted. During periods of uneven growth, we may incur costs before we realize the anticipated related benefits, which could harm our operating results. We have made, and will continue to make, significant investments in engineering, sales, service and support, marketing programs and other functions to support and grow our business. We are likely to recognize the costs associated with these investments earlier than some of the related anticipated benefits (revenue growth), and the return on these investments may be lower, or may develop more slowly, than we expect, which could harm our business, operating results and financial condition.

Conversely, if we are unable to effectively manage our resources and capacity during periods of increasing demand for our products, we could also experience an adverse impact to our business, operating results and financial condition. If the storage and data management market fails to grow, or grows slower than we expect, our revenues will be adversely affected. Also, even if IT spending increases, our revenues may not grow at the same pace.

Our gross margins have varied over time and may continue to vary, and such variation may make it more difficult to forecast our earnings.

Our total gross margins are impacted by the mix of product, software entitlements and maintenance and services revenues.

Our product gross margins have been and may continue to be affected by a variety of factors, including:

 

   

Demand for storage and data management products;

 

   

Pricing actions, rebates, sales initiatives, discount levels, and price competition;

 

   

Direct versus indirect and OEM sales;

 

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Changes in customer, geographic, or product mix, including mix of configurations within products;

 

   

The mix of sales to commercial and U.S. government sector end users;

 

   

The timing and amount of revenue recognized and deferred;

 

   

New product introductions and enhancements;

 

   

Licensing and royalty arrangements;

 

   

Excess inventory levels or purchase commitments as a result of changes in demand forecasts or last time buy purchases;

 

   

Possible product and software defects as we transition our products; and

 

   

The cost of components, contract manufacturing costs, quality, warranty, and freight.

Changes in software entitlements and maintenance gross margins may result from various factors, such as:

 

   

The size of the installed base of products under support contracts;

 

   

The timing of technical support service contract renewals;

 

   

Demand for and the timing of delivery of upgrades; and

 

   

The level of spending on our customer support infrastructure.

Changes in service gross margins may result from various factors, such as:

 

   

The mix of customers;

 

   

The size and timing of service contract renewals;

 

   

Spares stocking requirements to support new product introductions;

 

   

The volume, cost and use of outside partners to deliver support services on our behalf; and

 

   

Product quality and serviceability issues.

Due to such factors, gross margins are subject to variations from period to period and are difficult to predict.

An increase in competition and industry consolidation could materially and adversely affect our operating results.

The storage and data management markets are intensely competitive and are characterized by rapidly changing technology. In the storage market, our primary and near-line storage system products and our associated software portfolio compete primarily with storage system products and data management software from EMC (including its recently announced acquisition of Isilon), Hitachi Data Systems, HP (including its acquisition of 3Par), IBM, and Oracle Corporation. In addition, Dell, Inc. is a competitor in the storage marketplace as a result of its business arrangement with EMC, which allows Dell to resell EMC storage hardware and software products, as well as a result of several of Dell’s recent acquisitions. In the secondary storage market, which includes the disk-to-disk backup, compliance and business continuity segments, our solutions compete primarily against products from EMC and Oracle Corporation (through its acquisition of Sun Microsystems).

There has been a trend toward industry consolidation in our markets for several years. We expect this trend to continue as companies attempt to strengthen or hold their market positions in an evolving industry and as companies become unable to maintain their competitive positions or continue operations. We believe that industry consolidation may result in stronger competitors that are better able to compete as sole-source vendors for customers. In addition, current and potential competitors have established or may establish strategic alliances among themselves or with third parties, including some of our partners. It is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. We may not be able to compete successfully against current or future competitors. Competitive pressures we face could materially and adversely affect our business and operating results.

 

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Disruption of, or changes in, our distribution model could harm our sales.

If we fail to develop and maintain strong relationships with our distributors, or if our distributors fail to effectively manage the sale of our products or services on our behalf, our revenues and gross margins could be adversely affected.

We market and sell our storage data management solutions directly through our worldwide sales force and indirectly through channel partners such as value-added resellers, systems integrators, distributors, OEMs and strategic business partners, and we derive a significant portion of our revenues from these indirect channels. During the three and six month periods ended October 29, 2010, revenues generated from sales from our indirect channel distribution accounted for 72% and 70% of our revenues, respectively. In order for us to maintain or increase our revenues, we must effectively manage our relationships with channel partners.

Several factors could result in disruption of or changes in our indirect channel distribution model, which could materially harm our revenues and gross margins, including the following:

 

   

Our indirect channel partners may compete directly with other channel partners or with our direct sales force. Due to these conflicts, our indirect channel partners could stop or reduce their efforts in marketing our products.

 

   

Our indirect channel partners may demand that we absorb a greater share of the risks that their customers may ask them to bear;

 

   

Our indirect channel partners may have insufficient financial resources and may not be able to withstand changes and challenges in business conditions; and

 

   

Our indirect channel partners’ financial condition or operations may weaken.

There is no assurance that we will be able to attract new indirect channel partners, retain these indirect channel partners or that we will be able to secure additional or replacement indirect channel partners in the future, especially in light of changes in end customer demand patterns and changes in available and competing technologies from competitors. The loss of one or more of our key indirect channel partners in a given geographic area could harm our operating results within that area, as qualifying and developing new indirect channel partners typically requires a significant investment of time and resources before acceptable levels of productivity are met. Our inability to effectively establish, train, retain and manage our distribution channel could harm our sales.

In addition, we depend on our indirect channel partners to comply with applicable regulatory requirements in the jurisdictions in which they operate. Their failure to do so could have a material adverse effect on our revenues and operating results.

Our OEM relationship may not continue to generate significant revenues.

In April 2005, we entered into an OEM agreement with IBM, which enables IBM to sell IBM branded solutions based on NetApp unified solutions, including NearStore® and V-Series