NTAP

NetApp, Inc. 10-Q Summary: Quarter Ended July 30, 2010

Business Context and Reporting Period

This filing is a Quarterly Report on Form 10-Q for NetApp, Inc., a supplier of enterprise storage and data management software and hardware. The reporting period covers the three months ended July 30, 2010 (Fiscal 2011 Q1). The period consisted of 13 weeks (91 days), compared to 14 weeks (98 days) in the prior year comparable period.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Net revenues increased 36% year-over-year, driven by a 51% increase in product revenues and a 25% increase in service revenues. Product revenue growth was fueled by a 78% increase in configured systems unit volume.
• Profitability: Net income more than doubled to $141.8 million. Operating income increased significantly to $164.2 million, aided by a one-time $41.1 million acquisition-related income in the prior year (from a terminated merger) which is not present in the current period.
• Acquisitions: NetApp completed the acquisition of Bycast Inc. for $80.5 million in cash, adding object-based storage software capabilities. This resulted in $56.0 million of goodwill and $23.6 million of identified intangible assets.
• Operating Expenses: Total operating expenses increased 24% to $560.2 million, primarily due to an 8% increase in average headcount and higher commissions reflecting stronger sales performance.
• Cash Flow: Operating cash flow improved dramatically to $177.3 million, driven by net income and a $100 million decrease in accounts receivable.

Guidance, Outlook, and Risks

Management Commentary: Management attributes the strong performance to robust demand for storage efficiency and data management solutions across all geographies. Gross margins improved due to better product material costs, partially offset by lower average selling prices. Headcount increased to 8,973 from 8,042 in the prior year.

Outlook: The company expects to fund capital expenditures (approx. $200 million over the next 12 months) and working capital needs through existing cash and operating cash flows. No specific forward-looking revenue guidance was provided in this text.

Risks and Contingencies:

• Legal Proceedings: Ongoing patent infringement litigation with Oracle Corporation (formerly Sun Microsystems). No accrual has been recorded as the outcome is uncertain.
• Tax Audits: The company is undergoing federal income tax audits for fiscal years 2003-2007 and state audits. It is reasonably possible a settlement on the 2003-2004 audit will occur within 12 months.
• Investment Portfolio: The company holds $67.4 million in auction rate securities (ARS) with a cumulative temporary loss of $3.4 million. While management intends to hold these to maturity, further impairment charges could occur if market conditions deteriorate.
• Convertible Notes: $1.265 billion of 1.75% Convertible Senior Notes due 2013 are outstanding. The if-converted value exceeded the principal amount by approximately $415.1 million as of July 30, 2010.

Key Facts for Investor Verification

• Revenue Mix: Verify the sustainability of the 51% product revenue growth and the shift in unit mix toward smaller systems.
• One-Time Items: Note that the prior year's operating income included a $41.1 million gain from a terminated merger; current year operating income excludes such gains.
• Debt Conversion Risk: Assess the potential dilution from the $1.265 billion convertible notes, given the stock price ($42.30) is above the conversion price ($31.85).
• Investment Liquidity: Monitor the status of the $67.4 million in auction rate securities and potential for further other-than-temporary impairment charges.
• Tax Liability: Track the resolution of the IRS audit regarding fiscal years 2003-2004, which could impact future effective tax rates.