UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

Form 10-K

 

 

Commission File Number 0-27130

 

Network Appliance, Inc.

(Exact name of registrant as specified in its charter)

 

 

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

 

Securities registered pursuant to Section 12(b) of the Act:

None

 

 

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.001 Par Value

(Title of Class)

 

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ     No o

 

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

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 þ     No o

 

Indicate by a check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

 

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

The aggregate market value of voting stock held by nonaffiliates of the Registrant, as of October 28, 2005, the last day of Registrant’s most recently completed second fiscal quarter, was $6,336,402,987 (based on the closing price for shares of the Registrant’s common stock as reported by the Nasdaq National Market for the last business day prior to that date). Shares of common stock held by each executive officer, director, and holder of 5% or more of the outstanding common stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

 

On June 23, 2006, 373,430,742 shares of the Registrant’s common stock, $0.001 par value, were outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

The information called for by Part III of this Form 10-K is hereby incorporated by reference from the definitive Proxy Statement for our annual meeting of stockholders to be held on August 31, 2006, which will be filed with the Securities and Exchange Commission not later than 120 days after April 30, 2006.

 

 

TABLE OF CONTENTS

 

 

TRADEMARKS

 

^© 2006 Network Appliance, Inc. All rights reserved. Specifications subject to change without notice. NetApp, the Network Appliance logo, DataFabric, Data ONTAP, FAServer, FilerView, NearStore, NetCache, SecureShare, SnapDrive, SnapLock, SnapManager, SnapMirror, SnapRestore, SnapVault, SyncMirror, and WAFL are registered trademarks and Network Appliance, ApplianceWatch, FlexClone, FlexShare, FlexVol, LockVault, RAID-DP, Snapshot, and VFM are trademarks of Network Appliance, Inc. in the U.S. and other countries. Decru is a registered trademark and Decru DataFort is a trademark of Decru, a NetApp company. Sun is a trademark of Sun Microsystems, Inc. Oracle is a registered trademark of Oracle Corporation. Symantec is a registered trademark and NetBackup is a trademark of Symantec Corporation or its affiliates in the U.S. and other countries. Microsoft and Windows are registered trademarks 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.

 

Forward Looking Statements

 

With the exception of historical facts, the statements contained in this Annual Report on Form 10-K are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and are 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,” “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, (1) our belief that we are fully compliant with all applicable environmental laws; (2) our belief that we continue to maintain and enhance technological advantage over our competitors; (3) our intention to regularly introduce new products and product enhancements; (4) the possibility that we may engage in future acquisitions; (5) our intention to continue to establish and maintain business relationships with technology companies; (6) our belief that our strategic investments are targeted at some of the strongest growth areas of the storage market; (7) our anticipation that we will experience further price decline per petabyte for our products; (8) our expectation that our future gross margins will be negatively affected by factors such as global service investment cost; competition, indirect sales including OEM, high disk content partially offset by new product introductions and enhancements and product and add-on software mix; (9) our expectation that we will ship our new high-end products, launch our next-generation operating system with enhanced storage grid functionality, and offer a comprehensive suite of data protection solutions; (10) our plan to invest in the people, processes, and systems necessary to best optimize our revenue growth and long-term profitability; (11) our belief that the current and future potential for encryption and data protection technology will enable us to help our customers manage their risk of data theft and corruption; (12) our expectation that our data center penetration will win more NearStore^® deployments; (13) our belief that our new NearStore Virtual Tape Library solution will further expand our market opportunity; (14) our expectation to continue to expand our global services and support and that such investments will help accelerate the adoption rate of our technology; (15) our expectation that our investment in our services infrastructure will increase commensurate with our revenue growth; (16) our expectation that higher disk content associated with high-end storage systems will negatively affect our gross margins in the future, if not offset by software revenue and new products; (17) our estimates regarding future amortization of existing technology to cost of products revenues relating to our acquisitions; (18) our expectation that service margins will be in the mid 20% range for fiscal 2007; (19) our estimates regarding future amortization of trademarks, tradenames, customer contracts, and relationships relating to our acquisitions; (20) our expectation that we will continue to selectively add sales and professional services capacity; (21) our expectation that we will increase sales and marketing expenses commensurate with future revenue growth; (22) our estimates regarding future capitalized patents amortization expenses; (23) our belief that our future performance will depend in large part on our ability to maintain and enhance our current product line, develop new products, maintain technological competitiveness, and meet an expanding range of custo mer requirements; (24) our expectation that we will continuously support current and future product development and enhancement efforts and incur corresponding charges; (25) our intention to continuously broaden our existing product offerings and introduce new products; (26) our belief that our research and development expenses will increase in absolute dollars in fiscal 2007; (27) our belief that our general and administrative expenses will increase in absolute terms in fiscal 2007; (28) our estimates regarding future amortization of covenants not to compete relating to our acquisitions; (29) our expectation that research and development costs to bring the products from Decru to technological feasibility may not have a material impact on our future results of operations or financial conditions; (30) our expectation regarding estimated future deferred stock compensation expenses; (31) our expectation that interest income will increase in fiscal 2007; (32) our expectation that cash provided by operating activities may fluctuate in future periods as a result of a number of factors; (33) the possibility we may receive less cash from stock option exercises if stock option exercise patterns change; (34) our expectations regarding our contractual cash obligations and other commercial commitments at April 30, 2006, for the fiscal years 2007 through 2011 and thereafter; (35) our expectation that we will complete construction on our building under the BNP lease by approximately September 2007 and the estimates regarding

future minimum lease payments under the lease term; (36) our expectation that capital expenditures will increase consistent with our business growth; (37) our expectation that our existing facilities, and those currently being developed, are adequate for our requirements for the next two years and that additional space will be available as needed and that our contractual commitments, including operating leases, and any required capital expenditures over the next few years will be funded through cash from operations and existing cash and investments; (38) our expectation that we will incur higher capital expenditures in the near future to expand our operations; (39) the possibility that we may continue to repurchase our common stock, which would reduce cash, cash equivalents, and/or short-term investments available to fund future operations and meet other liquidity requirements; (40) our belief that our existing liquidity and capital resources will satisfy our working capital needs, capital expenditures, stock repurchases, contractual obligations, and other liquidity requirements associated with our operations through at least the next 12 months; (41) our expectation that market interest rate changes would not cause significant decline in our investment value or significant increase in lease and debt interest obligations; (42) our belief that the accounting policies included herein are the policies that most frequently require us to make estimates and judgments and are therefore “critical,” 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: (1) the amount of orders received in future periods; (2) our ability to ship our products in a timely manner; (3) our ability to achieve anticipated pricing, cost, and gross margins levels; (4) our ability to successfully introduce new products; (5) our ability to achieve and capitalize on changes in market demand; (6) acceptance of, and demand for, our products; (7) demand for our global service and support and professional services; (8) our ability to identify and respond to significant market trends and emerging standards; (9) our ability to realize our financial objectives through increased investment in people, process, and systems; (10) our ability to maintain our supplier and contract manufacturer relationships; (11) the ability of our competitors to introduce new products that compete successfully with our products; (12) our ability to expand direct and indirect sales and global service and support; (13) the general economic environment and the continued growth of the storage markets; (14) our ability to sustain and/or improve our cash and overall financial position; and (15) those factors discussed under “Risk Factors” elsewhere in this Annual Report on Form 10-K. 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 19.

 

Overview

 

Network Appliance, Inc. (“NetApp” or “Network Appliance”), a Delaware corporation, is a leading supplier of storage and data management solutions for enterprise customers worldwide. The company’s broad portfolio of innovative hardware and software products, partnerships, and services helps customers dramatically simplify the complexity of storing and managing corporate data. Many of the world’s largest and most demanding corporations and government agencies rely on Network Appliance^tm solutions for their storage and data management requirements.

 

NetApp was founded in 1992 around the idea of simplifying data management. Our initial product, the world’s first network storage appliance, was shipped in 1993. Now one of the Fortune 1000 and with over 4,900 employees, NetApp has thousands of customers in 120 countries around the globe.

 

NetApp strives to provide customers the lowest total cost of ownership (“TCO”) by offering innovative solutions that simplify their environments. The company blends a dedication to excellence with customer-focused innovation to address the following customer priorities:

 

 

 

Customer Challenges

 

Network Appliance enterprise data management solutions address several major information technology (“IT”) challenges that plague today’s corporations.

 

 

Products

 

NetApp offers highly available, scalable, and cost-effective storage consolidation solutions that incorporate the NetApp unified storage platform and the feature-rich functionality of data and resource management software to deliver storage that helps improve enterprise productivity, performance, and profitability, while providing investment protection and enhanced asset utilization. NetApp enterprise-class storage solutions are interoperable across all platforms and supported by our service expertise.

 

     Fabric-Attached Storage (“FAS”) Family

 

The NetApp family of modular, scalable, highly available, unified networked storage systems provides seamless access to a full range of enterprise data for users on a variety of platforms. The FAS6000, FAS900, FAS3000, and FAS200 series of fabric-attached storage enterprise systems are designed to consolidate UNIX^®, Windows^®, network-attached storage (“NAS”), Fibre Channel (“FC”), Internet Small Computer Systems Interface (“iSCSI”), storage area networks (“SAN”), and Web data in central locations running over the standard connection types: Gigabit Ethernet (“GbE”), Fibre Channel, and parallel SCSI (for backup). The NetApp design optimizes and consolidates high-performance data access for individuals in multiuser environments as well as for application servers and server clusters with dedicated access. All FAS systems run the highly efficient Data ONTAP^® microkernel operating system.

 

 

     V-Series Family

 

NetApp V-Series is a network-based solution that consolidates storage arrays from different suppliers enabling unified SAN and file access to data stored in heterogeneous Fibre Channel SAN storage arrays. Many enterprises have made significant investments in multiple storage architectures to support a variety of different application requirements. This approach often results in inefficient, fractionalized islands of underutilized storage that can be difficult to manage and costly to scale. With V-Series customers can consolidate storage from multiple vendors and achieve:

 

 

V-Series Family include V3000, V6000, gF270, and gF980 models and supports storage arrays from IBM Corporation (“IBM”), Hewlett-Packard (“H-P”), and Hitachi Data Systems (“HDS”).

 

     Data ONTAP and Key Core Systems Software

 

NetApp FAS and V-Series storage solutions are all based on Data ONTAP, a highly optimized, scalable, and flexible operating system that uniquely supports a mix of SAN, NAS and IP SAN (iSCSI) environments concurrently. Data ONTAP software integrates seamlessly into UNIX, Windows, and Web environments. The Data ONTAP operating system provides the foundation to build storage infrastructure and an enterprise-wide data fabric for mission-critical business applications, while lowering the TCO and complexity typically associated with the management of large-scale enterprise storage infrastructures.

 

Data ONTAP includes the patented NetApp WAFL^® (Write Anywhere File Layout) file management system and the resiliency offered by RAID-DP^tm (RAID Double Parity), a unique double-parity software RAID architecture. Data ONTAP supports all of the major industry-standard protocols’ storage, as well as our complete suite of data management, data replication, and data protection software products.

 

The operating system also includes integrated secure access capabilities and FilerView^®, a Web-based element manager. Snapshot^tm technology, included as part of the base system, enables online backups and provides rapid access to previous versions of data, without requiring complete separate copies. Snapshot technology also eliminates the need to recover data from a tape archive in the event of a disaster or user error. In addition, SecureShare^® is a multiprotocol lock management facility that is integrated into the Data ONTAP microkernel. The cross-protocol locking mechanism in SecureShare ensures heterogeneous data sharing without compromising security, data integrity, or performance.

 

During fiscal year 2006, we also installed our new high-performance operating system, Data ONTAP GX, at several customer sites. Data ONTAP GX, a next generation version of our operating system, leverages distributed systems technology acquired through the purchase of Spinnaker Networks. With Data ONTAP GX, multiple NetApp storage systems can be managed as a single entity under a global namespace. This enables all members of an application server cluster to access data stored across all of the FAS systems by using a single access point, eliminating the traditional complexities of mapping application servers to storage systems. This scale-out architecture is capable of achieving higher levels of aggregate system performance, because data volumes can span multiple storage nodes. Additionally, Data ONTAP GX provides the ability to dynamically add storage resources and transparently redistribute data without any disruption to client systems. The result is a storage system that combines the advantages of management simplicity with scalable performance and capacity.

     Data Management Software

 

Network Appliance products are in use today in some of the largest data centers in the world. These environments require enterprise class management tools. NetApp provides key management tools to increase productivity and simplify data management. Such tools include FlexVol^tm, FlexClone^tm, FlexShare^tm, and the Data Management Family.

 

          FlexVol

 

FlexVol technology, included in the Data ONTAP operating system, enables more efficient storage architectures with flexible volumes that do not require repartitioning of physical storage space. The FlexVol technology delivers storage virtualization solutions that can lower overhead and capital expenses, reduce disruption and risk, and provide the flexibility to adapt quickly and easily to the dynamic needs of the enterprise. FlexVol technology provisions storage resources automatically and enables the creation of multiple flexible volumes on a large pool of disks. This flexibility helps organizations maximize storage utilization and efficiency, simplify operations, and make changes quickly and seamlessly without downtime.

 

          FlexClone

 

NetApp FlexClone technology enables true data cloning, or the instant replication of data volumes and data sets without requiring additional storage space at the time of creation. Each cloned volume is a transparent, virtual copy that can be used for essential enterprise operations, such as testing and bug fixing, platform and upgrade checks, multiple simulations against large data sets, remote office testing and staging, and market-specific product variations. Only data that has changed uses actual disk space. FlexClone provides substantial space savings with minimal overhead. Customers can manage many more data set variations in less time and with less risk to production environments.

 

          FlexShare

 

FlexShare, introduced in fiscal year 2006 and included in Data ONTAP, directs the way storage system resources are used to deliver an appropriate level of service for each application. With FlexShare, you can host multiple workloads on a single NetApp system and assign individual priorities to each. FlexShare gives storage administrators the ability to leverage existing infrastructure and increase processing utilization without sacrificing the performance allocated to business-critical tasks. Using FlexShare, administrators can confidently consolidate disparate applications, prioritize specific data sets, and dynamically adjust priorities if business needs change.

 

          Data Management Family

 

Our Network Appliance Data Management Family of products provides comprehensive storage and data management tools to simplify IT administration and enhance productivity. NetApp has four suites of products targeted to different IT administrative roles:

 

Storage Suite

 

 

Data Suite

 

 

 

Server Suite

 

 

Application Suite

 

 

     Data Protection Products

 

In recent years, enterprises have centralized terabytes of data into networked storage environments to achieve lower costs, higher utilization, and simplified management. On the other hand, geopolitical events such as September 11, 2001; natural disasters such as the Katrina Hurricane disaster; government regulations such as Securities and Exchange Commission’s (“SEC”) Rule 17a-4; banking regulations such as Basel II; increased privacy concerns such as laptop thefts with sensitive data; and industry guidelines such as PCI (Payment Card Industry standard put forth by Visa and MasterCard), have all put a spotlight on the need to protect and retain data for both the public and private sectors. Consolidation, coupled with a higher probability of disasters, has created a heightened sensitivity to the impact of data loss and its disruptive impact on the business. At the same time, compliance and privacy concerns are requiring enterprises to retain data for long periods of time, as well as secure data at rest. Data protection and retention have become critical IT priorities, requiring cost-effective storage solutions that can help the enterprise protect itself from catastrophic business disruption at an affordable cost. NetApp offers a comprehensive set of hardware and software solutions, including the NearStore SATA-based storage, disk-to-disk backup solutions, a family of replication and business continuance solutions, compliance and security solutions, and tools to manage this information ecosystem.

 

          NearStore

 

The NetApp NearStore family of platforms represents SATA-based storage platforms optimized for data protection and retention applications. The NetApp NearStore system bridges the gap between primary storage and offline storage by providing much faster data access than offline storage at a cost much lower than primary storage. This makes NearStore ideal for data protection and retention applications such as disk-to-disk backup, business continuance, archival, compliant retention, and digital content storage.

 

The NearStore family consists of the R200 platform, the NearStore Virtual Tape Library (“VTL”) platforms, and the FAS platforms with SATA drives and NearStore personality licenses. The R200 is a

SATA-only platform based on Data ONTAP and is available in capacities up to 168TB. The NearStore VTL is a disk-to-disk backup appliance that appears like a tape library to a backup software application but provides the superior speed and reliability of disk technologies for any heterogeneous primary storage environment. NetApp has also expanded the capabilities of its entire FAS platform line for nearline uses through a NearStore personality license that optimizes the system for data protection and retention workloads.

 

          Virtual Tape Library

 

The NetApp NearStore VTL solution is a high-performance, easily managed system that significantly improves backup service levels and cost for traditional data center tape backup infrastructures. NearStore VTL ranges in capacity from 4.5TB to 168TB and is based on NetApp system software optimized for the rapid sequential data throughputs seen in data center backup environments that use traditional backup applications such as Symantec^® NetBackup^tm and Tivoli Storage Manager.

 

NearStore VTL delivers value to backup customers in two fundamental ways: 1) it provides a far more reliable and high-performance storage target to backup applications than that provided by physical tape drives and libraries, thus enabling more backups to be done in less time; and 2) when backup data is moved directly from the NearStore VTL to physical tape drives and libraries, the NearStore VTL streams the data at a rate that provides for highly efficient utilization of customers’ existing tape infrastructure. The net benefit to the customer is that backup service levels improve substantially and expenditure on tape infrastructure is slowed.

 

Key differentiators of the NearStore VTL versus other VTL competition are its Continuous Self Tuning and Tape Smart Sizing capabilities. Continuous Self Tuning enables the NearStore VTL to deliver maximum performance with no manual tuning at all capacities, something no other VTL can do. Tape Smart Sizing enables physical tape utilization that is far more efficient than is possible with other VTLs that directly create physical tapes.

 

          Data Protection Software Products

 

Network Appliance offers comprehensive business continuance and disk backup solutions for enterprise customer environments.

 

SyncMirror^®, MetroCluster, SnapMirror, and SnapRestore^® products provide the most appropriate level of data availability and cost of protection matched to the recovery point objectives (“RPOs”) and recovery time objectives (“RTOs”) of customer environments. SnapMirror supports fully synchronous, near-synchronous, and asynchronous remote replication for easy setup, management, and quick recovery. SyncMirror, in conjunction with other NetApp technologies such as RAID-DP, provides the highest level of local data availability to allow NetApp storage systems to continue delivering data after as many as five simultaneous physical disk component failures. MetroCluster enables a highly available campus or metropolitan business continuance solution, minimizing downtime through auto-site failover. SnapRestore greatly minimizes recovery time in the event of a data corruption or loss by allowing rapid restoration of a volume from an earlier point in time using Snapshot technology.

 

SnapVault, Open Systems SnapVault (“OSSV”), and SnapVault for NetBackup products provide network and storage-optimized disk-to-disk backup solutions. With the ability to transmit only the changes from one backup to the next, and eliminate duplicates in storage, NetApp disk-to-disk products offer very cost-effective solutions to help customers with shrinking backup windows, rapid recovery objectives, and remote office backup challenges. In conjunction with other products such as FlexClone and LockVault^tm, customers can significantly enhance the value of their backup investment by utilizing the backups for other uses such as test and development, compliant retention, and business intelligence.

          Data Retention and Archive Software Products

 

To meet growing regulatory compliance demands faced by most enterprises, Network Appliance offers a comprehensive suite of products to ensure data permanence, accessibility, and privacy across the variety of different regulations such as Sarbanes-Oxley Act, 21 CFR Part 11, SEC Rule 17a-4, and HIPAA. Immutable, cost-effective, resilient, and reliable storage architectures can be created utilizing the SnapLock^® products in conjunction with NetApp NearStore platforms. The Information Server 1200 products provide advanced capabilities for both the initial classification and subsequent e-discovery requirements. The Decru DataFort^tm product adds security and privacy by encrypting data, while still allowing the capability to search the compliant data for legal discovery purposes if the need arises.

 

A significant demand is being created for disk-based digital content storage in applications such as medical images (“PACS”), video surveillance, interactive voice records, and Web multi-media content. The NetApp NearStore storage platforms offer highly scalable, cost-effective platforms for these applications. The NetApp platforms, based on open standards-based protocols, are easily integrated into the Embedded Solution Vendor’s (“ESV”) overall solution for these applications. Search, indexing, and classification capabilities of the Information Server 1200 product provide an easy way to access the relevant content in these massive data repositories.

 

          Decru

 

NetApp also focuses on storage security, and with the acquisition of Decru, we have taken a leadership position in the emerging storage security category. Decru DataFort storage security appliances provide a unified platform for enterprise-wide security, including heterogeneous NAS, DAS, iSCSI, SAN, and tape environments. The Decru^® platform combines wire-speed encryption, access controls, authentication, and automated key management to provide strong security for data at rest. Over the last twelve months, Decru has secured design wins with many of the top global corporations, including the financial services, media, software, telecommunications, and pharmaceutical sectors, as well as numerous government agencies worldwide. Flagship customers such as Iron Mountain and the U.S. Marine Corps have highlighted Decru leadership in technology, security, and deployment capabilities.

 

Decru has announced strategic distribution agreements with EMC Corporation (“EMC”) and Quantum Corporation, and works closely with the major storage and networking firms, including Brocade Communication Systems, Inc.; Cisco Systems, Inc. (“Cisco”); H-P; IBM; McData Corporation; Oracle Corporation (“Oracle”); Sun Microsystems, Inc.; and Symantec Corporation (“Symantec”) to develop solutions and test interoperability.

 

     Content Delivery (NetCache^®)

 

The NetCache suite of solutions is designed to manage, control, and improve access to Web-based information. Built on an extremely reliable and scalable platform, and working with a range of software partners, NetCache provides solutions to large enterprises to manage Internet Access and Security (“IAS”), enabling IT managers to control who in their user base is going where on the Internet, when, and what content is being accessed. Furthermore, using compression, localized caching, and other techniques, NetCache also optimizes the Wide Area Network (“WAN”) to secure and accelerate delivery of information. The same functionality for public Internet access is used to control and improve access to internal Web information, such as Web-based portals and business applications such as Oracle and SAP, and streaming media.

 

On June 22, 2006, we entered into an Asset Purchase Agreement with Blue Coat Systems, Inc. to sell certain assets of the NetCache business. See Note 16 to the Consolidated Financials Statements accompanying this Annual Report on Form 10-K.

Solutions-Based Approach

 

Network Appliance turnkey solutions, which include hardware, software, service, and financing components, enable our customers to simplify their storage management, leverage their existing infrastructure, and increase their return on investment. The solutions include:

 

 

NetApp has strong application-level solutions with key partners, including Cadence Design Systems, Inc., Dassault Systemes, ESRI, IBM Corp./Rational, Landmark Graphics, Synopsys, Inc., and UGS Corp./PLM, assuring high performance, data availability, and ease of use. The combination of solutions and partners

enables customers in these industries to accelerate product development and data analysis, facilitate collaboration, and reduce operational costs.

 

 

The net effects are lower storage management costs and significant time savings, because storage is intelligently configured and reconfigured non-disruptively, even during production hours. Network Appliance Enterprise File Services solutions free up valuable organizational infrastructure and staff resources, increasing productivity, performance, and profitability.

 

Total Customer Experience

 

At Network Appliance, we believe in offering complete solutions to help customers effectively streamline operations. We strive to provide customers with the best experience in the industry with every interaction they have with NetApp products, services, and people. In addition to providing global service and support, and offering flexible financing solutions, we strive to simplify customer environments whenever possible by utilizing open standards, driving industry collaboration, and partnering with other industry leaders. Using the right combination of products, technologies, and partners, NetApp helps solve customer business challenges while maximizing their return on investment.

 

 

 

 

 

Markets and Distribution Channels

 

Markets

 

NetApp markets products globally in over 120 counties. Our diversified customer base represents a number of large segments and vertical markets. We focus primarily on the enterprise data management and storage solutions markets, offering an array of products from our ultra high-end products designed for large enterprise customers to our low-end products designed for small-to-medium sized businesses. We have also expanded into the virtual tape library and data encryption markets, bring us into parts of the data center we have not competed in before. With our next generation operating system, Data ONTAP GX, we offer storage grid architecture to high performance computing environments.

 

Distribution

 

NetApp employs a multichannel distribution strategy, selling products and services to end users through a direct sales force, value-added resellers, system integrators, OEMs, and distributors. In North America, Europe and Australia, we employ a mix of resellers and direct sales channels to sell to end users. In Asia, Africa, and South America, our products are primarily sold through resellers, which are supported by channel sales representatives and technical support personnel. No single customer or distributor accounted for 10% or more of net sales in fiscal 2006, 2005, or 2004.

The NetApp and IBM OEM (original equipment manufacturer) agreement formed in fiscal year 2005 allows IBM to sell IBM-branded solutions based on Network Appliance unified and open network-attached storage and iSCSI/IP SAN solutions, including NearStore and the NetApp V-Series systems, as well as associated software offerings. The strategic storage relationship expands IBM’s portfolio of storage solutions, which is one of the largest and most advanced sets of storage and information management products in the industry.

 

NetApp Global Services

 

NetApp Global Services brings a unique mix of data center management and deep storage expertise combined with a strategic business focus to give customers a full range of consulting, design and implementation services to provide our customers with comprehensive, enduring, storage solutions. From assessment, planning and design to project management, implementation and integration, our Professional Services group provides expertise in several key areas to help customers more efficiently manage their storage environments and the people and processes that support them.

 

Our Global Support organization supports our hardware and software offerings at worldwide customer sites 24 hours a day, 365 days a year. NetApp Global Services offers NetApp customers the following professional services and support services:

 

SupportEdge offers unprecedented flexibility, allowing enterprise customers the ability to create an integrated support strategy that encompasses everything from corporate data centers to remote offices. Outstanding support services are essential to the success of enterprise IT operations. Potential problems must be anticipated and prevented to ensure the highest possible data availability and operational efficiency. Network Appliance SupportEdge programs feature sophisticated monitoring and diagnostic tools plus regular system availability audits of installed equipment to help anticipate problems before they affect availability.

 

ConsultingEdge services are designed to meet the complex storage needs our customers experience as a result of rapid growth or change in their organizational, end-customer, and technological requirements. Business continuity, data security, and improving the efficiency of access and management for ever-expanding volumes of business-critical and mission-critical data are requirements. New solutions must integrate seamlessly with existing applications, servers, and storage to maximize asset utilization and preserve existing investments.

 

Benefits from using NetApp Global Services include:

 

 

We intend to continue to enhance our service offerings in this segment with additional capabilities by adding new resources and expertise.

 

Manufacturing

 

Manufacturing operations, with insourced and outsourced locations in Sunnyvale, San Jose, and Fremont, California; Livingston, Scotland; Shanghai, China; and Schiphol Airport, The Netherlands, include materials procurement, commodity management, component engineering, test engineering, manufacturing engineering, product assembly, product assurance, quality control, final test, and global logistics. We rely on a limited number of suppliers for materials, as well as several key subcontractors for the production of certain subassemblies and

finished systems. We multisource wherever possible to mitigate supply risk. Our strategy has been to develop close relationships with our suppliers, exchanging critical information and implementing joint quality programs. We also use contract manufacturers for the production of major subassemblies to improve our manufacturing redundancy.

 

See “Risk Factors — We rely on a limited number of suppliers” and “Risk Factors — The loss of our contract manufacturers.” This manufacturing strategy minimizes capital investment and overhead expenditures and creates flexibility for rapid expansion. We were awarded the ISO 9001 certification on May 29, 1997, ISO 9001:2000 certification on December 3, 2003, and continue to be ISO 9001:2000 certified. We were awarded ISO 14001:2004 certification on January 6, 2006.

 

Research and Development

 

Network Appliance finished fiscal year 2006 with its strongest product portfolio to date and a broad set of software solutions that satisfy the needs of our growing customer base. Continuing with our strategy of a unified storage platform based on the best price performance, we introduced the FAS3000 Family. The FAS3020 and FAS3050 deliver outstanding power to the mid-range server market. This product has achieved unprecedented volume shipments during the fiscal year. Our FAS6070, on the high end, began shipping in the fourth quarter of fiscal year 2006 and is now delivering industry leading performance and positions us well as we step further into the Enterprise Data Center. These new platforms are also being manufactured with RoHS (Restriction of Hazardous Substances) compliance.

 

Network Appliance has seen excellent growth in the SAN sector during the year. We were one of the first storage management providers to deliver a 4 gigabit per second capable Fibre Channel product in 2006. Our ongoing investment in delivering enterprise level capabilities through our Data ONTAP operating system and our licensed data management products is driving our growth and expanding our market share. New and unique virtualization capabilities and data management tools, such as our Operations Manager (also known as DFM), consistently place us in the forefront of our industry in solving the complex problems of the Enterprise Data Center.

 

Acquisitions from fiscal years 2004 and 2006 are now producing results. The NearStore VTL was introduced in the fourth quarter of fiscal year 2006, along with new industry leading storage security appliances from Decru. In addition, next generation, highly scalable systems based on technology acquired in the Spinnaker Networks acquisition have been delivered to an initial set of customers. We expect these products to help us continue our leadership in storage innovation.

 

See “Risk Factors — If we are unable to develop and introduce new products and respond to technological change, or if our new products do not achieve market acceptance, our operating results could be materially adversely affected.”

 

Segment and Geographic Information

 

See Note 9 to the Consolidated Financials Statements accompanying this Annual Report on Form 10-K.

 

Customer Base

 

Our diversified customer base spans a number of large segments and vertical markets. Examples include:

 

 

 

Seasonality

 

Although operating results have not been materially and adversely affected by seasonality in the past, because of the significant seasonal effects experienced within the industry, particularly in Europe, our future operating results could be materially adversely affected by seasonality.

 

See “Risk Factors — Factors beyond our control could cause our quarterly results to fluctuate” and “Risk Factors — Risks inherent in our international operations could have a material adverse effect on our operating results” accompanying this Annual Report on Form 10-K.

Backlog

 

Network Appliance manufactures products based on a combination of specific order requirements and forecasts of our customers’ demand. Orders are generally placed by customers on an as-needed basis. Products are typically shipped within one to four weeks following receipt of an order. In certain circumstances, customers may cancel or reschedule orders without penalty. For these reasons, “orders” may not constitute a firm backlog and may not be a meaningful indicator of revenues.

 

Competition

 

The storage and content delivery markets are intensely competitive and are characterized by rapidly changing technology.

 

In the storage market, our primary and nearline storage system products and our associated storage software portfolio compete primarily with storage system products and data management software from EMC, HDS, H-P, IBM, and Sun Microsystems. We also see Dell, Inc. as an emerging competitor in the storage marketplace, primarily due to a business partnership that has been established between Dell and EMC, allowing Dell to resell EMC storage hardware and software products. We have also historically encountered less-frequent competition from companies including Engenio Information Technologies, Inc. (formerly the Storage Systems Group of LSI Logic Corp.), Dot Hill Systems Corporation, and Xiotech Corporation. In the nearline storage market, which includes the disk-to-disk backup and regulated data storage segments, our NearStore appliances compete primarily against products from EMC and Sun Microsystems, as a result of their acquisition of StorageTek Technology Corporation. Our NearStore VTL appliances also compete directly with traditional tape backup solutions in the broader data backup/recovery space.

 

In the content delivery market, our NetCache appliances and content delivery software compete against caching appliance and content delivery software vendors including BlueCoat Systems (formerly CacheFlow, Inc.) and Cisco Systems. Our NetCache business is also subject to indirect competition from content delivery service products such as those offered by Akamai Technologies. On June 22, 2006, we entered into an Asset Purchase Agreement with Blue Coat Systems, Inc. to sell certain assets of the NetCache business. See Note 16 to the Consolidated Financials Statements accompanying this Annual Report on Form 10-K.

 

Additionally, a number of new, privately held companies are currently attempting to enter the storage systems and data management software markets, the nearline and VTL storage markets, and the caching and content delivery markets, some of which may become significant competitors in the future. We believe that the principal competitive factors affecting the storage and content delivery markets include product benefits such as response time, reliability, data availability, scalability, ease of use, price, multiprotocol capabilities, and customer service and support.

 

See “Risk Factors — An increase in competition could materially adversely affect our operating results” and “Risk Factors — If we are unable to develop and introduce new products and respond to technological change, or if our new products do not achieve market acceptance.”

 

Proprietary Rights

 

We currently rely on a combination of copyright and trademark laws, trade secrets, confidentiality procedures, contractual provisions, and patents to protect our proprietary rights. We seek to protect our software, documentation, and other written materials under trade secret, copyright, and patent laws, which afford only limited protection. We have registered our Network Appliance name and logo, Data ONTAP, DataFabric, FAServer^®, FilerView, NearStore, NetApp, NetCache, SecureShare, SnapManager, SnapMirror, SnapRestore, SnapLock, SnapVault, WAFL, and others as trademarks in the United States. Other U.S. trademarks and some of the other U.S. registered trademarks are registered internationally as well. We will continue to evaluate the registration of additional trademarks as appropriate. We generally enter into confidentiality agreements with our employees, resellers, and customers. We currently have multiple U.S. and international patent applications pending and multiple U.S. patents issued.

See “Risk Factors — If we are unable to protect our intellectual property, we may be subject to increased competition that could materially adversely affect our operating results.”

 

Environmental Disclosure

 

Various federal state and local provisions regulate the use and discharge of certain hazardous materials used in our manufacturing. Failure to comply with environmental regulations in the future could cause us to incur substantial costs or subject us to business interruptions. We believe we are fully compliant with all applicable environmental laws. See “Risk Factors — Our business is subject to changing laws and regulations, environmental legislation” accompanying this Annual Report on Form 10-K.

 

Employees

 

As of April 30, 2006, we had 4,976 employees. Of the total, 1,927 were in sales and marketing, 1,246 in research and development, 568 in finance and administration, and 1,235 in manufacturing and customer service operations. Our future performance depends in significant part on our key technical and senior management personnel, none of whom are bound by an employment agreement. We have never had a work stoppage and consider relations with our employees to be good.

 

Executive Officers

 

Our executive officers and their ages as of May 26, 2006, are as follows:

 

 

Daniel J. Warmenhoven joined the Company in October 1994 as president and chief executive officer and has been a member of the Board of Directors since October 1994. In May 2000, he resigned the role of president and currently serves as chief executive officer and as a member of the Board of Directors of Network Appliance, Inc. Prior to joining the Company, Mr. Warmenhoven served in various capacities, including president, chief executive officer, and chairman of the Board of Directors of Network Equipment Technologies, Inc., a telecommunications company, from November 1989 to January 1994. Prior to Network Equipment Technologies, Mr. Warmenhoven held executive and managerial positions at Hewlett-Packard from 1985 to 1989 and IBM Corporation from 1972 to 1985. Mr. Warmenhoven is a Director of Stoke, Inc. and PowerFile, Inc., both privately held companies. Mr. Warmenhoven holds a B.S. degree in electrical engineering from Princeton University.

 

Thomas F. Mendoza joined NetApp in 1994 and has served as president since 2000. Mr. Mendoza has more than 31 years as a high-technology executive. He holds a BA degree in economics from Notre Dame and is an alumnus of Stanford University’s Executive Business Program. In September 2000, the University of Notre Dame renamed their business school the Mendoza College of Business based upon an endowment from Tom and his wife, Kathy.

 

Steven J. Gomo joined Network Appliance in August 2002 as senior vice president of finance and chief financial officer. He was appointed executive vice president of finance and chief financial officer in October 2004. Prior to joining the Company, he served as chief financial officer of Silicon Graphics, Inc., from February 1998 to August 2000, and most recently, chief financial officer for Gemplus International S.A., headquartered in Luxembourg from November 2000 to April 2002. Prior to February 1998, he worked at Hewlett-Packard Company for 24 years in various positions, including financial management, corporate finance, general management, and manufacturing. Mr. Gomo currently serves on the board of SanDisk Corporation. Mr. Gomo holds a master’s degree in business administration from Santa Clara University and a BS degree in business administration from Oregon State University.

David Hitz co-founded NetApp in 1992. As founder and executive vice president, he is responsible for vision, strategy, and direction for NetApp. Mr. Hitz served as executive vice president, engineering from May 2000 to November 2004. Between 1992 and 2000, Mr. Hitz held executive positions at NetApp, including vice president and senior vice president, engineering. Prior to joining the Company in 1992, Mr. Hitz was a senior engineer at Auspex Systems, Inc. and held various engineering positions at MIPS Computer. Mr. Hitz holds a BS degree in computer science and electrical engineering from Princeton University.

 

Robert E. Salmon joined Network Appliance in January 1994 and was appointed executive vice president, field operations in December 2005. Mr. Salmon has served as the Company’s executive vice president of worldwide sales since September 2004. From August 2003 to September 2004, Mr. Salmon served as the Company’s senior vice president of worldwide sales and from May 2000 to August 2003, Mr. Salmon served as the Company’s vice president of North American sales. Mr. Salmon joined the Company in 1994 after nearly ten years with Sun Microsystems and Data General Corporation. Mr. Salmon graduated from California State University, Chico with a B.S. degree.

 

Additional Information

 

Our Internet address is www.netapp.com. We make available through our Internet Web site our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.

 

The SEC maintains an Internet site (www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. The public also may read and copy these filings at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. Information about this Public Reference Room is available by calling (800) SEC 0330.

 

The following risk factors and other information included in this Annual Report on Form 10-K 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 2 of this Annual Report on Form 10-K for additional discussion of these forward-looking statements. If any of the following risks actually occur, our business, operating results, and financial condition could be materially adversely affected.

 

Factors beyond our control could cause our quarterly results to 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. Many of the factors that could cause our quarterly operating results to fluctuate significantly in the future are beyond our control and include, but are not limited to, the following:

 

 

 

In addition, sales for any future quarter may vary and accordingly be different from what we forecast. We manufacture products based on a combination of specific order requirements and forecasts of our customer demands. Products are typically shipped within one to four weeks following receipt of an order. In certain circumstances, customers may cancel or reschedule orders without penalty. Product sales 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.

 

We derive a majority of our revenue in any given quarter from orders booked in the same quarter. Bookings typically follow intra-quarter seasonality patterns weighted towards the back-end of the quarter. If we do not achieve bookings in the latter part of a quarter consistent with our quarterly financial targets, our financial results will be adversely impacted.

 

Due to all of the foregoing factors, it is possible that in one or more future 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.

 

If we are unable to develop and introduce new products and respond to technological change, if our new products do not achieve market acceptance, or if we fail to manage the transition between our new and old products, our operating results could be materially and adversely affected.

 

Our future growth depends upon the successful development and introduction of new hardware and software products. Due to the complexity of storage subsystems and storage security appliances, and the difficulty in gauging the engineering effort required to produce new products, such products are subject to significant technical risks. However, our new products may not achieve market acceptance. Additional product introductions in future periods may also impact our sales of existing products. In addition, our new products must respond to technological changes and evolving industry standards. If we are unable, for technological or other reasons, to develop and introduce new

products in a timely manner in response to changing market conditions or customer requirements, or if such products do not achieve market acceptance, our operating results could be materially and adversely affected.

 

As new or enhanced products are introduced, we must successfully manage the transition from older products in order to minimize disruption in customers’ ordering patterns, avoid excessive levels of older product inventories, and ensure that enough supplies of new products can be delivered to meet customers’ demands.

 

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

 

The storage markets are intensely competitive and are characterized by rapidly changing technology.

 

In the storage market, our primary and nearline storage system products and our associated storage software portfolio compete primarily with storage system products and data management software from EMC, HDS, H-P, IBM, and Sun Microsystems. We also see Dell, Inc. as an emerging competitor in the storage marketplace, primarily due to a business partnership that has been established between Dell and EMC, allowing Dell to resell EMC storage hardware and software products. We have also historically encountered less-frequent competition from companies including Engenio Information Technologies, Inc. (formerly the Storage Systems Group of LSI Logic Corp.), Dot Hill Systems Corporation, and Xiotech Corporation. 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 Sun Microsystems, as a result of their acquisition of StorageTek Technology Corporation. Our NearStore VTL appliances also compete directly with traditional tape backup solutions in the broader data backup/recovery space.

 

In the content delivery market, our NetCache appliances and content delivery software compete against caching appliance and content delivery software vendors including BlueCoat Systems (formerly CacheFlow, Inc.) and Cisco Systems. On June 22, 2006, we entered into an Asset Purchase Agreement with Blue Coat Systems, Inc. to sell certain assets of the NetCache business. See Note 16 to the Consolidated Financials Statements accompanying this Annual Report on Form 10-K. Our NetCache business is also subject to indirect competition from content delivery service products such as those offered by Akamai Technologies.

 

Additionally, a number of new, privately held companies are currently attempting to enter the storage systems and data management software markets, the nearline and VTL storage markets, some of which may become significant competitors in the future.

 

We believe that the principal competitive factors affecting the storage markets include product benefits such as response time, reliability, data availability, scalability, ease of use, price, multiprotocol capabilities, and global service and support. We must continue to maintain and enhance this technological advantage over our competitors. If those competitors with greater financial, marketing, service, support, technical, and other resources were able to offer products that matched or surpassed the technological capabilities of our products, these competitors would, by virtue of their greater resources, gain a competitive advantage over us that could lead to greater sales for these competitors at the expense of our own market share, which would have a material adverse affect on our business, financial condition, and results of operations.

 

Increased competition could also result in price reductions, reduced gross margins, and loss of market share, any of which could materially and adversely affect our operating results. Our competitors may be able to respond more quickly than we can to new or emerging technologies and changes in customer requirements or devote greater resources to the development, promotion, sale, and support of their products. In addition, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. We cannot assure you that we will be able to compete successfully against current or future competitors. Competitive pressures we face could materially and adversely affect our operating results.

We rely on a limited number of suppliers, and any disruption or termination of these supply arrangements could delay shipment of our products and could materially and adversely affect our operating results.

 

We rely on a limited number of suppliers of several key components utilized in the assembly of our products. We purchase our disk drives through several suppliers. We purchase computer boards and microprocessors from a limited number of suppliers. Our reliance on a limited number of suppliers involves several risks, including:

 

 

Component quality is particularly significant with respect to our suppliers of disk drives. In order to meet product performance requirements, we must obtain disk drives of extremely high quality and capacity. In addition, there are periodic supply-and-demand issues for disk drives, microprocessors, and semiconductor memory components, which could result in component shortages, selective supply allocations, and increased prices of such components. We cannot assure you that we will be able to obtain our full requirements of such components in the future or that prices of such components will not increase. In addition, problems with respect to yield and quality of such components and timeliness of deliveries could occur. Disruption or termination of the supply of these components could delay shipments of our products and could materially and adversely affect our operating results. Such delays could also damage relationships with current, prospective customers and suppliers.

 

In addition, we license certain technology and software from third parties that is incorporated into our products. If we are unable to obtain or license the technology and software on a timely basis, we will not be able to deliver products to our customers in a timely manner.

 

The loss of any contract manufacturers or the failure to accurately forecast demand for our products or successfully manage our relationships with our contract manufacturers could negatively impact our ability to manufacture and sell our products.

 

We currently rely on several contract manufacturers to manufacture most of our products. Our reliance on our third-party contract manufacturers reduces our control over the manufacturing process, exposing us to risks, including reduced control over quality assurance, production costs, and product supply. If we should fail to effectively manage our relationships with our contract manufacturers, or if our contract manufacturers experience delays, disruptions, capacity constraints, or quality control problems in their manufacturing operations, our ability to ship products to our customers could be impaired and our competitive position and reputation could be harmed. Qualifying a new contract manufacturer and commencing volume production are expensive and time-consuming. If we are required to change contract manufacturers or assume internal manufacturing operations, we may lose revenue and damage our customer relationships. If we inaccurately forecast demand for our products, we may have excess or inadequate inventory or incur cancellation charges or penalties, which could adversely impact our operating results. As of April 30, 2006, we have no purchase commitment under these agreements.

 

We intend to regularly introduce new products and product enhancements, which will require us to rapidly achieve volume production by coordinating with our contract manufacturers and suppliers. We may need to increase our material purchases, contract manufacturing capacity, and internal test and quality functions to meet anticipated demand. The inability of our contract manufacturers to provide us with adequate supplies of high-quality products, or the inability to obtain raw materials, could cause a delay in our ability to fulfill orders.

Our future financial performance depends on growth in the storage, and data management markets. If these markets do not continue to grow at the rates at which we forecast growth, our operating results will be materially and adversely impacted.

 

All of our products address the storage and data management markets. Accordingly, our future financial performance will depend in large part on continued growth in the storage and data management markets and on our ability to adapt to emerging standards in these markets. We cannot assure you that the markets for storage and data management will continue to grow or that emerging standards in these markets will not adversely affect the growth of UNIX, Windows, and the World Wide Web server markets upon which we depend.

 

For example, we provide our open access data retention solutions to customers within the financial services, healthcare, pharmaceuticals, and government market segments, industries that are subject to various evolving governmental regulations with respect to data access, reliability, and permanence (such as Rule 17(a)(4) of the Securities Exchange Act of 1934, as amended) in the United States and in the other countries in which we operate. If our products do not meet, and continue to comply with, these evolving governmental regulations in this regard, customers in these market and geographical segments will not purchase our products, and, therefore, we will not be able to expand our product offerings in these market and geographical segments at the rates for which we have forecast.

 

In addition, our business also depends on general economic and business conditions. A reduction in demand for storage and data management caused by weakening economic conditions and decreases in corporate spending will result in decreased revenues and lower revenue growth rates. The network storage market growth declined significantly beginning in the third quarter of fiscal 2001 through fiscal 2003, causing both our revenues and operating results to decline. If the storage and data management markets grow more slowly than anticipated or if emerging standards other than those adopted by us become increasingly accepted by these markets, our operating results could be materially and adversely affected.

 

Our gross margins may vary based on the configuration of our product and service solutions, and such variation may make it more difficult to forecast our earnings.

 

We derive a significant portion of our sales from the resale of disk drives as components of our storage systems, and the resale market for hard disk drives is highly competitive and subject to intense pricing pressures. Our sales of disk drives generate lower gross margin percentages than those of our storage systems. As a result, as we sell more highly configured systems with greater disk drive content, overall gross margin percentages may be negatively affected.

 

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

 

 

 

Changes in service gross margins may result from various factors such as continued investments in our customer support infrastructure, changes in the mix between technical support services and professional services, as well as the timing of technical support service contract initiations and renewals.

 

Our effective tax rate may increase or fluctuate, which could increase our income tax expense and reduce our net income.

 

Our effective tax rate could be adversely affected by several factors, many of which are outside of our control, including:

 

 

The price of our common stock could decline to the extent that our financial results are materially affected by an adverse change in our effective tax rate. We have been notified of examinations in the U.S. and several foreign tax jurisdictions. The rights to some of our intellectual property (“IP”) is 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. Recently, some other companies have had their foreign IP arrangements challenged as part of an examination. Our management does not believe, based upon information currently known to us that the final resolution of any of our audits will have a material adverse effect upon our consolidated financial position and the results of operations and cash flows. If the ultimate determination of our taxes owed in any of these tax jurisdictions is for an amount in excess of the tax provision we have recorded or reserved for, our operating results, cash flows, and financial condition could be adversely affected.

 

We may incur problems with current or future acquisitions and equity investments, and these investments may not achieve our objectives.

 

As part of our strategy, we are continuously evaluating opportunities to buy other businesses or technologies that would complement our current products, expand the breadth of our markets, or enhance our technical capabilities. We may engage in future acquisitions that dilute our stockholders’ investments and cause us to use cash, to incur debt, or to assume contingent liabilities.

Acquisitions of companies entail numerous risks, and we may not be able to successfully integrate acquired operations and products or realize anticipated synergies, economies of scale, or other value. Integration risks and issues may include, but not limited to, key personnel retention and assimilation, management distraction, technical development, and unexpected costs and liabilities, including goodwill impairment charges. In addition, we may be unable to recover strategic investments in development stage entities. Any such problems could have a material adverse effect on our business, financial condition, and results of operation.

 

From time to time, we also make equity investments for the promotion of business and strategic objectives. We have already made strategic investments in a number of storage and data management-related technology companies. Equity investments may result in the loss of investment capital. The market price and valuation of our equity investments in these companies may fluctuate due to market conditions and other circumstances over which we have little or no control. To the extent that the fair value of these securities is less than our cost over an extended period of time, our results of operations and financial position could be negatively impacted.

 

We cannot assure you that our OEM relationship with IBM will generate significant revenue.

 

In April 2005, we announced a strategic partner relationship with IBM. As part of the relationship, we entered into an original equipment manufacturing (OEM) agreement that enables IBM to sell IBM branded solutions based on Network Appliance unified and open network attached storage (NAS) and iSCSI/IP SAN solutions, including NearStore and the NetApp V-Series Systems, as well as associated software offerings. While this agreement is an element of our strategy to expand our reach into more customers and countries, we do not have an exclusive relationship with IBM and there is no minimum commitment for any given period of time, and therefore, we cannot assure you that this relationship will contribute any revenue in future years. In addition, we have no control over the products IBM selects to sell, their release schedule and timing of those products, nor do we control their pricing. Revenues from the IBM relationship were not significant during fiscal 2006 and accounted for approximately 1.0% of our total consolidated revenue. In the event that sales through IBM were to gain significant traction, we may experience distribution channel conflicts between our direct sales force and IBM, or among our channel partners. If we fail to minimize channel conflicts, our operating results and financial condition could be harmed. In addition, since this agreement is relatively new, we do not have a history upon which to base our analysis of its future success.

 

Currently we do not, and cannot assure you that this OEM relationship will generate significant revenue or that this strategic partnership will continue to be in effect for any specific period of time.

 

If we are unable to maintain our existing relationships and develop new relationships with major strategic partners, our revenue may be impacted negatively.

 

An element of our strategy to increase revenue is to strategically partner with major third-party software and hardware vendors that integrate our products into their products and also comarket our products with these vendors. We have significant partner relationships with database, business application and backup management companies including Microsoft, Oracle, SAP and Symantec. A number of these strategic partners are industry leaders that offer us expanded access to segments of the storage market. There is intense competition for attractive strategic partners, and even if we can establish strategic relationships with these partners, we cannot assure you that these partnerships will generate significant revenue or that the partnerships will continue to be in effect for any specific period of time.

 

We intend to continue to establish and maintain business relationships with technology companies to accelerate the development and marketing of our storage solutions. To the extent we are unsuccessful in developing new relationships and maintaining our existing relationships, our future revenue and operating results could be impacted negatively. In addition, the loss of a strategic partner could have a material adverse effect on the progress of our new products under development with that partner.

We are expanding our indirect channel, we cannot assure you that we are able to maintain existing resellers, attract new resellers, and that channel conflicts will not materially adversely affect our channel relationships. In addition, we do not have exclusive relationships with our resellers and accordingly there is a risk that those resellers may give higher priority to products of other suppliers, which could materially adversely affect our operating results.

 

We market and sell our storage solutions directly through our worldwide sales force and indirectly through channels such as value-added resellers, or VARs, systems integrators, distributors, OEMs and strategic business partners and derive a significant portion of our revenue from these indirect channel partners. In fiscal 2006, Fujitsu Siemens and our two-tier distribution partners, Arrow and Avnet, accounted for 4.2% and 10.6%, respectively, of our consolidated revenue.

 

However, in order for us to maintain our current revenue sources and grow our revenue as we have forecasted, we must effectively manage our relationships with these indirect channel partners. To do so, we must attract and retain a sufficient number of qualified channel partners to successfully market our products. However, because we also sell our products directly to customers through our sales force, on occasion we compete with our indirect channels for sales of our products to our end customers, competition that could result in conflicts with these indirect channel partners and make it harder for us to attract and retain these indirect channel partners. At the same time, our indirect channel partners may offer products that are competitive to ours. In addition, because our reseller partners generally offer products from several different companies, including products of our competitors, these resellers may give higher priority to the marketing, sales, and support of our competitors’ products than ours. If we fail to manage effectively our relationships with these indirect channel partners to minimize channel conflict and continue to evaluate and meet our indirect sales partners’ needs with respect to our products, we will not be able to maintain or increase our revenue as we have forecasted, which would have a materially adverse affect on our business, financial condition, and results of operations. Additionally, if we do not manage distribution of our products and services and support effectively, or if our resellers’ financial conditions or operations weaken, our revenues and gross margins could be adversely affected.

 

Risks inherent in our international operations could have a material adverse effect on our operating results.

 

We conduct business internationally. For the year ended April 30, 2006, 45.7% of our total revenues were from international customers (including U.S. exports). Accordingly, our future operating results could be materially and adversely affected by a variety of factors, some of which are beyond our control, including regulatory, political, or economic conditions in a specific country or region, trade protection measures and other regulatory requirements, government spending patterns, and acts of terrorism and international conflicts.

 

Our international sales are denominated in U.S. dollars and in foreign currencies. An increase in the value of the U.S. dollar relative to foreign currencies could make our products more expensive and, therefore, potentially less competitive in foreign markets. For international sales and expenditures denominated in foreign currencies, we are subject to risks associated with currency fluctuations. We utilize forward and option contracts to hedge our foreign currency exposure associated with certain assets and liabilities as well as anticipated foreign currency cash flows. All balance sheet hedges are marked to market through earnings every quarter, while gains and losses on cash flow hedges are recorded in other comprehensive income. These hedges attempt to reduce, but do not always entirely eliminate, the impact of currency exchange movements. Factors that could have an impact on the effectiveness of our hedging program include the accuracy of forecasts and the volatility of foreign currency markets. There can be no assurance that such hedging strategies will be successful and that currency exchange rate fluctuations will not have a material adverse effect on our operating results.

 

Additional risks inherent in our international business activities generally include, among others, longer accounts receivable payment cycles and difficulties in managing international operations. Such factors could materially and adversely affect our future international sales and, consequently, our operating results.

 

We receive significant tax benefits from sales to our non-U.S. customers. These benefits are contingent upon existing tax regulations in the U.S. and in the countries in which our international operations are located. Future changes in domestic or international tax regulations could adversely affect our ability to continue to realize these tax benefits. Our effective tax rate could also be adversely affected by different and evolving interpretations of existing

law or regulations. Potentially adverse tax consequences could negatively impact the operating and financial results from international operations. International operations currently benefit from a tax ruling concluded in the Netherlands.

 

Although operating results have not been materially and adversely affected by seasonality in the past, because of the significant seasonal effects experienced within the industry, particularly in Europe, our future operating results could be materially and adversely affected by seasonality.

 

We cannot assure you that we will be able to maintain or increase international market demand for our products.

 

If we fail to manage our expanding business effectively, our operating results could be materially and adversely affected.

 

We experienced growth in fiscal 2006, 2005 and 2004. Our future operating results depend to a large extent on management’s ability to successfully manage expansion and growth, including but not limited to, expanding international operations, forecasting revenues, addressing new markets, controlling expenses, implementing and enhancing infrastructure, systems and processes, and managing our assets.

 

The growth in our business requires that we invest in people, processes and systems to best optimize our revenue growth and long term profitability. However, growth in our sales or continued expansion in the scope of our operations could strain our current management, financial, manufacturing and other systems, and may require us to implement and improve those systems. If we experience any problems with any improvement or expansion of these systems, procedures or controls, or if these systems, procedures or controls are not designed, implemented or improved in a cost-effective and timely manner, our operations may be materially and adversely affected. In addition, any failure to implement, improve and expand such systems, procedures, and controls in a timely and efficient manner could harm our growth strategy and materially and adversely affect our financial condition and ability to achieve our business objectives.

 

In addition, an unexpected decline in the growth rate of revenues without a corresponding and timely reduction in expense growth or a failure to manage other aspects of growth could materially and adversely affect our operating results.

 

A significant percentage of our expenses are fixed, which could materially and adversely affect our net income.

 

Our expense levels are based in part on our expectations as to future sales, and a significant percentage of our expenses are fixed. As a result, if sales levels are below expectations or previously higher levels, net income will be disproportionately affected in a material and adverse manner.

 

The market price for our common stock has fluctuated significantly in the past and will likely continue to do so in the future.

 

The market price for our common stock has experienced substantial volatility in the past, and several factors could cause the price to fluctuate substantially in the future. These factors include but are not limited to:

 

 

 

In addition, the stock market has experienced volatility that has particularly affected the market prices of equity securities of many technology companies. Additionally, certain macroeconomic factors such as changes in interest rates, the market climate for the technology sector, and levels of corporate spending on information technology could also have an impact on the trading price of our stock. As a result, the market price of our common stock may fluctuate significantly in the future, and any broad market decline, as well as our own operating results, may materially and adversely affect the market price of our common stock.

 

We depend on the ability of our personnel, raw materials, equipment and products to move reasonably unimpeded around the world. Our business could be materially and adversely affected as a result of a natural disaster, terrorist acts, or other catastrophic events.

 

Any political, military, world health (e.g., SARS, Avian Flu) or other issue which hinders this movement or restricts the import or export of materials could lead to significant business disruptions. Furthermore, any strike, economic failure, or other material disruption cased by fire, floods, hurricanes, power loss, power shortages, telecommunications failures, break-ins, and similar events could also adversely affect our ability to conduct business. If such disruptions result in cancellations of customer orders or contribute to a general decrease in economic activity or corporate spending on information technology, or directly impact our marketing, manufacturing, financial and logistics functions, our results of operations and financial condition could be materially adversely affected. In addition, our headquarters are located in Northern California, an area susceptible to earthquakes. If any significant disaster were to occur, our ability to operate our business could be impaired.

 

We depend on attracting and retaining qualified technical and sales personnel. If we are unable to attract and retain such personnel, our operating results could be materially and adversely impacted.

 

Our continued success depends, in part, on our ability to identify, attract, motivate, and retain qualified technical and sales personnel. Because our future success is dependent on our ability to continue to enhance and introduce new products, we are particularly dependent on our ability to identify, attract, motivate, and retain qualified engineers with the requisite education, backgrounds, and industry experience. Competition for qualified engineers, particularly in Silicon Valley, can be intense. The loss of the services of a significant number of our engineers or salespeople could be disruptive to our development efforts or business relationships and could materially and adversely affect our operating results.

 

Undetected software, hardware errors, or failures found in new products may result in loss of or delay in market acceptance of our products, which could increase our costs and reduce our revenues.

 

Our products may contain undetected software, hardware errors, or failures when first introduced or as new versions are released. Despite testing by us and by current and potential customers, errors may not be found in new products until after commencement of commercial shipments, resulting in loss of or delay in market acceptance, which could materially and adversely affect our operating results.

 

If we are unable to protect our intellectual property, we may be subject to increased competition that could materially and adversely affect our operating results.

 

Our success depends significantly upon our proprietary technology. We rely on a combination of copyright and trademark laws, trade secrets, confidentiality procedures, contractual provisions, and patents to protect our proprietary rights. We seek to protect our software, documentation, and other written materials under trade secret, copyright, and patent laws, which afford only limited protection. Some U.S. trademarks and some U.S.-registered trademarks are registered internationally as well. We will continue to evaluate the registration of additional trademarks as appropriate. We generally enter into confidentiality agreements with our employees and with our resellers, strategic partners, and customers. We currently have multiple U.S. and international patent applications pending and multiple U.S. patents issued. The pending applications may not be approved, and if patents are issued, such patents may be challenged. If such challenges are brought, the patents may be invalidated. We cannot assure

you that we will develop proprietary products or technologies that are patentable, that any issued patent will provide us with any competitive advantages or will not be challenged by third parties, or that the patents of others will not materially and adversely affect our ability to do business.

 

Litigation may be necessary to protect our proprietary technology. Any such litigation may be time-consuming and costly. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. In addition, the laws of some foreign countries do not protect proprietary rights to as great an extent as do the laws of the United States. We cannot assure you that our means of protecting our proprietary rights will be adequate or that our competitors will not independently develop similar technology, duplicate our products, or design around patents issued to us or other intellectual property rights of ours.

 

We are subject to intellectual property infringement claims. We may, from time to time, receive claims that we are infringing third parties’ intellectual property rights. Third parties may in the future claim infringement by us with respect to current or future products, patents, trademarks, or other proprietary rights. We expect that companies in the appliance market will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. Any such claims could be time-consuming, result in costly litigation, cause product shipment delays, require us to redesign our products, or require us to enter into royalty or licensing agreements, any of which could materially and adversely affect our operating results. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all.

 

Our business is subject to increasingly complex corporate governance, public disclosure, accounting, and tax requirements and environmental legislation that have increased both our costs and the risk of noncompliance.

 

Because our common stock is publicly traded, we are subject to certain rules and regulations of federal, state, and financial market exchange entities charged with the protection of investors and the oversight of companies whose securities are publicly traded. These entities, including the Public Company Accounting Oversight Board, the SEC, and NASDAQ, have implemented new requirements and regulations and continue developing additional regulations and requirements in response to recent corporate scandals and laws enacted by Congress, most notably the Sarbanes-Oxley Act of 2002. Our efforts to comply with these new regulations have resulted in, and are likely to continue resulting in, increased general and administrative expenses and diversion of management time and attention from revenue-generating activities to compliance activities.

 

We have recently completed our evaluation of our internal controls over financial reporting as required by Section 404 of the Sarbanes-Oxley Act of 2002. Although our assessment, testing, and evaluation resulted in our conclusion that as of April 30, 2006, our internal controls over financial reporting were effective, we cannot predict the outcome of our testing in future periods. If our internal controls are ineffective in future periods, our business and reputation could be harmed. We may incur additional expenses and commitment of management’s time in connection with further evaluations, either of which could materially increase our operating expenses and accordingly reduce our net income.

 

The impact of option expensing under SFAS No. 123R will result in lower reported earnings per share, which could negatively impact our future stock price. This could also impact our ability to use or our future practice of utilizing, broad-based employee stock plans to attract, reward, and retain employees, which could also adversely impact our operations. In addition, the option pricing models used to estimate the fair value of employee stock options are based on highly subjective inputs and assumptions. If another party asserts that the fair value of our employee stock options is misstated, securities class action litigation could be brought against us, or the market price of our common stock could decline, or both could occur. As a result, we could incur significant losses, and our operating results may be below our expectations and those of investors and stock market analysts.

 

We also face increasing complexity in our product design and procurement operations as we adjust to new and upcoming requirements relating to the materials composition of many of our products. The European Union (“EU”) has adopted two directives to facilitate the recycling of electrical and electronic equipment sold in the EU. One of these is the Restriction on the Use of Certain Hazardous Substances in Electrical and Electronic Equipment

(“RoHS”) directive. The RoHS directive restricts the use of lead, mercury, and certain other substances in electrical and electronic products placed on the market in the European Union after July 1, 2006.

 

In connection with our compliance with such environmental laws and regulations, we could incur substantial costs (including excess component inventory) and be subject to disruptions to our operations and logistics. In addition, we will need to ensure that we can manufacture compliant products, and that we can be assured a supply of compliant components from suppliers. Similar laws and regulations have been or may be enacted in other regions, including in the United States, China, and Japan. Other environmental regulations may require us to reengineer our products to utilize components that are more environmentally compatible, and such reengineering and component substitution may result in additional costs to us. Although we do not anticipate any material adverse effects based on the nature of our operations and the effect of such laws, there is no assurance that such existing laws or future laws will not have a material adverse effect on our business.

 

The U.S. government has contributed to our revenue growth and become an important customer for us. However, government demand is unpredictable, and there is no guarantee of future revenue growth from the U.S. government.

 

The U.S. government has become an important customer for the storage market and for us. Government agencies are subject to budgetary processes and expenditure constraints that could lead to delays or decreased capital expenditures in IT spending on infrastructures. If the government or individual agencies within the government reduce or shift their capital spending pattern, our financial results may be harmed. We cannot assure you that revenue from the U.S. government will continue to grow in the future.

 

There are currently no unresolved issues with respect to any Commission staff’s written comments that were received at least 180 days before the end of the Company’s fiscal year to which this report relates and that relate to the Company’s periodic or current reports under the Act.

 

On April 28, 2006, the Company received a comment letter from the staff of the Commission relating to a routine review of the Company’s periodic and current reports under the Act. The Company is currently in the process of working to resolve these comments with the staff.

 

Our headquarters site for corporate general administration, sales and marketing, research and development, global services, and manufacturing operations is located in Sunnyvale, California. We own and occupy approximately 800,000 square feet of space in buildings at our Sunnyvale headquarters.

 

We have commitments related to a lease arrangement with BNP Paribas LLC (“BNP”) for approximately 190,000 square feet of office space to be located on land currently owned by us in Sunnyvale, California (as further described below under “Contractual Cash Obligations and Other Commercial Commitments”). We expect to pay lease payments on the completed buildings from BNP on September 2007 for a term of five years. We have the option to renew the lease for two consecutive five-year periods upon approval by BNP.

 

We lease other sales offices and research and development facilities throughout the United States and internationally. We expect that our existing facilities and those being developed in Sunnyvale, California; RTP, 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.

 

See additional discussion regarding properties in “Note 4 under Item 8. Financial Statements and Supplementary Data — Notes to Consolidated Financial Statements” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources.”

 

We are subject to legal proceedings, claims, and litigation arising in the ordinary course of business. We defend ourselves vigorously against any such claims. While the outcome of these matters is currently not determinable, management does not expect that the ultimate costs to resolve these matters will have a material adverse effect on our consolidated financial position, results of operations, or cash flows.

 

No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this Annual Report on Form 10-K.

 

Our common stock commenced trading on the Nasdaq National Market on November 21, 1995, and is traded under the symbol “NTAP.” As of April 30, 2006 there were 1,384 holders of record of the common stock. The closing price for our common stock on July 10, 2006 was $31.47. The following table sets forth for the periods indicated the high and low closing sale prices for our common stock as reported on the Nasdaq National Market.

 

 

We believe that a number of factors may cause the market price of our common stock to fluctuate significantly. See “Item 1. Business — Risk Factors.”

 

Dividend Policy

 

We have never paid cash dividends on our capital stock. We currently anticipate retaining all available funds, if any, to finance internal growth and product development as well as other possible management initiatives, including stock repurchases and acquisitions. Payment of dividends in the future will depend upon our earnings and financial condition and such other factors as the directors may consider or deem appropriate at the time.

 

Information regarding securities authorized for issuance under equity compensation plans is incorporated by reference from our Proxy Statement for the 2006 Annual Meeting of Stockholders.

 

Unregistered Securities Sold in Fiscal 2006

 

On August 26, 2005, we acquired Decru, Inc. (“Decru”) which resulted in the issuance of 8.3 million shares of our common stock with a fair value of $191.9 millions, 1.9 million shares of stock options and restricted stock with a fair value of $36.1 million and the payment of $54.5 million in cash, and $0.7 million acquisition-related transaction costs, for a total purchase price of $283.2 million.

 

We relied on an exemption from registration pursuant to Section 3(a)10 of the Securities Act and the related fairness hearing relating to our issuance of unregistered securities in connection with the Decru merger. On September 2, 2005, a Form S-8 registration statement was filed with the SEC to register the assumed options of the Decru, Inc. 2001 Equity Incentive Plan.

 

See Note 7 for securities authorized for issuance under our Equity Compensation Plans.

Issuer Purchases of Equity Securities

 

The table below sets forth activity in the fourth quarter of fiscal 2006:

 

 

 

 

The data set forth below are qualified in their entirety by reference to, and should be read in conjunction with, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and related notes thereto included in this Annual Report on Form 10-K.

 

Five fiscal years ended April 30, 2006

 

 

 

 

The following discussion of our financial condition and results of operations should be read together with the financial statements and the related notes set forth under “Item 8. Financial Statements and Supplementary Data.” The following discussion also contains trend information and other forward looking statements that involve a number of risks and uncertainties. The Risk Factors set forth in “Item 1. Business” are hereby incorporated into the discussion by reference.

 

Overview

 

Enterprises are generating vast quantities of data. The rapidly growing amount of data a company generates and the requirements to retain data for longer periods of time are driving an increasing demand for storage and data management solutions. There is an increase in demand for online access to historical information for business or regulatory requirements. The growth in storage capacity requirements further increases the complexity of data management. Managing the continued growth in the volume of data and the on-demand information access continue to challenge our enterprise customers. Companies are looking for solutions to help simplify data storage, IT administration and reduce total costs of ownership. Companies are migrating toward modular, unified storage systems away from large, fixed, expensive, frame-class arrays and inefficient direct-attached storage. There is a growing trend toward consolidating storage and serving a variety of applications from a unified storage pool.

 

In recent years, enterprises have centralized terabytes of data into networked storage environments to achieve lower costs, higher utilization, and simplified management. On the other hand, geopolitical events such as September 11, 2001; natural disasters such as the Katrina Hurricane disaster; government regulations such as Securities and Exchange Commission’s (“SEC”) Rule 17a-4; banking regulations such as Basel II; increased privacy concerns such as laptop thefts with sensitive data; and industry guidelines such as PCI (Payment Card Industry standard put forth by Visa and MasterCard), have all put a spotlight on the need to protect and retain data for both the public and private sector. Consolidation, coupled with a higher probability of disasters, has created a heightened sensitivity to the impact of data loss and its disruptive impact on the business. At the same time, compliance and privacy concerns are requiring enterprises to retain data for long periods of time, as well as secure data at rest. Data protection and retention have become a critical IT priorities, requiring cost-effective storage solutions that can help the enterprise protect itself from catastrophic business disruption at an affordable cost.

 

We believe that our strategic investments are targeted at some of the strongest growth areas of the storage market, such as modular storage, data protection, data retention, data security, iSCSI, and grid computing. However, if any storage market trends and emerging standards on which we are basing our assumptions do not materialize as anticipated, our business could be materially adversely affected. The fiscal 2006 revenue growth and increased gross margins have occurred while the market for our storage products and solutions has grown more competitive with downward pricing pressures that could negatively impact our future revenue growth rate and our future gross margins. At the same time, we anticipate and continue to experience further price decline per petabyte for our products which may have an adverse impact on our future gross margins if not offset by favorable software mix and higher average selling prices associated with new products. We expect our future gross margins to be negatively affected by factors such as global service investment cost; competition, indirect sales including OEM, high disk content partially offset by new product introductions and enhancements and product and add-on software mix.

 

Continued revenue growth is dependent on the introduction and market acceptance of our new products. In fiscal 2007, we expect to ship our new high-end products, launch our next-generation operating system with enhanced storage grid functionality and offer a comprehensive suite of data protection solutions. If we fail to timely deliver new products or successfully integrate acquired technology into our existing architecture, or if our new products do not achieve market acceptance or if there is no or reduced demand for these or our current products, we may experience a decline in revenue. Additionally, we plan to invest in the people, processes, and systems necessary to best optimize our revenue growth and long-term profitability. However, we cannot assure you that such investments will achieve our financial objectives.

Fiscal 2006 Highlights

 

In fiscal 2006, we continued to enhance our enterprise solutions, broaden our customer portfolio, extend our channel/partner opportunities, build additional infrastructure to manage our growth and broaden our total addressable market. During the second quarter of fiscal 2006, we acquired Decru, Inc. that develops and sells encryption software and appliances which offers data protection solutions for enterprises and governments, including regulatory compliance, privacy, secure consolidation, and outsourcing. We believe that the current and future potential for this technology will enable us to help our customers manage their risk of data theft and corruption with data encryption and authentication products. Some of the key fiscal 2006 highlights included:

 

Penetrated in enterprise data centers and expanded our breadth of disk-to-disk backup and security solutions.  We achieved revenue growth and profitability in fiscal 2006 driven primarily by our new FAS3000 midrange product line. For the first time, customers can choose to purchase Fibre Channel and/or lower-cost ATA drives, on the same system. Combined with our patented RAID-DP protection and our FlexVol and FlexClone technologies, the FAS3000 allows more cost-effective “ATA” drives to be used safely in primary storage applications, which offers the best price-performance value to our customers. We expect our data center penetration will win more NearStore deployments as customers choose NetApp data production solutions to back up their mission critical systems. During fiscal 2006, we introduced an array of products, technologies, and services that highlight the broad range of NetApp disk-to-disk backup and security solutions which simplify data backup procedures, improve recoverability, and lower backup infrastructure expenses. We believe that our new NearStore Virtual Tape Library solution will further expand our market opportunity as we can now provide disk-to-disk backup solutions for all open systems enterprise primary storage.

 

Extended our channel/partner opportunities.  We continued to make progress in penetrating and expanding our business in enterprise data centers with mission critical partners. Our fiscal 2006 channel mix demonstrated increased expansion through our partner programs, with approximately 55.5% of our business coming through indirect channels and the remaining 44.5% coming through direct sales. The majority of our block-based storage business and the U.S. Federal business came from indirect channels. Higher growth rates in our indirect channels demonstrated our increasing leverage, giving us broader market reach and increasing enterprise penetration.

 

Expanded our global services and support.  It is an element of our strategy to expand and offer a global, comprehensive, end-to-end suite of world-class service and support solutions designed to help our customers meet their goals of simplifying their storage solutions. We increased our business with our top enterprise customers who typically purchase more complete and longer-term service packages. The growth in service revenue in fiscal 2006 was also driven by increases in professional services. We expect to continue to expand our global services and support and believe that such investments will help accelerate the adoption rate of our technology. We cannot assure you that service revenue will continue to grow at previous rates. We expect to invest in our services infrastructure commensurate with our revenue growth.

 

Broadened our total addressable market and extended our product lines into adjacent spaces.  We have brought a more comprehensive set of products to the market place, with the new high end offering next generation operating system with enhanced storage grid functionality, the disk-to-disk backup solution on the VTL space, the Decru security and encryption solutions and in early fiscal 2007 our entry into the small-to-medium businesses. We also continued to broaden our addressable market by increasing our focus on the V-Series product line, which uses virtualization to let customers take advantage of the management simplicity of NetApp Data ONTAP with their storage from other vendors.

 

Fiscal 2006 Financial Performance

 

 

 

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 that the following accounting policies are “critical” as defined by the Securities and Exchange Commission, in 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. We also have other important policies, including those related to derivative instruments and concentration of credit risk. However, these policies do not meet the definition of critical accounting policies because they do not generally require us to make estimates or judgments that are difficult or subjective. These policies are discussed in Note 2 to the Consolidated Financial Statements accompanying this Annual Report on Form 10-K.

 

We believe the accounting policies described below are the ones that most frequently require us to make estimates and judgments, and therefore are critical to the understanding of our results of operations:

 

 

Revenue Recognition and Allowances

 

We apply the provisions of Statement of Position (“SOP”) No. 97-2, “Software Revenue Recognition,” and related interpretations to our product sales because we believe our firmware and operating software are essential to the functionality of our hardware products. We recognize revenue when:

 

 

For arrangements with multiple elements, we allocate revenue to each element using the residual method. When all of the undelivered elements are software-related, this allocation is based on vendor specific objective evidence of fair value of the undelivered items. When the undelivered elements include non-software related items that are only sold as a bundle with software related items, this allocation is based on objective and reliable evidence of fair value, in accordance with Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (“EITF 00-21”). We defer the portion of the arrangement fee equal to the fair value of the undelivered elements until they are delivered. Vendor specific objective evidence of fair value is based on the price charged when the element is sold separately. If vendor specific evidence cannot be obtained to determine fair value of the undelivered elements, revenue from the entire arrangement would be deferred and recognized as these elements are delivered. This would have a material effect on the timing of product revenues.

 

A typical arrangement includes product, software subscription, and maintenance. Some arrangements include technical consulting and training. Software subscriptions represent the right to unspecified product upgrades and enhancements on a when-and-if-available basis, bug fixes, and patch releases. Service maintenance includes contracts for technical support and hardware maintenance. Revenue from software subscriptions and service maintenance is recognized ratably over the contractual term, generally one to three years. We typically sell technical consulting services and training separately from any of our other revenue elements, either on a time and materials basis or for fixed price standard projects. The type of work that is performed is not essential to the functionality of the software or hardware. Accordingly, we recognize revenue as the services are performed and in accordance with EITF 03-05 “Applicability of AICPA Statement of Position 97-2 to Non-Software Deliverables in an Arrangement Containing More-Than-Incidental Software”. Revenue from hardware installation services is a non-software deliverable because the software is not essential to the functionality of the installation service and is therefore outside of the scope of SOP 97-2. Revenue from shipping and handling is included in product revenue and its related cost included in cost of product revenue.

 

We record reductions to revenue for estimated sales returns at the time of shipment. Sales returns are estimated based on historical sales returns, changes in customer demand, current trends, and our expectations regarding future experience. Reductions to revenue associated with sales returns include consideration of historical sales levels, the timing and magnitude of historical sales returns and a projection of this experience into the future. We monitor and analyze the accuracy of sales returns estimate by reviewing actual returns and adjust it for future expectations to

determine the adequacy of our current and future reserve needs. If actual future returns and allowances differ from past experience and expectation, additional allowances may be required.

 

We also maintain a separate allowance for doubtful accounts for estimated losses based on our assessment of the collectibility of specific customer accounts and the aging of the accounts receivable. We analyze accounts receivable and historical bad debts, customer concentrations, customer solvency, current economic and geographic trends, and changes in customer payment terms and practices when evaluating the adequacy of the allowance for doubtful accounts. In circumstances where we are aware of a specific customer’s inability to meet its financial obligations to us, a specific allowance for bad debt is estimated and recorded which reduces the recognized receivable to the estimated amount we believe will ultimately be collected. We monitor and analyze the accuracy of allowance for doubtful accounts estimate by reviewing past collectibility and adjust it for future expectations to determine the adequacy of our current and future allowance. Our allowance for doubtful accounts as of April 30, 2006 was $2.4 million, compared to $5.4 million as of April 30, 2005. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

 

Valuation of Goodwill and Intangibles

 

Identifiable intangible assets are amortized over time, while in-process research and development is recorded as a charge on the date of acquisition and goodwill is capitalized, subject to periodic review for impairment. Accordingly, the allocation of the acquisition cost to identifiable intangible assets has a significant impact on our future operating results. The allocation process requires extensive use of estimates and assumptions, including estimates of future cash flows expected to be generated by the acquired assets. Should conditions be different than management’s current assessment, material write-downs of the fair value of intangible assets may be required. We periodically review the estimated remaining useful lives of our other intangible assets. A reduction in the estimate of remaining useful life could result in accelerated amortization expense or a write-down in future periods. As such, any future write-downs of these assets would adversely affect our gross and operating margins.

 

Under our accounting policy we perform an annual review in the fourth quarter of each fiscal year, or more often if indicators of impairment exist. Triggering events for impairment reviews may be indicators such as adverse industry or economic trends, restructuring actions, lower projections of profitability, or a sustained decline in our market capitalization. Evaluations of possible impairment and, if applicable, adjustments to carrying values, require us to estimate, among other factors, future cash flows, useful lives, and fair market values of our reporting units and assets. When we conduct our evaluation of goodwill, the fair value of goodwill is assessed using valuation techniques that require significant management judgment. Should conditions be different from management’s last assessment, significant write-downs of goodwill may be required. In fiscal 2006 and 2005, we performed such evaluation and found no impairment. However, any future write-downs of goodwill would adversely affect our operating margins. As of April 30, 2006, our assets included $487.5 million in goodwill. See Note 14, “Goodwill and Purchased Intangible Assets” to our consolidated financial statements.

 

During fiscal 2006, we adjusted goodwill by $3.5 million and $2.1 million relating to the tax benefits associated with the subsequent exercise of previously vested assumed Spinnaker and Decru options, respectively. Estimated future adjustments to goodwill related to the tax benefits associated with subsequent exercise of previously vested assumed options by previous acquisitions are approximately $8.4 million, subject to future cancellations relating to employee terminations.

 

Accounting for Income Taxes

 

The determination of our tax provision is subject to judgments and estimates due to operations in several tax jurisdictions outside the U.S. Earnings derived from our international business are generally taxed at rates that are lower than U.S. rates, resulting in a reduction of our effective tax rate. The ability to maintain our current effective tax rate is contingent upon existing tax laws in both the U.S. and the respective countries in which our international subsidiaries are located. Future changes in domestic or international tax laws could affect the continued realization of the tax benefits we are currently receiving and expect to receive from international business. In addition, a

decrease in the percentage of our total earnings from our international business or in the mix of international business among particular tax jurisdictions could increase our overall effective tax rate.

 

While most of our profits are earned in foreign jurisdictions with income tax rates generally lower than the combined U.S. federal and state income tax rates, judgment must be made with respect to other estimates of income tax provision, such as R&D tax credits and valuation allowances against deferred tax assets, primarily those set up for net operating losses and income tax credits.

 

The carrying value of our net deferred tax assets, which consists primarily of the reversal of net deductible temporary differences including credits and net operating loss carryforwards, assumes that we will be able to generate sufficient future taxable income to fully utilize these tax attributes. If we do not generate sufficient future income, the realization of these deferred tax assets may be impaired, resulting in additional income tax expense. We have provided a valuation allowance of $431.2 million as of April 30, 2006 on the deferred tax attributes associated with the exercise of employee stock options (primarily credits and net operating loss carryforwards) because of uncertainty regarding their realization due to the expectation that future employee stock option exercises will reduce our ability to generate sufficient taxable income in the future. In the event these attributes are realized, the associated tax benefit will be credited to stockholders’ equity, rather than as a reduction in the income tax provision.

 

Prior to fiscal year 2006, our current effective tax rate assumed that U.S. income taxes were not provided for undistributed earnings of certain non-U.S. subsidiaries. However, pursuant to the one-time incentive created under Section 965 of The American Jobs Creation Act of 2004 (the “Jobs Act”), our foreign subsidiaries remitted approximately $405.5 million in accumulated earned income on which we incurred approximately $22.5 million in federal and state income taxes in the fourth quarter of fiscal year 2006. In fiscal 2004, we recorded an income tax benefit of $16.8 million associated with a favorable foreign tax ruling. This favorable ruling from the Netherlands provided for retroactive benefits dating back to fiscal year 2001 and continuing until December 31, 2005. Subsequent to our fiscal 2005 year end, we obtained a new tax ruling from the Netherlands, which terminated the first ruling and provides for continuing favorable tax rate benefits until April 30, 2010. As of April 30, 2006, our Netherlands subsidiary had a conditional royalty expense carryforward of $51.7 million that may become available for offset against future Dutch income. The carryforward may not, however, be used to offset income under the new Dutch tax ruling expiring April 30, 2010. We have established a valuation allowance against the deferred tax asset for this carryforward based upon our belief that we will not be able to utilize this attribute.

 

We have been notified of examinations in the U.S. and several foreign tax jurisdictions. Our management does not believe, based upon information currently known to it that the final resolution of any of these audits will have a material adverse effect on our results of operations. However, if upon the conclusion of these audits the ultimate determination of our taxes owed in any of these tax jurisdictions is for an amount in excess of the tax provision we have recorded or reserved for, our overall effective tax rate may be adversely impacted.

 

Beginning with the fiscal year 2007 implementation of SFAS No. 123R, we may experience adverse impacts to future years effective tax rates in the event that we determine that our APIC pool as of the beginning of fiscal year 2007 is not sufficient enough to cover the impacts of future stock compensation shortfalls.

 

Inventory Write-Downs

 

Our inventories net balance was $64.5 million as of April 30, 2006, compared with $39.0 million as of April 30, 2005. Inventories are stated at the lower of cost (first-in, first-out basis) or market. We perform an in depth excess and obsolete analysis of our inventory based upon assumptions about future demand and market conditions. We adjust the inventory value based on estimated excess and obsolete inventories determined primarily by future demand forecasts. Although we strive for accuracy in our forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of our inventory and commitments, and our reported results. If actual market conditions are less favorable than those projected, additional write-downs and other charges against earnings may be required. If actual market conditions are more favorable, we may realize higher gross margins in the period when the written-down inventory is sold.

We record purchase commitment liabilities with our contract manufacturers and suppliers as a result of changes in demand forecasts or as we transition our products. As of April 30, 2006, we do not have purchase commitment under such arrangements.

 

We engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers. We also provide for the estimated cost of known product failures based on known quality issues when they arise. Should actual cost of product failure differ from our estimates, revisions to the estimated liability would be required.

 

We are subject to a variety of federal, state, local and foreign environmental regulations relating to the use, storage, discharge and disposal of hazardous chemicals used during our manufacturing process or requiring design changes or recycling of products we manufacture. We will continue to monitor our environmental compliance and could incur higher costs including additional reserves for excess component inventory.

 

Restructuring Accruals

 

In fiscal 2002, as a result of continuing unfavorable economic conditions and a reduction in IT spending rates, we implemented two restructuring plans, which included reductions in our workforce and a consolidation of our facilities. In fiscal 2006, we implemented the third restructuring plan related to the move of our global service center operations. In determining restructuring charges, we analyze our future business requirements in order to properly align and manage our business commensurate with our future revenue levels.

 

Our restructuring costs, and any resulting accruals, involve significant estimates made by management using the best information available at the time the estimates are made, some of which may be provided by third parties. In recording severance reserves, we accrue a liability when the following conditions have been met: employees’ rights to receive compensation is attributable to employees’ services already rendered; the obligation relates to rights that vest or accumulate; payment of the compensation is probable; and the amount can be reasonably estimated. In recording facilities lease restructuring reserve, we make various assumptions, including the time period over which the facilities are expected to be vacant, expected sublease terms, expected sublease rates, anticipated future operating expenses, and expected future use of the facilities.

 

Our estimates involve a number of risks and uncertainties, some of which are beyond our control, including future real estate market conditions and our ability to successfully enter into subleases or lease termination agreements with terms as favorable as those assumed when arriving at our estimates. We regularly evaluate a number of factors to determine the appropriateness and reasonableness of our restructuring and lease loss accruals including the various assumptions noted above. If actual results differ significantly from our estimates, we may be required to adjust our restructuring and lease loss accruals in the future. In fiscal 2005, we estimated our facility restructuring reserve to be $4.5 million. Our fiscal 2006 estimate for the facility restructuring reserve was $2.7 million which included a $1.0 million adjustment due to the execution of new sublease agreement for our Tewksbury facility net of related cost.

 

Impairment Losses on Investments

 

As of April 30, 2006, our short-term investments have been classified as “available-for-sale” and are carried at fair value. There have been no significant declines in fair value of investments that are considered to be other-than-temporary, for any of the three years in the period ended April 30, 2006. The fair value of our available-for-sale investment reflected in the Consolidated Balance Sheets was $1,102.8 million and $976.4 million as of April 30, 2006 and 2005, respectively. We have not identified any of these declines to be other than temporary as market declines of our investments have been caused by interest rate changes and were not due to credit worthiness. Because we have the ability to hold these investments until maturity, we would not expect any significant decline in value of our investments caused by market interest rate changes. We have no impairment losses on our available-for-sale investment or investment in privately held companies for fiscal 2006, 2005 and 2004.

 

All of our available-for-sale investments and non-marketable equity securities are subject to a periodic impairment review. Investments are considered to be impaired when a decline in fair value is judged to be

other-than-temporary. This determination requires significant judgment. For publicly traded investments, impairment is determined based upon the specific facts and circumstances present at the time, including factors such as current economic and market conditions, the credit rating of the security’s issuer, the length of time an investment’s fair value has been below our carrying value, and our ability to hold investments to maturity. If an investment’s decline in fair value, caused by factors other than changes in interest rates, is deemed to be other-than-temporary, we would reduce its carrying value to its estimated fair value, as determined based on quoted market prices or liquidation values. Our investments in privately held companies were $11.0 million and $1.8 million as of April 30, 2006 and 2005, respectively. For non-marketable equity securities, the impairment analysis requires the identification of events or circumstances that would likely have a significant adverse effect on the fair value of the investment, including, revenue and earnings trends, overall business prospects, limited capital resources, limited prospects of receiving additional financing, limited prospects for liquidity of the related securities and general market conditions in the investees’ industry.

 

Accounting for Stock-Based Compensation

 

We adopted the disclosure-only provisions of SFAS No. 123 as amended by SFAS No. 148 and provide pro forma disclosure using the Black-Scholes option pricing model to value our employee stock options. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model, and is not remeasured as a result of subsequent stock price fluctuations. Option pricing models require the input of highly subjective assumptions, including the expected stock price volatility, expected life and forfeiture rate. We are currently evaluating the expected volatility rates in accordance with SAB No. 107, including the use of historical, blended and implied volatility. As of May 1, 2006, the contractual life of our stock options has been shortened to seven years from ten years for options issued on or after this date, and to the extent that the shorter life changes employees’ exercise behavior, it may change the expected term of an option going forward. SFAS No. 123R will require us to include estimated forfeitures, and therefore, the required adoption of SFAS No. 123R could have a material impact on the timing of and, based on the accuracy of estimates of future actual forfeiters, the amount stock compensation expense. Any changes in these highly objective assumptions may significantly impact the stock compensation expenses for the future.

 

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”), see discussion under New Accounting Standards below. In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB 107”). SAB 107 includes interpretive guidance for the initial implementation of SFAS No. 123R. We will apply the principles of SAB 107 in conjunction with our adoption of SFAS No. 123R in our first quarter of fiscal 2007, which begins on May 1, 2006.

 

Loss Contingencies

 

We are subject to the possibility of various loss contingencies arising in the course of business. We consider the likelihood of the loss or impairment of an asset or the incurrence of a liability as well as our ability to reasonably estimate the amount of loss in determining loss contingencies. An estimated loss contingency is accrued when it is probable that a liability has been incurred or an asset has been impaired and the amount of loss can be reasonably estimated. In fiscal 2006, 2005 and 2004, we did not identify or accrue for any loss contingencies. We regularly evaluate current information available to us to determine whether such accruals should be adjusted.

 

New Accounting Standards

 

In November 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position FSP 115-1 which addresses the determination as to when an investment is considered impaired, whether that impairment is other-than-temporary, and the measurement of an impairment loss. This FSP also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in this FSP amends Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities” and APB Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock.” The guidance in FSP 115-1 shall be applied to reporting periods beginning after December 15, 2005. We are required to adopt FSP 115-1 for fiscal years beginning after May 1, 2006. We are

currently evaluating the effect that the adoption of FSP 115-1 will have on our consolidated results of operations and financial condition but do not expect it to have a material impact.

 

In June 2005, the FASB issued SFAS No. 154 (“SFAS No. 154”), Accounting Changes and Error Corrections: a Replacement of Accounting Principles Board Opinion No. 20 (“APB 20”) and FASB Statement No 3.  SFAS No. 154 requires retrospective application for voluntary changes in accounting principle unless it is impracticable to do so. Retrospective application refers to the application of a different accounting principle to previously issued financial statements as if that principle had always been used. SFAS No. 154’s retrospective-application requirement replaces APB 20’s requirement to recognize most voluntary changes in accounting principle by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. This Statement defines retrospective application as the application of a different accounting principle to prior accounting periods as if that principle had always been used or as the adjustment of previously issued financial statements to reflect a change in the reporting entity. This Statement also redefines restatement as the revising of previously issued financial statements to reflect the correction of an error. The requirements are effective for accounting changes made in fiscal years beginning after December 15, 2005 and will only impact the consolidated financial statements in periods in which a change in accounting principle is made.

 

In November 2004, the FASB issued SFAS No. 151 “Inventory Costs” (SFAS No. 151). This statement amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). SFAS No. 151 requires that those items be recognized as current-period charges. In addition, this Statement requires that allocation of fixed production overhead to costs of conversion be based upon the normal capacity of the production facilities. The provisions of SFAS No. 151 are effective for inventory cost incurred in fiscal years beginning after June 15, 2005. As such, we are required to adopt these provisions at the beginning of fiscal 2007, which begins on May 1, 2006. We do not expect the adoption of SFAS No. 151 to have a material impact on our consolidated financial statements.

 

In December 2004, the FASB issued SFAS No. 123R. Generally, the requirements of SFAS No. 123R are similar to those of SFAS No. 123. However, SFAS No. 123R requires companies to now recognize all share-based payments to employees, including grants of employee stock options, in their statements of operations based on the fair value of the payments. Pro forma disclosure will no longer be an alternative. The effective date of the new standard for our consolidated financial statements is the first quarter of fiscal 2007, which begins on May 1, 2006.

 

In March 2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 107, which provides guidance on the implementation of SFAS No. 123R, “Share-Based Payments” (SFAS No. 123R) (see discussion below). In particular, SAB No. 107 provides key guidance related to valuation methods (including assumptions such as expected volatility and expected term), the accounting for income tax effects of share-based payment arrangements upon adoption of SFAS No. 123R, the modification of employee share options prior to the adoption of SFAS No. 123R, the classification of compensation expense, capitalization of compensation cost related to share-based payment arrangements, first-time adoption of SFAS No. 123R in an interim period, and disclosures in Management’s Discussion and Analysis subsequent to the adoption of SFAS No. 123R.

 

In November 2005, the FASB issued FSP FAS 123R-3, Transition Election and Accounting for Tax Effects.  The guidance provides a simplified method to calculate the Additional Paid-In Capital (APIC) pool for beginning balance of excess tax benefits and the method of determining the subsequent impact on the pool of option awards that are outstanding and fully or partially vested upon the adoption of SFAS No. 123R beginning on May 1, 2006. In addition, this FSP addresses that when the alternative APIC pool calculation is used, tax benefits related to certain employee awards should be included as a cash flow from financing activities and a cash outflow from operating activities within the statements of cash flows. The FSP allows companies up to one year from the later of the adoption date of SFAS No. 123R or November 10, 2005 to evaluate the available transition alternatives and make a one-time election. We are in the process of evaluating the impact of the new method provided by this guidance.

 

SFAS No. 123R and its related guidance permits public companies to adopt its requirements using one of two methods: modified prospective method or modified retrospective method. We plan to adopt SFAS No. 123R using the modified prospective method, in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS No. 123R for all share-based payments granted after the effective date and

(b) based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123R that remain unvested on the effective date. We will recognize in our results of operations the compensation cost for stock-based awards issued after April 30, 2006 on a straight-line basis over the requisite service period for the entire award. For stock-based awards issued prior to May 1, 2006, we amortized the related compensation costs using the graded-vesting method.

 

As permitted by SFAS No. 123, we currently account for share-based payments to employees using the APB 25 intrinsic value method and, as such, generally recognize no compensation cost for employee stock options as grant date value equals fair value. The adoption of the SFAS No. 123R fair value method will have a significant impact on our reported results of operations because the stock-based compensation expense will be charged directly against our reported earnings. The pre-tax balance of unearned stock-based compensation to be expensed in the period fiscal 2007 through 2010 related to share-based awards unvested as of April 30, 2006, as previously calculated under the disclosure-only requirements of SFAS No. 123, is approximately $240.5 million. If there are any modifications or cancellations of the underlying unvested securities, we may be required to accelerate, increase, or cancel any remaining unearned stock-based compensation expense. To the extent that we grant additional equity securities to employees or assume unvested securities in connection with any acquisitions, our stock-based compensation expense will be increased by the additional unearned compensation resulting from those additional grants or acquisitions. We anticipate that we will grant additional employee stock options and restricted stock units in fiscal 2007. The fair value of these grants cannot be predicted with certainty at this time due to the fact that the expense amount will depend on the timing of new grants, the number of new grants, changes in the market price or the volatility of our common stock. However, we currently estimate that the impact on our first fiscal quarter will be between $0.07 — $0.09 per share. As of May 1, 2006, the contractual life of our stock options has been shortened to seven years from ten years for options issued on or after this date, and to the extent that the shorter life changes employees’ exercise behavior, it may change the expected term of an option going forward. We are not aware of any other changes in business practices and do not expect any violations of debt covenants due to the adoption of SFAS No. 123R.

 

Results of Operations

 

The following table sets forth certain consolidated statements of income data as a percentage of total revenues for the periods indicated:

 

 

Fiscal 2006 Compared to Fiscal 2005

 

Product Revenues — Product revenues increased by 25.1% to $1,577.4 million in fiscal 2006, from $1,260.6 million in fiscal 2005. Product revenues growth was across all geographies. This net increase year over year was specifically attributable to increased software licenses, an increase in units shipped, and an increase in demand for data protection and mission-critical storage environments, partially offset by a decline in shipments and lower average selling prices of older generation products, lower cost-per-megabyte disks. Our systems are highly configurable because of customer requirements in the open systems storage markets we serve. As a result, the wide variation in customized configuration can significantly impact revenue, cost of revenues, and gross margin performance. Price changes, volumes and product model mix can have an effect on changes in product revenues, the impact on these forces is significantly affected by the configuration of systems shipped.

 

Product revenues were favorably affected by the following factors:

 

 

Product revenues were negatively affected by the following factors:

 

 

The Decru acquisition and the IBM OEM relationship did not have a significant impact on the revenue for fiscal 2006. There can be no assurance that IBM and Decru will contribute meaningful revenue in future quarters. We also cannot assure you that we will be able to maintain or increase market demand for our products.

 

Software Subscriptions Revenues — Software subscriptions revenues increased by 40.9% to $239.1 million in fiscal 2006, from $169.7 million in fiscal 2005 due primarily to a larger installed base renewals, upgrades and an increasing number of new enterprise customers. Software subscriptions revenues represent 11.6% and 10.6% of total revenues for fiscal 2006 and 2005, respectively.

 

Service Revenues — Service revenues, which include hardware support, professional services, and educational services, increased by 48.9% to $249.9 million in fiscal 2006, from $167.8 million in fiscal 2005.

 

The increase in absolute dollars was due to the following factors:

 

 

While it is an element of our strategy to expand and offer a more comprehensive, global enterprise support and service solution, we cannot assure you that service revenue will grow at the current rate in fiscal 2007.

 

A large portion of our service revenues is deferred and, in most cases, recognized ratably over the service obligation periods, which are typically one to three years, and are classified as short-term and long-term deferred revenue on our Consolidated Balance Sheets. Service revenues represented 12.1% and 10.5% of total revenues for fiscal year 2006 and 2005, respectively.

 

International total revenues — International total revenues (including U.S. exports) increased by 23.2% in fiscal year 2006 compared with fiscal 2005. International total revenues were $943.8 million, or 45.7% of total revenues for fiscal year 2006 compared with $765.8 million or 47.9% of total revenues for fiscal 2005. The increase in international sales was primarily a result of revenue growth from our European and Asia Pacific geographies, driven by increased demand for our solutions portfolio, new customers, and higher storage spending in certain geographic regions as compared to the same period in the prior fiscal year. We cannot assure you that we will be able to maintain or increase international revenues in fiscal 2007.

 

Product Gross Margins — Product gross margins decreased to 60.5% for fiscal 2006, from 61.4% for fiscal 2005.

 

Product gross margins were negatively affected by the following factors:

 

 

Product gross margins were favorably affected by the following factors:

 

 

We expect higher disk content associated with high-end storage systems will negatively affect our gross margins in the future, if not offset by software revenue and new products.

 

Amortization of existing technology from acquisitions included in cost of product revenues was $11.8 million and $3.4 million for fiscal 2006 and 2005, respectively. Estimated future amortization of existing technology to cost of product revenues relating to acquisitions will be $15.5 million for each of fiscal years 2007 and 2008; $14.7 million for fiscal year 2009; $10.3 million for fiscal year 2010, $2.8 million for fiscal year 2011; and none thereafter.

 

Software Subscriptions Gross Margins — Software subscriptions gross margins increased slightly to 99.4% for fiscal 2006, from 99.1% for fiscal 2005 due primarily to improved headcount utilization and a larger installed base renewals, upgrades and an increasing number of new enterprise customers.

 

Service Gross Margins — Service gross margins increased to 25.9% in fiscal 2006 compared to 19.4% in fiscal 2005. Cost of service revenue increased by 36.9% to $185.0 million in fiscal 2006, from $135.2 million in fiscal 2005.

 

The improvement in service gross margins for fiscal 2006 compared to fiscal 2005 was primarily due to an increase in services revenue and improved headcount utilization offset by the continued spending in our service infrastructure to support our increasing enterprise customer base. This spending included additional professional support engineers, increased support center activities, and global service partnership programs. Service gross margins will typically experience some variability over time due to the timing of technical support service initiations, renewals and additional investments in our customer support infrastructure. In fiscal 2007, we expect service gross margins to be in the mid 20% range, as we continue to build out our service capability and capacity to support our growing enterprise customers and new products. Our fiscal 2007 total gross margin will also be negatively impacted by stock compensation expenses as a result of the adoption of SFAS No. 123R.

 

Sales and Marketing — Sales and marketing expenses consist primarily of salaries, commissions, advertising and promotional expenses, and certain customer service and support costs. Sales and marketing expenses increased 27.7% to $595.2 million for fiscal 2006, from $466.0 million for fiscal 2005. These expenses were 28.9% and 29.1% of total revenues for fiscal 2006 and fiscal 2005, respectively. The increase in absolute dollars was attributed to increased commission expenses resulting from increased revenues, higher performance-based payroll expenses due to higher profitability, higher partner program expenses, and the continued worldwide investment in our sales and global service organizations associated with selling complete enterprise solutions.

 

Amortization of acquisitions-related trademarks/tradenames and customer contracts and relationships included in sales and marketing expenses was $2.1 million and $0.8 million for fiscal 2006 and fiscal 2005, respectively. Estimated future amortization of trademarks, tradenames, customer contracts, and relationships relating to acquisitions and included in sales and marketing expenses will be $2.3 million for fiscal 2007, $2.2 million for fiscal 2008, 2009, and 2010, $1.3 million for fiscal 2011 and $0.3 million thereafter.

 

Sales and marketing headcount increased to 1,927 at April 30, 2006, from 1,918 at April 30, 2005. We expect to continue to selectively add sales capacity in an effort to expand domestic and international markets, introduce new products, establish and expand new distribution channels, and increase product and company awareness. Our sales and market expenses will also increase as a result of the adoption of SFAS No. 123R. We expect to increase our sales and marketing expenses commensurate with future revenue growth.

 

Research and Development — Research and development expenses consist primarily of salaries and benefits, prototype expenses, non-recurring engineering charges, fees paid to outside consultants and amortization of capitalized patents.

 

Research and development expenses increased 42.1% to $243.0 million for fiscal 2006 from $171.0 million for fiscal 2005. These expenses represented 11.8% and 10.7% of total revenues for fiscal 2006 and 2005, respectively. The increase in research and development expenses was primarily a result of increased headcount, ongoing operating impact of the acquisitions, ongoing support of current and future product development and enhancement efforts, and higher performance-based payroll expenses due to higher profitability. Research and development

headcount increased to 1,246 as of April 30, 2006, compared to 827 as of April 30, 2005. For both fiscal 2006 and 2005, no software development costs were capitalized.

 

Included in research and development expenses is amortization of acquired patents of $2.0 million and $1.8 million for fiscal 2006 and 2005, respectively. Based on acquired patents existing at April 30, 2006, estimated future capitalized patents amortization expenses will be $2.0 million for each of the fiscal years 2007 and 2008, respectively, and $0.5 and $0.2 million for fiscal 2009 and 2010.

 

We believe that our future performance will depend in large part on our ability to maintain and enhance our current product line, develop new products that achieve market acceptance, maintain technological competitiveness, and meet an expanding range of customer requirements. We expect to continuously support current and future product development and enhancement efforts, and incur prototyping expenses and nonrecurring engineering charges associated with the development of new products and technologies. We intend to continuously broaden our existing product offerings and introduce new products that expand our solutions portfolio.

 

We believe that our research and development expenses will increase in absolute dollars for fiscal 2007, primarily due to ongoing costs associated with the development of new products and technologies, projected headcount growth, the operating impact of potential future acquisitions as compared to fiscal 2006, and stock-based compensation as a result of the adoption of SFAS No. 123R.

 

General and Administrative — General and administrative expenses increased 19.4% to $91.9 million for fiscal 2006, from $76.9 million for fiscal 2005. These expenses represented 4.4% and 4.8% of total revenues for fiscal 2006 and 2005, respectively. This increase in absolute dollars was primarily due to expenses associated with expanded regulatory requirements, higher legal expenses and professional fees for general corporate matters including patents and higher performance-based payroll expenses due to higher profitability.

 

General and administrative headcount increased to 568 at April 30, 2006, from 331 at April 30, 2005. We believe that our general and administrative expenses will increase in absolute dollars for fiscal 2007 due to projected G&A headcount growth and the stock-based compensation as a result of the adoption of SFAS No. 123R. Amortization of acquisitions-related covenants not to compete included in general and administrative expenses was $2.2 million and $5.1 million for fiscal 2006 and 2005, respectively. Estimated future amortization of covenants not to compete relating to acquisitions will be $1.0 million for fiscal year 2007, and $0.2 million in fiscal year 2008.

 

In-Process Research and Development — We recorded in-process research and development charges of $5.0 million in fiscal 2006 related to the acquisition of Decru. The purchase price of the transaction was allocated to the acquired assets and liabilities based on their estimated fair values as of the date of the acquisition. Approximately $5.0 million was allocated to in-process research and development and charged to operations because the acquired technology had not reached technological feasibility and had no alternative uses. The value was determined by estimating the costs to develop the acquired in-process technology into commercially viable products, estimating the resulting future net cash flows from such projects, and discounting the net cash flows back to their present value. The discount rate included a factor that took into account the uncertainty surrounding the successful development of the acquired in-process technology. These estimates are subject to change, given the uncertainties of the development process, and no assurance can be given that deviations from these estimates will not occur. Research and development costs to bring the products from Decru to technological feasibility are not expected to have a material impact on our future results of operations or financial conditions.

 

Stock Compensation — Stock compensation expenses were $13.3 million and $8.1 million for fiscal 2006 and 2005, respectively. This net increase in year-over-year stock compensation expenses reflected primarily higher stock compensation relating to stock options and restricted stocks assumed in acquisitions, and restricted stock awards, partially offset by forfeitures of unvested options and forfeited restricted stock assumed in the acquisitions. Based on deferred stock compensation recorded at April 30, 2006, estimated future deferred stock compensation amortization expenses, excluding the impact of SFAS No. 123R, are $20.3 million in fiscal 2007, $14.3 million in fiscal 2008, $8.1 million in fiscal 2009, and $6.6 million in fiscal 2010.

 

Restructuring Charges — In fiscal 2002, as a result of continuing unfavorable economic conditions and a reduction in IT spending rates, we implemented two restructuring plans, which included reductions in our workforce and consolidations of our facilities. As of April 30, 2006, we have no outstanding balance in our

restructuring liability for the first restructuring. The second restructuring related to the closure of an engineering facility and consolidation of resources to the Sunnyvale headquarters. In the second quarter of fiscal 2006, we implemented a third restructuring plan related to the move of our global services center operations from Sunnyvale to our new flagship support center at our Research Triangle Park facility in North Carolina.

 

Our restructuring estimates are reviewed and revised periodically and may result in a substantial charge or reduction to restructuring expense should different conditions prevail than were anticipated in previous management estimates. Such estimates included various assumptions such as the time period over which the facilities will be vacant, expected sublease terms, and expected sublease rates. In fiscal 2006, we recorded a reduction in restructuring reserve of $1.3 million resulting from the execution of a new sublease agreement for our Tewksbury facility. In fiscal 2006, we recorded a restructuring charge of $1.1 million, primarily attributed to severance-related amounts and relocation expenses related to the third restructuring plan.

 

Of the reserve balance at April 30, 2006, $0.9 million was included in other accrued liabilities and the remaining $2.1 million was classified as long-term obligations. The balance of the reserve is expected to be paid by fiscal 2011.

 

The following analysis sets forth the significant components of the second restructuring at April 30, 2006 (in thousands):

 

 

Interest Income — Interest income was $41.5 million and $24.2 million for fiscal 2006 and 2005, respectively. Included in interest income for fiscal 2005 was a $1.3 million interest received on a tax refund. The increase in interest income was primarily driven by higher average interest rates on our investment portfolio. We expect interest income to increase for fiscal 2007 as a result of rising average interest rates and higher cash and invested balances in a higher interest-rate portfolio environment.

 

Interest Expense — Interest expense was $1.3 million and $0.1 million in fiscal 2006 and 2005, respectively. The increase in fiscal 2006 was primarily due to interest incurred in connection with our debt.

 

Other Income (Expense), Net — Other Income (Expense), Net, included net exchange gains from foreign currency transactions of $1.7 million in fiscal 2006, due primarily to forecast variances offset by hedging costs as a result of higher U.S. interest rates compared to other countries. Net exchange losses from foreign currency transactions were $1.6 million in fiscal 2005 as a result of exchange rate volatility, forecast variances and higher hedging costs.

 

Provision for Income Taxes — The provision for income taxes for fiscal 2006 included an income tax provision of $22.5 million or $0.06 per share associated with the repatriation of cumulative foreign earnings which occurred during the fourth quarter of fiscal 2006 under the one-time incentive created pursuant to Section 965 of the Jobs Act. We will invest these earnings pursuant to an approved Domestic Reinvestment Plan that conforms to the Jobs Act guidelines.

For fiscal 2006, we had an effective tax rate of 23.9% to pretax income, which included a 6.4% increase to account for the income tax provision of $22.5 million associated with the cash repatriation of cumulative foreign earnings. The effective tax rate for fiscal 2006 differed from the U.S. statutory rate primarily due to a beneficial foreign tax ruling for our principal European subsidiary, the availability of tax credits, and the generation of foreign earnings in lower tax jurisdictions. For fiscal 2005, our effective tax rate was 18.3%.

 

Fiscal 2005 Compared to Fiscal 2004

 

Product Revenues — Product revenues increased by 33.4% to $1,260.6 million in fiscal 2005, from $944.9 million in fiscal 2004. Product revenues growth was across all geographies. This increase in product revenues was specifically attributable to increased software licenses and an increase in units shipped, compared to the prior year.

 

Product revenues were favorably affected by the following factors:

 

 

Product revenues were negatively affected by the following factors:

 

 

Software Subscriptions Revenues — Software subscriptions revenues increased by 49.8% to $169.7 million in fiscal 2005, from $113.3 million in fiscal 2004 due primarily to a larger installed base renewals, upgrades and an increasing number of new enterprise customers. Software subscription revenues represent 10.6% and 9.7% of total revenues for fiscal year 2005 and 2004, respectively.

 

Service Revenues — Service revenues, which include hardware support, professional services, and educational services, increased by 49.7% to $167.8 million in fiscal 2005, from $112.1 million in fiscal 2004. Service revenues are generally deferred and, in most cases, recognized ratably over the service obligation periods, which are typically one to three years. Service revenues represented 10.5%, and 9.6% of total revenues for fiscal year 2005 and 2004, respectively. The increase in absolute dollars was due to an increasing number of enterprise customers, which typically purchase more complete and generally longer-term service packages. Higher service revenues were also related to a growing installed base resulting in new customer support contracts in addition to support contract renewals by existing customers.

 

International Total Revenues — International total revenues (including U.S. exports) increased by 39.0% in fiscal year 2005 compared with fiscal 2004. International total revenues were $765.8 million, or 47.9% of total revenues for fiscal year 2005 compared with $551.0 million or 47.1% of total revenues for fiscal 2004. The increase in international sales for fiscal year 2005 was primarily a result of revenue growth from our European and Asia Pacific geography, driven by larger storage implementations, increased demand for our solutions portfolio, new customers, and higher storage spending in certain geographic regions, as compared to the same period in the prior fiscal year.

Product Gross Margins — Product gross margins increased to 61.4% for fiscal 2005, from 60.8% for fiscal 2004. Amortization of existing technology included in cost of product revenues was $3.4 million and $3.7 million for fiscal 2005 and 2004, respectively.

 

Product gross margins were favorably affected by the following factors:

 

 

Product gross margins were negatively affected by the following factors:

 

 

Software Subscriptions Gross Margins — Software Subscriptions gross margins increased to 99.1% for fiscal 2005, from 98.9% for fiscal 2004 due primarily to improved headcount utilization and a larger installed base renewals, upgrades and an increasing number of new enterprise customers.

 

Service Gross Margins — Service gross margins increased to 19.4% in fiscal 2005 as compared to 15.9% in fiscal 2004. Cost of service revenue increased by 43.4% to $135.2 million in fiscal 2005, from $94.3 million in fiscal 2004. The improvement in service gross margins for fiscal 2005 compared to fiscal 2004 was primarily due to an increase in services revenue and improved headcount utilization offset by the continued spending in our service infrastructure to support our increasing enterprise customer base. This spending included additional professional support engineers, increased support center activities, and global service partnership programs. Service gross margins will typically experience some variability over time due to the timing of technical support service initiations and renewals and additional investments in our customer support infrastructure.

 

Sales and Marketing — Sales and marketing expenses consist primarily of salaries, commissions, advertising and promotional expenses, and certain global service and support costs. Sales and marketing expenses increased 33.3% to $466.0 million for fiscal 2005, from $349.5 million for fiscal 2004. These expenses were 29.1% and 29.9% of total revenues for fiscal 2005 and fiscal 2004, respectively. The increase in absolute dollars was attributed to increased commission expenses resulting from increased revenues, higher performance-based payroll expenses due to higher profitability, higher sales kickoff expenses, higher partner program expenses, and the continued worldwide spending in our sales and global service organizations associated with selling complete enterprise solutions, partially offset by an extra week of business in fiscal 2004 as compared to fiscal 2005.

 

Amortization of acquired trademarks/tradenames and customer contracts, and relationships included in sales and marketing expenses was $0.8 million and $0.2 million for fiscal 2005 and fiscal 2004, respectively.

 

Sales and marketing headcount increased to 1,918 at April 30, 2005, from 1,421 at April 30, 2004.

 

Research and Development — Research and development expenses consist primarily of salaries and benefits, prototype expenses, nonrecurring engineering charges, fees paid to outside consultants and amortization of capitalized patents. Research and development expenses increased 29.7% to $171.0 million for fiscal 2005 from $131.9 million for fiscal 2004. These expenses represented 10.7% and 11.3% of total revenues for fiscal 2005 and

2004, respectively. The increase in research and development expenses was primarily a result of increased headcount, ongoing impact of the Spinnaker acquisition, ongoing support of current and future product development and enhancement efforts, higher performance-based payroll expenses due to higher profitability, partially offset by an extra week of expenses in fiscal 2004 compared to fiscal 2005, cost control, and reduction in discretionary spending efforts. Research and development headcount increased to 827 as of April 30, 2005, compared to 650 as of April 30, 2004. For both fiscal 2005 and 2004, no software development costs were capitalized. Included in research and development expenses is capitalized patents amortization of $1.8 million and $1.5 million for fiscal 2005 and 2004, respectively.

 

General and Administrative — General and administrative expenses increased 41.0% to $76.9 million for fiscal 2005, from $54.6 million for fiscal 2004. These expenses represented 4.8% and 4.7% of total revenues for fiscal 2005 and 2004, respectively. This increase in absolute dollars was primarily due to expenses associated with expanded regulatory requirements, higher legal expenses and professional fees for general corporate matters including patents, higher performance-based payroll expenses due to higher profitability, partially offset by reduced expenses as a result of one less week of expenses in fiscal 2005 compared to fiscal 2004 and higher expenses associated with investments in our enterprise-wide ERP system and back-office infrastructure in fiscal 2004, which we did not incur in fiscal 2005.

 

General and administrative headcount increased to 432 at April 30, 2005, from 331 at April 30, 2004. Amortization of Spinnaker covenants not to compete included in general and administrative expenses was $5.1 million and $1.1 million for fiscal 2005 and 2004, respectively.

 

Stock Compensation — Stock compensation expenses were $8.1 million and $3.9 million for fiscal 2005 and 2004, respectively. This net increase year-over-year in stock compensation expenses reflected primarily higher stock compensation relating to stock options and restricted stocks assumed in the Spinnaker acquisition, restricted stock awards, partially offset by forfeitures of unvested options and forfeited restricted stock assumed in the Spinnaker acquisition.

 

Restructuring Charges — In fiscal 2002, as a result of continuing unfavorable economic conditions and a reduction in IT spending rates, we implemented two restructuring plans, which included reductions in our workforce and consolidations of our facilities. During fiscal 2005, we paid $0.6 million pursuant to final resolution of certain severance-related restructuring accruals. As of April 30, 2005, we have no outstanding balance in our restructuring liability for the first restructuring. The second restructuring related to the closure of an engineering facility and consolidation of resources to the Sunnyvale headquarters. Of the reserve balance at April 30, 2005, $0.8 million was included in other accrued liabilities and the remaining $3.7 million was classified as long-term obligations.

 

Interest Income — Interest income was $24.2 million and $13.7 million for fiscal 2005 and 2004, respectively. Included in interest income for fiscal 2005 was $1.3 million interest received on a tax refund. In addition, the increase in interest income was primarily driven by higher cash and investment balances provided by operating activities and higher average interest rates on our investment portfolio.

 

Other Income (Expense), Net — Other Income (Expense), Net, included net exchange losses from foreign currency transactions of $1.6 million and $2.9 million in fiscal 2005 and 2004, respectively. The net exchange loss was a result of the volatility of the currency exchange market and increased hedging costs associated with our forward and option activities.

 

Provision for Income Taxes — For fiscal 2005, we had an effective tax rate of 18.3% to pretax income. The effective tax rate for fiscal 2005 differed from the U.S. statutory rate primarily due to a beneficial foreign tax ruling for our principal European subsidiary, the availability of tax credits, and the generation of foreign earnings in lower tax jurisdictions. For fiscal 2004, our effective tax rate was 10.8% which included 9.9% reduction to account for the $16.8 million benefit from the retroactive portion of foreign tax ruling.

Liquidity and Capital Resources

 

The following sections discuss the effects of changes in our balance sheet and cash flows, contractual obligations and other commercial commitments, stock repurchase program, capital commitments, other sources and uses of cash flows and tax opportunities on our liquidity and capital resources.

 

Balance Sheet and Other Cash Flows

 

As of April 30, 2006, compared to April 30, 2005, our cash, cash equivalents, and short-term investments increased by $152.9 million to $1,322.9 million. We derive our liquidity and capital resources primarily from our cash flows from operations and from working capital. Working capital increased by $60.3 million to $1,116.0 million as of April 30, 2006, compared to $1,055.7 million as of April 30, 2005.

 

During fiscal 2006, we recorded cash flows from operating activities of $554.3 million as compared with $462.1 million and $313.0 million for fiscal 2005 and fiscal 2004, respectively. The largest driver of this increase was fiscal 2006 net income of $266.5 million as compared to $225.8 million and $152.1 million in fiscal 2005 and fiscal 2004, respectively. Noncash adjustments were higher in fiscal 2006 compared to fiscal 2005, including depreciation, which was higher by $9.2 million due to worldwide facilities expansion; amortization of intangible assets, which was higher by $6.8 million; stock compensation, which was higher by $5.1 million, and acquired in-process research and development of $5.0 million. The increase in these acquisition-related non-cash charges was related to the Decru and Alacritus acquisitions during fiscal 2006. In addition to higher net income and noncash adjustments in fiscal 2006 compared to fiscal 2005 and fiscal 2004, the primary factors that impacted the period-to-period change in cash flows relating to operating activities included the following:

 

 

The above factors were partially offset by the effects of the following:

 

 

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, inventory management, and the timing of tax and other payments.

 

Cash used in investing activities was $326.0 million in fiscal 2006 as compared to $351.3 million and $259.8 million in fiscal 2005 and fiscal 2004, respectively. Capital expenditures for fiscal 2006 were $132.9 million, compared to $93.6 million and $48.7 million in fiscal 2005 and fiscal 2004, respectively. We used net proceeds of $128.5 million, $266.8 million, and $191.7 million in fiscal 2006, 2005, and 2004, respectively, for net purchases/redemptions of short-term investments. In fiscal 2006, we acquired Alacritus and Decru and incurred total cash

payments including related transactions costs totaling $53.7 million. In fiscal 2004, we incurred $8.0 million on related transactions costs and assumed $1.2 million relating to the Spinnaker acquisition. In fiscal 2005 and 2004, we acquired additional patents for a purchase price of approximately $0.9 million and $9.0 million, respectively. Investing activities in fiscal 2006, 2005, and 2004 also included new investments in privately held companies of $9.3 million, $0.4 million and $0.9 million, respectively. We received $0.1 million, $0.3 million, and $1.1 million in proceeds from sales of investments in fiscal 2006, 2005, and 2004, respectively. Under a split dollar insurance arrangement with our CEO entered in May 2000, we paid total premiums of $10.2 million, including $0.2 million and $3.9 million for fiscal years 2005, and 2004, respectively. In April 2005, our CEO reimbursed us $10.2 million for these premiums.

 

Cash provided by financing activities was $42.8 million in fiscal 2006 as compared to cash used in financing activities of $12.1 million and $54.6 million in fiscal 2005 and fiscal 2004, respectively. During fiscal 2006, 2005 and 2004, we repurchased 17.4 million, 7.7 million and 6.9 million shares of common stock at a total of $488.9 million, $192.9 million and $136.2 million, respectively. Other financing activities provided $232.7 million, $181.9 million, and $81.5 million in fiscal 2006, 2005, and 2004, respectively, which related to sales of common stock from employee stock transactions. Pursuant to the provisions of our Stock Option plans, we allowed optionees to satisfy withholding tax obligations by electing to have us withhold from the shares to be issued upon exercise of a restricted stock the equivalent shares having a fair market value equal to $1.1 million in withholding taxes in both fiscal 2006 and fiscal 2005 to cover for federal, state, and local withholding taxes. During fiscal 2006, we borrowed $300.0 million to fund the repatriation in cash from foreign earnings and investments under the Jobs Act.

 

The change in cash flows from financing activities was primarily due to the effects of higher common stock repurchases partially offset by proceeds from issuance of common stock under employee programs compared to the same periods in the prior year. Net proceeds from the issuance of common stock related to employee participation in employee stock programs have historically been a significant component of our liquidity. The extent to which our employees participate in these programs generally increases or decreases based upon changes in the market price of our common stock. As a result, our cash flows resulting from the issuance of common stock related to employee participation in employee stock programs will vary.

 

Stock Repurchase Program

 

Through April 30, 2006, the Board of Directors had authorized the repurchase of up to $650.0 million in shares of our outstanding common stock. At April 30, 2006, $405.7 million remained available for future repurchases. The stock repurchase program may be suspended or discontinued at any time.

 

Other Sources and Uses of Cash and Tax Opportunities

 

The Jobs Act created a one-time incentive for U.S. corporations to repatriate accumulated income earned abroad by providing an 85% dividend-received deduction for certain dividends from certain non-U.S. subsidiaries. During the fourth quarter of fiscal 2006, we repatriated $405.5 million of accumulated foreign earnings and recorded a $22.5 million federal and state income tax liability upon the remittance of these foreign earnings.

 

For fiscal 2006, 2005, and 2004, we recorded tax benefits, in the form of reduced payments, of $42.2 million, $27.8 million, and $49.5 million, respectively, associated with disqualifying dispositions of employee stock options. If stock option exercise patterns change, we may receive less cash from stock option exercises and may not receive the same level of tax benefits in the future, which could cause our cash payments for income taxes to increase.

 

Debt

 

In March 2006, we received proceeds of the term loans totaling $300.0 million to finance a dividend under the Jobs Act. (See Note 6). The loan repayments of $166.2 million and $133.8 million are due in fiscal 2007 and 2008, respectively. This debt was collateralized by restricted investments totaling $241.2 million, as well as certain foreign receivables. In accordance with the payment terms of the loan agreement, interest payments will be approximately $12.4 million and $4.1 million in fiscal 2007 and 2008, respectively. As of April 30, 2006, we are in compliance with the liquidity and leverage ratio as required by the Loan Agreement with the lenders.

Contractual Cash Obligations and Other Commercial Commitments

 

The following summarizes our contractual cash obligations and commercial commitments at April 30, 2006, and the effect such obligations are expected to have on our liquidity and cash flows in future periods (in thousands):

 

 

For purposes of the above table, contractual obligations for the purchase of goods and services are defined as agreements that are enforceable, legally binding on us, and subject us to penalties if we cancel the agreement. 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 third parties, and other factors. Because these estimates and assumptions are necessarily subjective, the enforceable and legally binding obligations we will actually pay in future periods may vary from those reflected in the table.

 

 

 

 

 

Capital Expenditure Requirements

 

We expect capital expenditures to increase in the future consistent with the growth in our business, as we continue to invest in people, land, buildings, capital equipment and enhancements to our worldwide infrastructure. We expect that our existing facilities and those being developed in Sunnyvale, California; RTP, 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 finance these construction projects, including our commitments under facilities and equipment operating leases, and any required capital expenditures over the next few years through cash from operations and existing cash, cash equivalents and investments.

 

Off-Balance Sheet Arrangements

 

As of April 30, 2006, our financial guarantees of $1.8 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, and a foreign lease.

 

As of April 30, 2006, our notional fair values of foreign exchange forward and foreign currency option contracts totaled $345.1 million. We do not believe that these derivatives present significant credit risks because the counterparties to the derivatives consist of major financial institutions, and we manage the notional amount of contracts entered into with any one counterparty. We do not enter into derivative financial instruments for

speculative or trading purposes. 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.

 

We have entered 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 in accordance with FASB, Interpretation 45, of FIN 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” See “Guarantees” in footnote 15 for further discussion of these indemnification agreements.

 

We have commitments related to a lease arrangement with BNP for approximately 190,000 square feet of office space to be located on land currently owned by us in Sunnyvale, California (as further described above under “Contractual Cash Obligations and Other Commercial Commitments”). We have evaluated our accounting for this lease under the provisions of FIN 46R, and have determined the following:

 

 

Accordingly, under the current FIN 46R standard, we are not required to consolidate either the leasing entity or the specific assets that we lease under the BNP lease. Assuming this transaction will continue to meet the provisions of FIN 46R as new standards evolve over time, our future minimum lease payments under this real estates lease will amount to a total of $43.5 million reported under our Note 4 “Commitments and Contingencies”.

 

As of April 30, 2006, except for operating leases and other contractual obligations outlined under the “Contractual Cash Obligations” table, we do not have any off-balance sheet financing arrangements or liabilities, retained or contingent interests in transferred assets, or any obligation arising out of a material variable interest in an unconsolidated entity. We also do not have any majority-owned subsidiaries that are not included in the consolidated financial statements. Additionally, we do not have any interest in or relationship with, any special purpose entities.

 

Liquidity and Capital Resource Requirements

 

Key factors affecting our cash flows include our ability to effectively manage our working capital, in particular, accounts receivable and inventories and future demand for our products and related pricing. We expect to incur higher capital expenditures in the near future to expand our operations. We will from time to time acquire products and businesses complementary to our business. In the future, we may continue to repurchase our common stock, which would reduce cash, cash equivalents, and/or short-term investments available to fund future operations and meet other liquidity requirements. Based on past performance and current expectations, we believe that our cash and cash equivalents, short-term investments, and cash generated from operations will satisfy our working capital needs, capital expenditures, stock repurchases, contractual obligations, and other liquidity requirements associated with our operations.

 

We are exposed to market risk related to fluctuations in interest rates 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 Interest and Interest Income Risk

 

Interest and Investment Income — As of April 30, 2006, we had available-for-sale investments of $1,102.8 million. Our investment portfolio primarily consists of highly liquid investments with original maturities at the date of purchase of greater than three months, which are classified as available for sale. These highly liquid investments, consisting primarily of government, municipal, corporate debt, and auction-rate securities, are subject to interest rate and interest income risk and will decrease in value if market interest rates increase. A hypothetical 10% increase in market interest rates from levels at April 30, 2006, would cause the fair value of these short-term investments to decline by approximately $3.5 million. Because we have the ability to hold these investments until maturity, we would not expect any significant decline in value of our investments caused by market interest rate changes. Declines in interest rates over time will, however, reduce our interest income. We do not use derivative financial instruments in our investment portfolio.

 

Lease Commitments — As of April 30, 2006, we have arrangements with BNP to lease our land for a period of 50 years to construct approximately 190,000 square feet of office space costing up to $38.5 million. After completion of construction, we will pay minimum lease payments which vary based on London Interbank Offered Rate (“LIBOR”) plus a spread. We expect to pay lease payments on the completed buildings from BNP on September 2007 for a term of five years. We have the option to renew the lease for two consecutive five-year periods upon approval by BNP. A hypothetical 10% increase in market interest rates from levels at April 30, 2006, would increase our total lease payments under the initial 5-year term by approximately $0.9 million. We do not currently hedge against market interest rate increases. As cash from operating cash flows are invested in a higher interest rate environment, it will offer a natural hedge against interest rate risk from our lease commitments in the event of a significant increase in market interest rate.

 

Debt Obligation — We have an outstanding variable rate term loan totaling $300.0 million as of April 30, 2006. Under terms of these arrangements, we expect to pay interest payments at LIBOR plus a spread. Due to the short-term nature of these debt arrangements, a hypothetical 10% change in interest rates would not have a material effect on our financial position, results of operations and cash flows over the next two fiscal years. We do not currently use derivatives to manage interest rate risk.

 

Equity securities — We have from time to time made cash investments in companies with distinctive technologies that are potentially strategically important to us. Our investments in non-marketable equity securities would be negatively affected by an adverse change in equity market prices, although the impact cannot be directly quantified. Such a change, or any negative change in the financial performance or prospects of the companies whose non-marketable securities we own, would harm the ability of these companies to raise additional capital and the likelihood of our being able to realize any gains or return of our investments through liquidity events such as initial public offerings, acquisitions and private sales. These types of investments involve a high degree of risk, and there can be no assurance that any company we invest in will grow or be successful. Accordingly, we could lose all or part of our investment. Our investments in non-marketable equity securities had a carrying amount of $11.0 million as of April 30, 2006 and $1.8 million as of April 30, 2005. If we determine that an other-than-temporary decline in fair value exists for a non-marketable equity security, we write down the investment to its fair value and record the related write-down as an investment loss in our Consolidated Statements of Income.

 

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 certain sales and operating expenses. These derivatives are designated as cash flow hedges under SFAS No. 133. For cash flow hedges outstanding at April 30, 2006, the 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 foreign exchange forward contracts and currency options contracts outstanding on April 30, 2006 (in thousands):

 

 

The following table provides information about our foreign exchange forward contracts and currency options contracts outstanding on April 30, 2005 (in thousands):

 

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Stockholders of

Network Appliance, Inc.

Sunnyvale, California

 

We have audited the accompanying consolidated balance sheets of Network Appliance, Inc. and its subsidiaries (the “Company”) as of April 30, 2006 and 2005, and the related consolidated statements of income, cash flows and stockholders’ equity and comprehensive income (loss) for each of the three years in the period ended April 30, 2006. Our audits also included the consolidated financial statement schedule listed in Item 15(a)(2). These financial statements and the financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and the financial statement schedule based on our audits.

 

We conducted our audits in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Network Appliance, Inc. and its subsidiaries as of April 30, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended April 30, 2006 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the consolidated financial statement schedule listed in Item 15(a)(2), when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of April 30, 2006, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated July 11, 2006 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

 

/s/     DELOITTE & TOUCHE LLP

 

San Jose, California

July 11, 2006

NETWORK APPLIANCE, INC.

 

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share amounts)

 

 

See notes to consolidated financial statements.

NETWORK APPLIANCE, INC.

 

CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share amounts)