UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-Q

 

 

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

 

 

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 check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes þ     No o

 

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

 

Number of shares outstanding of the registrant’s common stock, $0.001 par value, as of the latest practicable date.

 

 

 

TABLE OF CONTENTS

 

 

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

See accompanying notes to unaudited condensed consolidated financial statements.

NETWORK APPLIANCE, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollar and share amounts in thousands, except per-share data)
(Unaudited)

 

1.  The Company

 

Based in Sunnyvale, California, Network Appliance was incorporated in California in April 1992 and reincorporated in Delaware in November 2001. Network Appliance, Inc. is a leading supplier of enterprise storage and data management software and hardware products and services. Its solutions help global enterprises meet major information technology challenges such as managing storage growth, assuring secure and timely information access, protecting data and controlling costs by providing innovative solutions that simplify the complexity associated with managing corporate data. Network Appliance solutions are the data management and storage foundation for many of the world’s leading corporations and government agencies.

 

2.  Condensed Consolidated Financial Statements

 

The accompanying interim unaudited condensed consolidated financial statements have been prepared by Network Appliance, Inc. without audit and reflect all adjustments, consisting only of normal recurring adjustments which are, in the opinion of management, necessary for a fair presentation of our financial position, results of operations and cash flows for the interim periods presented. The statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“generally accepted accounting principles”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 10-01 of Regulation S-X. Accordingly, they do not include all information and footnotes required by generally accepted accounting principles for annual consolidated financial statements. Certain prior period balances have been reclassified to conform with the current period presentation.

 

We operate on a 52-week or 53-week year ending on the last Friday in April. For presentation purposes we have indicated in the accompanying interim unaudited condensed consolidated financial statements that our fiscal year end is April 30. The first six months of fiscal 2006 and 2005 were both 26-week fiscal periods.

 

These financial statements should be read in conjunction with the audited consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the year ended April 30, 2005. The results of operations for the three and six-month period ended October 28, 2005 are not necessarily indicative of the operating results to be expected for the full fiscal year or future operating periods. In the following notes to our interim condensed consolidated financial statements, Network Appliance Inc. is also referred to as “we”, “our” and “us”.

 

3.  Use of Estimates

 

The preparation of the condensed consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Such estimates include, but are not limited to, revenue recognition and allowances; valuation of goodwill and intangibles; accounting for income taxes; inventory reserves and write-down; restructuring accruals; impairment losses on investments; accounting for stock-based compensation; and loss contingencies. Actual results could differ from those estimates.

 

4.   Stock Compensation

 

We account for stock-based compensation in accordance with the provisions of Accounting Principle Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” (APB No. 25) and comply with the disclosure provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation” (SFAS No. 123). Deferred compensation recognized under APB No. 25 is amortized ratably

 

NETWORK APPLIANCE, INC.

 

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FINANCIAL STATEMENTS — (Continued)

to expense over the vesting periods. We account for stock options issued to non-employees in accordance with the provisions of SFAS No. 123 under the fair value based method.

 

We amortize deferred stock-based compensation ratably over the vesting periods of the applicable stock purchase rights, restricted stocks and stock options, generally four years. Deferred stock compensation under APB No. 25 and pro forma net income under the provisions of SFAS No. 123 are adjusted to reflect cancellations and forfeitures due to employee terminations as they occur.

 

We recorded $3,379 and $5,361 of deferred compensation expense for the three and six-month periods ended October 28, 2005, respectively, and $1,968 and $3,995 for the three and six-month periods ended October 29, 2004, respectively, primarily related to the amortization of deferred stock compensation from unvested options assumed in the Decru, Alacritus and Spinnaker acquisitions, the retention escrow shares relative to Spinnaker, the grant of stock options to certain highly compensated employees below fair value at the date of grant (discontinued as of December 31, 2004) and the award of restricted stock to certain employees. The net increase in stock compensation expenses reflected primarily higher stock compensation relating to the Decru acquisition and restricted stock awards.

 

Based on deferred stock compensation recorded at October 28, 2005, estimated future deferred stock compensation amortization for the remainder of fiscal year 2006, fiscal years 2007, 2008, 2009 and 2010 are expected to be $7,901, $14,631, $8,243 and $1,533 and $50, respectively, and none thereafter.

 

We recorded an adjustment of $(35) and a charge of $11 in compensation expense in the three and six-month periods ending October 28, 2005, respectively, and $171 and $248 in the three and six-month periods ending October 29, 2004, respectively, for the fair value of options granted to a member of the Board of Directors in recognition for services performed outside of the normal capacity of a board member.

 

Had compensation expense been determined based on the fair value at the grant date for awards, consistent with the provisions of SFAS No. 123, the impact on net income and net income per share would be as follows:

 

 

NETWORK APPLIANCE, INC.

 

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FINANCIAL STATEMENTS — (Continued)

 

5.   Inventories

 

Inventories are stated at the lower of cost (first-in, first-out basis) or market. Inventories consist of the following:

 

 

6.  Goodwill and Intangible Assets

 

Goodwill is reviewed annually for impairment (or more frequently if indicators of impairment arise). We completed our annual impairment assessment in fiscal 2005 and concluded that goodwill was not impaired. In the first six months of fiscal 2006, there were no indicators that would suggest the impairment of goodwill and intangible assets.

 

During May 2005, we acquired Alacritus Inc. (“Alacritus”) and recorded goodwill of $5,845 and intangible assets of $5,700 resulting from the allocation of the purchase price. See Note 14, “Business Combinations.” In the second quarter of fiscal 2006, the Alacritus goodwill was increased by $479 to reflect an adjustment for the deferred tax impact on deferred stock compensation.

 

During August 2005, we acquired Decru, Inc. (“Decru”) and recorded goodwill of $192,949 and intangible assets of $68,100 resulting from the allocation of the purchase price. See Note 14, “Business Combinations.”

 

Identified intangible asset balances as of October 28, 2005 and April 30, 2005 are summarized as follows:

 

 

Amortization expense for identified intangible assets is summarized below:

 

 

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED

FINANCIAL STATEMENTS — (Continued)

 

Based on the identified intangible assets recorded at October 28, 2005, the future amortization expense of identified intangibles for the remainder of fiscal 2006, the next four fiscal years and thereafter is as follows:

 

 

7.  Derivative Instruments

 

As a result of our significant international operations, we are subject to risks associated with fluctuating exchange rates. We use derivative financial instruments, principally currency forward contracts and currency options, to attempt to minimize the impact of exchange rate movements on our balance sheet and operating results. 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. These programs reduce, but do not always entirely eliminate, the impact of currency exchange movements. The maturities of these instruments are generally less than one year.

 

Currently, we do not enter into any foreign exchange forward contracts to hedge exposures related to firm commitments or equity investments. Our major foreign currency exchange exposures and related hedging programs are described below:

 

Balance Sheet Exposures.  We utilize foreign currency forward and options contracts to hedge exchange rate fluctuations related to certain foreign assets and liabilities. Gains and losses on these derivatives offset gains and losses on the assets and liabilities being hedged and the net amount is included in earnings. For the three-month period ended October 28, 2005, net gains generated by hedged assets and liabilities totaled $137 and were offset by losses on the related derivative instruments of $302. For the six-month period ended October 28, 2005, net losses generated by hedged assets and liabilities totaled $3,576 and were offset by gains on the related derivative instruments of $3,148. For the three and six-month periods ended October 29, 2004, net gains generated by hedged assets and liabilities totaled $2,983 and $4,273, respectively, and were offset by losses on the related derivative instruments of $2,992 and $5,208, respectively.

 

The premiums paid on the foreign currency option contracts are recognized as a reduction to other income when the contract is entered into. Other than the risk associated with the financial condition of the counterparties, our maximum exposure related to foreign currency options is limited to the premiums paid.

 

Forecasted Transactions.  We use currency forward contracts to hedge exposures related to forecasted sales and operating expenses denominated in certain foreign currencies. These contracts are designated as cash flow hedges and in general closely match the underlying forecasted transactions in duration. The contracts are carried on the balance sheet at fair value and the effective portion of the contracts’ gains and losses is recorded as other comprehensive income until the forecasted transaction occurs.

 

If the underlying forecasted transactions do not occur, or it becomes probable that they will not occur, the gain or loss on the related cash flow hedge is recognized immediately in earnings. For the three and six-month periods ended October 28, 2005 and October 29, 2004, we did not record any gains or losses related to forecasted transactions that did not occur or became improbable.

 

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED

FINANCIAL STATEMENTS — (Continued)

 

As of October 28, 2005, our notional fair values of foreign exchange forward and foreign currency option contracts totaled $262,491. 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 several counterparties. 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 forward points and premiums paid.

 

8.  Earnings Per Share

 

Basic net income per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding excluding unvested restricted stock for that period. Diluted net income per share is computed giving effect to all dilutive potential shares that were outstanding during the period. Dilutive potential common shares consist of incremental common shares subject to repurchase, common shares issuable upon exercise of stock options and restricted stock awards.

 

During all periods presented, we had certain options outstanding, which could potentially dilute basic earnings per share in the future, but were excluded in the computation of diluted earnings per share in such periods, as their effect would have been antidilutive. These options were antidilutive in the three and six-month periods ended October 28, 2005 and October 29, 2004 as their exercise prices were above the average market prices in such periods. For the three-month periods ended October 28, 2005 and October 29, 2004, 21,853 and 19,589 shares of common stock options with a weighted average exercise price of $44.85 and $46.14, respectively, were excluded from the diluted net income per share computation. For the six-month periods ended October 28, 2005 and October 29, 2004, 18,718 and 23,443 shares of common stock options with a weighted average exercise price of $48.52 and $42.26, respectively, were excluded from the diluted net income per share computation.

 

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED

FINANCIAL STATEMENTS — (Continued)

 

The following is a reconciliation of the numerators and denominators of the basic and diluted net income per share computations for the periods presented:

 

 

9.  Stockholders’ Equity

 

 

As of April, 28, 2005, $20,925 was available for the repurchase of common shares under the Stock Repurchase Program. On May 24, 2005, our Board approved an incremental stock repurchase program in which up to $300,000 of additional shares may be repurchased. Share repurchase activities for the first three and six-months of fiscal 2006 and 2005, were as follows:

 

 

At October 28, 2005, $76,361 remained available for repurchases under the plan.

 

Since the inception of the stock repurchase program through October 28, 2005, we have purchased a total of 24,152 shares of our common stock at an average price of $23.75 per share for an aggregate purchase price of $573,639.

 

In November 2005, our Board of Directors approved a new $650,000 stock repurchase program which amount includes the $76,361 remaining from all prior authorizations.

 

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED

FINANCIAL STATEMENTS — (Continued)

 

 

The components of comprehensive income, were as follows:

 

 

The components of accumulated other comprehensive loss were as follows:

 

 

10.  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 workforce and consolidations of facilities. As of October 28, 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.

 

During the first quarter of fiscal 2006, we recorded a reduction in restructuring reserve of $1,256 resulting from the execution of new sublease agreement for our Tewksbury facility. Our restructuring estimates are reviewed and revised periodically and may result in a substantial charge 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.

 

During the second quarter of fiscal 2006, we recorded a restructuring charge of $645 relating to a subleasing of the Tewksbury facility and severance-related amounts 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. We expect to incur additional restructuring charges of approximately $500 associated with the move of our support center during the second half of fiscal 2006.

 

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED

FINANCIAL STATEMENTS — (Continued)

 

The following analysis sets forth the changes in the restructuring reserve for the three months ended October 28, 2005 (in thousands):

 

 

Of the restructuring reserve balance at October 28, 2005, $604 was included in other accrued liabilities and the remaining $2,406 was classified as long-term obligations, relating to the facility charges for the second restructuring and the global services center restructuring charges.

 

11.  Short-Term Investments

 

All our investments are classified as available for sale at October 28, 2005 and April 30, 2005. Available-for-sale investments with original maturities of greater than three months are classified as short-term investments, as these investments generally consist of highly marketable securities that are intended to be available to meet current cash requirements. Investment securities classified as available-for-sale are reported at fair market value, and net unrealized gains or losses are recorded in accumulated other comprehensive loss, a separate component of stockholders’ equity. Realized gains or losses on sales of investments are computed based upon specific identification and are included in interest income and other, net. For all periods presented, realized gains and losses on available-for-sale investments were not material. Management evaluates investments on a regular basis to determine if an other-than-temporary impairment has occurred and there were none as of October 28, 2005. The unrealized losses on these investments at October 28, 2005 were primarily due to interest rate fluctuations. We have the ability and intent to hold these investments until recovery of their carrying values. We also believe that we will be able to collect all principal and interest amounts due to us at maturity given the high credit quality of these investments. Accordingly, we do not consider these investments to be other-than-temporarily impaired at October 28, 2005.

 

Beginning in the third quarter of fiscal 2005, we have classified all investments in auction rate securities as short-term investments. To conform to current period presentation, we have reclassified $136,800 of auction rate securities from cash equivalents to short-term investments for the first half of fiscal 2005. The impact on the Consolidated Statements of Cash Flows was a decrease in cash used for investing activities of $12,022 for the first half of fiscal 2005. The reclassification had no impact on the Consolidated Statements of Income or Cash Flows from Operations for any of the periods presented.

 

12.  New Accounting Pronouncements

 

In June 2004, the FASB ratified Emerging Issues Task Force Issue (“EITF”) No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-1 includes new guidance for evaluating and recording impairment losses on debt and equity investments, as well as new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the Financial

 

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED

FINANCIAL STATEMENTS — (Continued)

Accounting Standards Board (“FASB”) approved the issuance of a FASB Staff Position to delay the recognition and measurement provisions of EITF 03-1. In June 2005, the FASB decided not to provide additional guidance on the meaning of other-than-temporary impairment under EITF 03-1. The FASB directed the staff to issue FASB Staff Position Paper (“FSP”) 115-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments (“ FSP 115-1”), superseding EITF 03-1. FSP 115-1 will replace the accounting guidance on the determination of whether an investment is other-than-temporarily impaired as set forth in EITF 03-1 with references to existing other-than-temporary impairment guidance. In November 2005, the 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 FASB Statement 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 beginning January 28, 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 October 2005, the FASB issued FASB Staff Position (“FSP”) FSP Nos. FAS 13-1, Accounting for Rental Costs Incurred during a Construction Period, (“FSP 13-1”) addresses the accounting for rental costs associated with operating leases that are incurred during a construction period. The adoption of the provisions of FSP 13-1 is not expected to have a material impact on our financial position or results of operations.

 

In June 2005, the FASB issued 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”). 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 March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligation.” (Interpretation No. 47). Interpretation No. 47 clarifies that an entity must record a liability for a “conditional” asset retirement obligation if the fair value of the obligation can be reasonably estimated. Interpretation No. 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. Interpretation No. 47 is effective no later than the end of the fiscal year ending after December 15, 2005. We are currently evaluating the provision and do not expect that our adoption in the fourth quarter of fiscal 2006 will have a material impact on our results of operations or financial condition.

 

In March 2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 107, which provides guidance on the implementation of Statement of Financial Accounting Standards (“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,

 

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED

FINANCIAL STATEMENTS — (Continued)

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. SAB No. 107 became effective on March 29, 2005. It did not 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.

 

SFAS No. 123R permits public companies to adopt its requirements using one of two methods: (1) a “modified prospective” method under which compensation cost is recognized beginning with the effective date based on the requirements of SFAS No. 123R for all share-based payments granted after the effective date and based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123R that are unvested on the effective date; or (2) a “modified retrospective” method which includes the requirements of the modified prospective method and also permits companies to restate either all prior periods presented or prior interim periods of the year of adoption using the amounts previously calculated for pro forma disclosure under SFAS No. 123. We have not yet determined which method we will select for our adoption of SFAS No. 123R.

 

As permitted by SFAS No. 123, we currently account for share-based payments to employees using APB No. 25’s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options through our consolidated statements of operations but rather, discloses the effect in its consolidated financial statement footnotes. Accordingly, the adoption of SFAS No. 123R’s fair value method will have a significant impact on our reported results of operations. However, the impact of the adoption of SFAS No. 123R cannot be quantified at this time because it will depend on levels of share-based payments granted in the future as well as other variables that effect the fair market value estimates, which cannot be forecasted at this time.

 

In January 2005, the FASB issued FASB Staff Position (“FSP”) No. FAS 109-1, “Application of SFAS No. 109 to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004.” (FSP No. 109-1) This FSP provides guidance for the accounting of a deduction provided to U.S. manufacturing companies and is effective immediately. We believe the adoption of this position currently will not have a material effect of its financial position or results of operations. However, there is no assurance that there will not be a material impact in the future.

 

In December 2004, the FASB issued FSP No. FAS 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004” (FSP No. 109-2). The American Jobs Creation Act introduces a special one-time dividends received deduction on the repatriation of certain foreign earnings to U.S. companies, provided certain criteria are met. FSP No. 109-2 provides accounting and disclosure guidance on the impact of the repatriation provision on a company’s income tax expense and deferred tax liability. We are currently studying the impact of the one-time favorable foreign dividend provision and intend to complete the analysis by the end of our fourth quarter of fiscal 2006. Accordingly, we have not adjusted income tax expense or deferred tax liability to reflect the tax impact of any repatriation of non-U.S. earnings.

 

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

 

NETWORK APPLIANCE, INC.

 

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FINANCIAL STATEMENTS — (Continued)

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.

 

13.  Commitments and Contingencies

 

The following summarizes our commitments and contingencies at October 28, 2005, and the effect such obligations may have on our future periods:

 

 

 

 

 

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FINANCIAL STATEMENTS — (Continued)

 

 

From time to time, we have committed to purchase various key components used in the manufacture of our products. We establish accruals for estimated losses on purchased components for which we believe it is probable that they will not be utilized in future operations. To the extent that such forecasts are not achieved, our commitments and associated accruals may change.

 

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

 

14.  Business Combinations

 

Acquisition of Decru

 

On August 26, 2005, we completed our acquisition of Decru, Inc. (“Decru”), a Delaware corporation that develops and sells encryption software and appliances which encrypt network data. The acquisition resulted in the issuance of approximately 8,270 shares of our common stock with a fair value of approximately $191,874, approximately 1,907 stock options and restricted stock with a fair value of approximately $36,142 and the payment of approximately $54,482 in cash (of which approximately $34,049 has been placed in escrow to secure the Decru stockholders’ indemnification obligations to us pursuant to the Merger Agreement), and $711 acquisition-related transaction costs, for a total purchase price of approximately $283,209. The common stock issued in the acquisition was valued at $23.20 per share using a measurement date of August 11, 2005 in accordance with EITF 99-12, Determination of the Measurement Date for the Market Price of Acquirer Securities Issued in a Purchase Business Combination. The options were valued using the Black-Scholes option pricing model with the following inputs: volatility factor of 69%, expected life of 3.8 years, risk-free interest rate of 2.9%, and a market value for Network Appliance’s stock of $23.20 per share, which was determined as described above. A summary of the total purchase price is as follows:

 

 

In accordance with SFAS 141, we have preliminarily allocated the purchase price to the estimated tangible and intangible assets acquired and liabilities assumed, including in-process research and development, based on their estimated fair values. The excess purchase price over those fair values is recorded as goodwill. Decru’s technology will augment our data protection and security solutions and provide for a wide variety of deployments with vendors’ storage systems in NAS, DAS, SAN, iSCSI, and even tape backup environments, which will allow us to pursue expanded market opportunities. These opportunities, along with the ability to leverage the Decru workforce, were significant contributing factors to the establishment of the purchase price, resulting in the recognition of a significant amount of goodwill. The fair values assigned to tangible and intangible assets acquired and liabilities assumed are based on management estimates and assumptions, and other information compiled by management, including third-party valuations that utilized established valuation techniques appropriate for the high-technology industry. Goodwill recorded as a result of this acquisition is not expected to be deductible for tax purposes. In accordance with SFAS 142, Goodwill and Other Intangible Assets (“SFAS 142”), goodwill is not amortized but will

 

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FINANCIAL STATEMENTS — (Continued)

be reviewed at least annually for impairment. Purchased intangibles with finite lives will be amortized over their respective estimated useful lives on a straight line basis. The purchase price has been preliminarily allocated as follows:

 

 

Useful lives are primarily based on the underlying assumptions used in the discounted cash flow models. The allocation is preliminary and subject to change if we obtain additional information concerning the fair values of certain acquired assets and liabilities of Decru.

 

Net Tangible Assets

 

Decru’s assets and liabilities as of August 26, 2005 were reviewed and adjusted, if required, to their estimated fair value. Included in net tangible assets acquired above are $13,277 of cash assumed in connection with the Decru acquisition.

 

Amortizable Intangible Assets

 

We valued the identified intangible assets utilizing a discounted cash flow (“DCF”) model, which uses forecasts of future revenues and expenses related to the intangible assets. We are amortizing these intangible assets over 2-6 years on a straight-line basis.

 

In-process Research and Development (“IPR&D”)

 

Of the total purchase price, $5,000 has been allocated to in-process research and development (“IPR&D”) and was expensed in the quarter ended October 28, 2005. Projects that qualify as IPR&D represent those that have not yet reached technological feasibility and which have no alternative future use. Technological feasibility is established when an enterprise has completed all planning, designing, coding, and testing activities that are necessary to establish that a product can be produced to meet its design specifications including functions, features, and technical performance requirement. The value of IPR&D was determined by estimating the stage of completion and risk associated with IPR&D to determine the level of discount rate to be applied, estimating costs to develop the

 

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED

FINANCIAL STATEMENTS — (Continued)

purchased IPR&D into commercially viable products, estimating the resulting net cash flows from the projects when completed and discounting the net cash flows to their present value based on the percentage of completion of the IPR&D projects.

 

 

On May 2, 2005, we acquired Alacritus, Inc., a privately held company based in Pleasanton, California, that develops and sells disk-based virtual tape library software for data protection solutions. Under terms of the agreement, we paid Alacritus $11,000 in cash and assumed options to acquire 79 shares of common stock at an average price of $26.37 per share and 43 shares of restricted stock units at $0 per share. We also incurred certain transaction costs and assumed certain operating assets and liabilities. The historical operations of Alacritus were not significant.

 

The acquisition was accounted for under the purchase method of accounting. The total purchase price for Alacritus and Decru are summarized below:

 

 

 

In accordance with FASB Interpretation No. 44, “Accounting for Certain Transactions involving Stock Compensation”, we recorded the intrinsic value, measured as the difference between the grant price and fair market value on the acquisition consummation date, of unvested options and restricted stock units assumed in the Alacritus and Decru acquisitions as deferred stock compensation. Such deferred stock compensation which aggregated $1,199 for Alacritus and $18,549 for Decru, are recorded as a separate component of stockholders’ equity in the accompanying condensed consolidated balance sheet and will be amortized over the vesting term of the related options. In connection with the Decru merger, we assumed all options to purchase Decru common stock granted under the Decru, Inc. 2001 Equity Incentive Plan that were outstanding at the closing of the Merger, which options shall be exercisable for an aggregate of 1,907 shares of our Common Stock at an average price of $11.86 per share.

 

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and 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 our new FAS 3000 will be a very competitive product; (2) our expectation that units shipped of the FAS 3000 will increase and FAS 960 and R200 units will continue to decline; (3) our expectation that the FAS 960 and R200 products will be gradually replaced by the FAS 3000 series and next-generation products for the remainder of fiscal 2006; (4) our belief that our FlexVol^tm and FlexClone^tm technologies will virtualize storage and improve utilization rates; (5) our expectation that the introduction of our new high-end products, targeted for shipping before the end of our fiscal 2006, will increase both performance and capacity and restore the balance between the sales of our midrange and high-end products; (6) our belief in the competitiveness of our products and our ability to grow our business; (7) our belief that our products continue to offer the best price-performance value in the industry; (8) our expectation to continue to introduce new products and to deliver our next-generation operating systems and data protection solutions; (9) our plan to invest in the people, processes and systems necessary to best optimize our revenue growth; (10) our expectation that higher disk content associated with high-end storage systems may negatively affect our gross margin; (11) our estimates of future intangibles and stock compensation amortization expense relating to our acquisitions; (12) our expectation that service margins will be in the mid 20% range for fiscal 2006; (13) our expectation that we will continue to add sales and professional services capacity; (14) our expectation that we will increase sales and marketing expenses commensurate with future revenue growth; (15) our intention to continuously broaden our existing product offerings and introduce new products; (16) our estimates regarding future capitalized patents amortization expenses and future amortization of existing technology; (17) our expectation that we will continuously support current and future product development and enhancement efforts and incur corresponding charges; (18) our belief that our research and development expenses will increase in absolute dollars for the remainder of fiscal 2006; (19) our belief that our general and administrative expenses will increase in absolute terms in the remainder of fiscal 2006; (20) our expectation that we may repatriate foreign earnings and pay taxes under the Jobs Act and our expectation of the amount to be repatriated and the consequent tax liability; (21) our expectation regarding estimated future deferred stock compensation amortization expenses and future amortization of intangible assets; (22) our expectation that interest income will increase for the remainder of fiscal 2006; (23) our expectations regarding our contractual cash obligations and other commercial commitments at October 28, 2005 for the remainder of fiscal 2006 and fiscal years 2007 through 2010 and thereafter; (24) our expectation that capital expenditures will increase consistent with our business growth; (25) our expectation that our existing facilities and those currently being developed, will be sufficient for our needs for at least the next two years 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; (26) our belief that our existing liquidity and capital resources are sufficient to fund our operations for at least the next twelve months; (27) our belief that foreign currency hedging contracts will not subject us to significant credit risk; (28) our belief that we have been able to compete successfully with our principal competitors based on the superior technology of our products; (29) our intent to regularly introduce new products and product enhancements; (30) the possibility that we may need to increase our materials purchases, contract manufacturing capacity and internal test and quality functions to meet anticipated demand; (31) our intention to continue to establish and maintain business relationships with technology companies; (32) the possibility that we may continue to engage in future acquisitions; (33) our expectation that we will increasingly rely on our indirect sales channel for a significant portion of our revenue; (34) our expectation that the ultimate costs to resolve any outstanding legal claims or proceedings will not be material to our business; (35) our expectation that companies in the appliance market will increasingly be subject to infringement claims as the industry grows; (36) our expectation that the value of our investments will not decline significantly because of changes in market interest rates, (37) our expectation regarding Advanced Technology Attachment’s (“ATA”) future impact on the storage market; (38) our expectation that our investments in emerging technologies will contribute to our long term

growth; (39) cash from operating activities may fluctuate in future periods; (40) our expectation that we will acquire products and businesses complementary to our business; (41) our expectation that both IBM and Decru will contribute more meaningful revenue over the second half of fiscal 2006 and beyond; (42) our expectation that we will incur additional charges of approximately $0.5 million associated with the global service center restructuring during the second half of fiscal 2006, and (43) our expectation that R&D costs to bring Decru products to technological feasibility will not be material, 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. 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 and factors described in the Risk Factors included on page 33.

 

Second Quarter Fiscal 2006 Overview

 

We achieved growth in revenue and profitability during the second quarter of fiscal 2006, driven primarily by our new FAS 3000 midrange product line. Product revenues growth was primarily in the U.S. and Europe. The increase in product revenues year over year was specifically attributable to increased software licenses and software subscriptions, an increase in units shipped of the new FAS 3000 series, partially offset by declines in units shipped of our FAS 960 and R200 products. We continue to make progress across many areas of the organization, including broadening and enhancing our enterprise solutions, supporting our channel/partners, and deepening our professional services coverage. We also expanded our leadership in data security with the completion of the acquisition of Decru; demonstrated growth in iSCSI, NAS and SAN; and expanded our operations in Research Triangle Park, North Carolina.

 

We believe our new FAS 3000 series delivers the best value and cost per megabyte to our customers. 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^tm and FlexClone^tm technologies, the FAS 3000 allows more cost-effective “ATA” drives to be used safely in primary storage applications, which we believe will be a competitive product in the marketplace. We believe our FlexVol and FlexClone technologies are the beginning of a paradigm shift in the industry: using software to virtualize storage and improve utilization rates. We believe our products continue to offer the best price-performance value in the industry, and we further extended our ability to help customers “do-more-with-less” with the introduction of our FAS 3000 midrange series.

 

We expect unit shipments of the FAS 3000 to increase and unit shipments of the FAS 960 and NearStore R200 to continue to decline in the second half of fiscal 2006. We expect the FAS 960 and lower-capacity NearStore products to be gradually replaced by the FAS 3000 series products. However, this shift to the FAS 3000 may negatively impact our revenue in the near term as the dollar value of our FAS 3000 sales may be lower compared to sales of our FAS 960 and R200 products. We also saw a sequential decline in FAS 980, both in units shipped and in revenue, quarter-over-quarter, as customers deployed clustered FAS 3000s as an alternative solution. In the longer term, we expect this decline in the high-end products to be mitigated by the introduction of our next-generation high-end products, which is targeted for shipping before the end of our fiscal 2006. We also expect this introduction will increase both performance and capacity compared to the FAS 980, and will restore the balance between the sales of our high-end and mid-range products.

 

Continued revenue growth is dependent on the introduction and market acceptance of our new products. In the second half of fiscal 2006, we expect to introduce new products, deliver our next-generation operating system with enhanced storage grid functionality and enhance our suite of data protection solutions. If we fail to timely introduce new products or successfully integrate acquired technology into our existing architecture, or if there is no or reduced demand for these or our current products, we may experience a decline in revenue. We plan to continue 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.

Second Quarter Fiscal 2006 Financial Performance

 

 

Results of Operations

 

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

 

 

Discussion and Analysis of Results of Operations

 

Product Revenues — Product revenues increased by 26.1% to $424.8 million for the second quarter of fiscal 2006, from $336.8 million for the second quarter of fiscal 2005. Product revenues increased by 23.9% to $819.4 million for the first half of fiscal 2006, from $661.4 million for the first half of fiscal 2005.

 

Product revenues were favorably impacted by the following factors:

 

 

Product revenues were negatively impacted by the following factors:

 

 

The Decru acquisition and the IBM OEM relationship did not have a significant impact on the second quarter and the first half of fiscal 2006 revenue. We expect both IBM and Decru will contribute more meaningful revenue over the second half of fiscal 2006 and beyond. However, we cannot assure you that we will be able to maintain or increase market demand for our products.

 

Service Revenues — Service revenues, which include hardware support, professional services, and educational services, increased by 51.9% to $58.3 million in the second quarter of fiscal 2006, from $38.4 million in the second quarter of fiscal 2005. Service revenues, which include hardware support, professional services, and educational services, increased by 55.3% to $112.1 million in the first half of fiscal 2006, from $72.2 million in the first half of 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 the remainder of fiscal 2006.

 

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 12.1% and 12.0% of total revenues for the three and six-month periods ended October 28, 2005, respectively, and 10.2% and 9.8% of total revenues for the three and six-month periods ended October 29, 2004, respectively.

 

International total revenues — International total revenues (including United States exports) increased by 24.9% and 23.3% for the three and six-month periods ended October 28, 2005 as compared to the same periods in fiscal 2005. International total revenues were $194.3 million and $376.0 million, respectively, or 40.2% and 40.4% of total revenues, respectively, for the three and six-month periods ended October 28, 2005. International total revenues were $155.6 million and $304.9 million, respectively, or 41.5% and 41.6% of total revenues, respectively, for the three and six-month periods ended October 29, 2004. The increase in international sales in absolute dollars was primarily a result of European net revenue growth, driven by increased demand for our solutions, new customers and higher storage spending in certain geographic regions as compared to the same periods in the prior fiscal year. We cannot assure you that we will be able to maintain or increase international revenues in the remainder of fiscal 2006.

 

Product Gross Margin — Product gross margins were 66.8% for both the second quarters of fiscal 2006 and 2005. Product gross margin increased to 66.5% for the first half of fiscal 2006, from 65.8% for the first half of fiscal 2005.

 

Product gross margin was favorably impacted by: