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:

 

 

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

None

 

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.

 

Large accelerated filer þ          Accelerated filer o          Non-accelerated filer o

 

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 27, 2006, the last day of Registrant’s most recently completed second fiscal quarter, was $7,421,945,441 (based on the closing price for shares of the Registrant’s common stock as reported by the NASDAQ Global Select 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 22, 2007, 363,479,924 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 September 5, 2007, which will be filed with the Securities and Exchange Commission not later than 120 days after April 27, 2007.

 

 

TABLE OF CONTENTS

 

 

TRADEMARKS

 

^©2007 Network Appliance, Inc. All rights reserved. Specifications subject to change without notice. NetApp, the Network Appliance logo, DataFabric, Data ONTAP, FAServer, FilerView, FlexClone, FlexVol, MultiStore, NearStore, NetCache, SecureShare, SnapDrive, SnapLock, SnapManager, SnapMirror, SnapRestore, SnapVault, SyncMirror, Topio, VFM, and WAFL are registered trademarks and Network Appliance, ApplianceWatch, FlexShare, LockVault, Protection Manager, RAID-DP, ReplicatorX, Snapshot, StoreVault, and Virtual File Manager are trademarks of Network Appliance, Inc. in the U.S. and other countries. Decru and Decru DataFort are registered trademarks of Decru, a NetApp company. 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 expectation to pay lease payments on our lease arrangements; (3) our expectation that our existing facilities and those being developed are adequate for our requirements over at least the next two years; (4) our anticipation that we will retain all available funds to finance internal growth and product development as well as other possible management initiatives; (5) our belief that our strategic investments are targeted at some of the strongest growth areas of the storage market; (6) our anticipation that we will experience further price decline per petabyte for our hardware products; (7) our expectation that our future gross margins will be negatively affected by various factors such as global service investment cost and competition; (8) our belief that our products continue to offer the best price-performance value in the industry; (9) our anticipation regarding the SAN competitiveness of our new products; (10) our expectation that higher disk content associated with high-end storage systems will negatively affect our gross margins in the future; (11) our estimates regarding future amortization of existing technology relating to our acquisitions; (12) our expectation that service margins will experience some variability; (13) our estimates regarding future amortization of trademarks, tradenames, customer contracts, and relationships relating to our acquisitions; (14) our expectation that we will continue to selectively add sales capacity in an effort to expand domestic and international markets; (15) our expectation that we will increase our sales and marketing expenses commensurate with future revenue growth; (16) our estimates regarding future capitalized patents amortization expenses; (17) 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 customer requirements; (18) our expectation that we will continuously support current and future product development and enhancement efforts and incur corresponding charges; (19) our intention to continuously broaden our existing product offerings and introduce new products; (20) our belief that our research and development, and general and administrative expenses will increase in absolute dollars in fiscal 2008; (21) our estimates regarding future amortization of covenants not to compete relating to our acquisitions; (22) our expectation that interest income will increase in fiscal 2008; (23) our belief that period-to-period changes in foreign exchange gains or losses will continue to be impacted by hedging costs associated with our forward and option activities and forecast variance; (24) our expectation that cash provided by operating activities may fluctuate in future periods; (25) the possibility we may receive less cash from stock option exercises if stock option exercise patterns change; (26) our expectations regarding our contractual cash obligations and other commercial commitments at April 27, 2007, for future periods; (27) our expectation regarding the complete construction of our building under the BNP lease and the estimates regarding future minimum lease payments under the lease term; (28) our expectation that capital expenditures will increase consistent with our business growth; (29) our expectation that we will incur higher capital expenditures in the near future to expand our operations; (30) 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; (31) 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 twelve months; (32) 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, and (33) our belief that the results of our GSA audit will not have a materially adverse effect on us, 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 build non-deferred backlog to levels more consistent with our past results and to increase our revenue over the next several quarters (5) our ability to successfully introduce new products; (6) our ability to achieve and capitalize on changes in market demand; (7) acceptance of, and demand for, our products; (8) demand for our global service and support and professional services; (9) our ability to identify and respond to significant market trends and emerging standards; (10) our ability to realize our financial objectives through increased investment in people, process, and systems; (11) our ability to maintain our supplier and contract manufacturer relationships; (12) the ability of our competitors to introduce new products that compete successfully with our products; (13) our ability to expand direct and indirect sales and global service and support; (14) the general economic environment and the continued growth of the storage markets; (15) our ability to sustain and/or improve our cash and overall financial position; (16) the results of our GSA audit; and (17) 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 20.

 

Overview

 

Network Appliance, Inc. (“Network Appliance” or “NetApp”), a Delaware corporation, is a leading provider of data management solutions that simplify the complexities of storing, managing, protecting, and archiving enterprise data. NetApp has a broad portfolio of data-center proven solutions that deliver unmatched simplicity and value. Meeting the needs of today’s data center means delivering not only products of the highest quality and reliability, but also products that can meet the expansive requirements and demanding service-levels of today’s critical business applications. To better meet these requirements, NetApp has partnerships with key industry leaders such as IBM Corporation (“IBM”), Microsoft Corporation (“Microsoft”), Oracle Corporation (“Oracle”), SAP Corporation (“SAP”), Symantec Corporation (“Symantec”), and VMware, Inc. (“VMware”), with whom we work closely to ensure our integrated solutions work well together.

 

NetApp was founded in 1992 with the goal of simplifying data management. We shipped the world’s first network storage appliance a year later. Since then, we have brought to market many significant advancements in storage and data management, and we have introduced technologies to increase the efficiency and reliability of enterprise storage systems. These are the result of applied innovation — solutions specifically designed to help customers quickly adapt and respond to change. The company has grown to over 6,600 employees. To date, thousands of customers in 138 countries around the world have deployed more than 94,000 NetApp systems.

 

The NetApp approach to delivering value to our customers is unique. Our unified architecture offers unparalleled scalability and flexibility. It also employs a single set of software and processes across all attachment types and tiers of storage, increasing the efficiency of our customers’ people, systems, processes, and business.

 

From the quality and reliability of the products we ship, to the support and services we provide, to our financial interactions, to the way we manage customer accounts, we strive to go beyond “customer satisfaction” to help our customers succeed in their businesses. We measure our success by our customers’ success, and we work to form long-lasting partnerships with our customers and partners, built on the principles of trust and integrity.

 

NetApp endeavors to provide the lowest total cost of ownership (“TCO”) by offering a broad portfolio of solutions that:

 

 

 

Customer Challenges

 

Network Appliance^tm 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.

 

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 any 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 Data ONTAP operating system includes two standard features, FlexVol^tm and FlexShare^tm, which improve the effectiveness of consolidation. FlexVol creates volumes that can be readily expanded or contracted while reducing the need for spare capacity. FlexShare enables the consolidation and prioritization of disparate workloads by ensuring that critical workloads get fast response.

 

The operating system also includes integrated secure access capabilities and FilerView^®, a Web-based element manager. Snapshot technology, included as part of the base system, enables 256 virtual 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.

 

Data ONTAP GX is our high-performance operating system, to support fully integrated, multinode systems. Data ONTAP GX systems are optimized to meet the extreme performance requirements of high-performance computing applications running on large Linux^® and UNIX clusters, while delivering unmatched management simplicity and reliability. 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. NetApp is in the process of merging the features of Data ONTAP 7G with Data ONTAP GX.

 

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, FlexClone^®, FlexShare^tm, FlexCache and MultiStore^®.

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 2007 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.

 

FlexCache

 

FlexCache technology allows the creation of read-writeable replicas of volumes by creating caching volumes on multiple storage controllers. FlexCache technology is used by top enterprise customers in compute farm environments to scale Network File System (“NFS”) read I/O operations per second by surrounding volumes with multiple storage controllers. FlexCache technology is also used in distributed environments to improve user productivity by providing locally cached access to remote volumes over NFS.

 

MultiStore

 

NetApp MultiStore software lets you quickly and easily create completely separate logical partitions in storage systems and network storage resources. Each virtual storage partition maintains absolute separation from every other storage partition. The result is that different enterprise departments sharing the same storage resources cannot access or in any way find other partitions. MultiStore assures that no information on any virtual partition can be viewed, used, or downloaded by unauthorized users.

 

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 network (“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.

 

 

When installed with the NearStore software bundle, the FAS6000 systems are optimized for secondary disk operations (data protection and retention) and are flexible disk-based near-line storage systems that combine the powerful Data ONTAP operating system with economical, high-capacity disk drives providing the performance, reliability, and flexibility of disk storage at near-tape storage costs.

 

 

V-Series Family

 

NetApp V-Series is a network-based solution that consolidates storage arrays from different suppliers behind the NetApp data management interface, enabling unified SAN and NAS file access to data stored in 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 will be able to:

 

 

The V-Series family includes V3000 and V6000 models and supports storage arrays from EMC Corporation (“EMC”), IBM, Hewlett-Packard (“HP”), Hitachi Data Systems (“HDS”), and Fujitsu.

 

Data Protection Software Products

 

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

 

MetroCluster, SnapMirror^®, SyncMirror^®, 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 automatic 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 Protection Platform Products

 

In recent years, enterprises have centralized terabytes of data into networked storage environments to achieve lower costs, higher utilization, and simplified management. However, geopolitical events such as September 11, 2001; natural disasters such as the Hurricane Katrina 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 thefts of laptops 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 to 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 cost-effective SATA-based storage with built-in data reduction capabilities, disk-to-disk backup solutions, a family of replication and business continuance solutions, compliance and security solutions, and tools to manage this information ecosystem.

 

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 the 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. Our DataFort^® 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 multimedia 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, as well as meet the electronic discovery needs for our customers.

 

NearStore

 

The NetApp NearStore family of products 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 near-line 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 7TB to 336TB 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 benefits to the customer are 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 hardware-accelerated compression and tape smart sizing capabilities. Hardware-accelerated compression enables NearStore VTL to compress backup data onto disk at very high sequential throughput rates (up to 1900MB/sec in the most high-end NetApp VTL solution), thus enabling large amounts of customer data to be backed up in short amounts of time while using VTL disk very efficiently. Tape smart sizing enables physical tape utilization that is far more efficient than is possible with other VTLs that directly create physical tapes.

 

Storage Security Products

 

Security has become a critical element of data management, and NetApp has taken a leading role in driving security innovation. Our DataFort storage security appliances provide a unified platform for enterprise-wide security, including heterogeneous NAS, IP SAN, FC SAN, and tape backup environments. The platform combines wire-speed encryption, access controls, authentication, and automated key management to provide strong security for data at rest.

NetApp works closely with many of the major storage and networking vendors, including Brocade Communication Systems, Inc.; Cisco Systems, Inc.; EMC and its RSA business unit; HP; IBM; Quantum Corporation; Sun Microsystems, Inc.; and Symantec to offer joint solutions and provide ongoing interoperability testing.

 

Storage Management and Application Software

 

Our Network Appliance management software family of products provides comprehensive storage and data management tools to simplify IT administration and enhance flexibility and productivity. NetApp delivers our own differentiated products and collaborates with industry open standards and interfaces to deliver this value to our customers.

 

NetApp has four suites of products targeted to different IT administrative roles:

 

Storage Suite

 

 

Data Suite

 

 

Server Suite

 

 

Application Suite

 

 

Industry Collaboration with Open Standards and Interfaces

 

 

 

StoreVault^tm

 

StoreVault is an Enterprise-proven ONTAP technology developed to focused on serving small to medium-sized businesses (“SMBs”). The product is exclusively sold through value added resellers (“VAR”) in the U.S. and has garnered several accolades for its industry-leading ease of use and simplicity. StoreVault is the only packaging of advanced enterprise storage technologies that has been simplified and made available for SMB use. To serve this high-volume, low-cost market, StoreVault has innovated on multiple dimensions, including product, manufacturing, support and distribution. It is currently in the channel expansion phase.

 

Content Delivery (NetCache^®)

 

In order to focus resources on core storage and data management solutions, NetApp sold the NetCache assets during the year. NetCache solutions required technology investments that were not synergistic with our storage investments, as its internet access and security (“IAS”) and wide area network (“WAN”) optimization offerings were sold to different buyers within enterprise customers. For the long-term success of our customers, employees, and overall business, on September 11, 2006, NetApp completed the sale of NetCache business assets to Blue Coat Systems, Inc.

 

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 nondisruptively, 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 work 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 138 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 (“SMBs”). We have also expanded into the virtual tape library and data encryption markets, bringing us into parts of the data center we have not competed in before. With our next-generation operating system, Data ONTAP GX, we offer a 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, original equipment manufacturers (“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 2007, 2006, or 2005.

 

The NetApp and IBM OEM 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.

 

NetApp Global Services

 

NetApp Global Services brings a valuable mix of data center management and storage expertise combined with a strategic business focus to give customers a full range of professional services designed to provide our customers with comprehensive, enduring storage solutions. From assessment, design and implementation, custom consulting, and ongoing storage management, our Professional Services team provides the expertise our customers require to more efficiently manage their storage environments and the people and processes that support them.

 

Our Global Support Services 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:

 

Global Support 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. The Network Appliance Global Support portfolio features sophisticated monitoring and diagnostic tools plus regular system availability audits of installed equipment to help anticipate problems before they affect availability.

 

Professional Services is designed to address 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

 

We have manufacturing operations in insourced and outsourced locations in Sunnyvale, San Jose, and Fremont, California; Livingston, Scotland; Shanghai, China; Tao Yuan Shien, Taiwan; and Schiphol Airport, The Netherlands. These operations 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. This manufacturing strategy minimizes capital investments 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.

 

See “Risk Factors — We rely on a limited number of suppliers” and “Risk Factors — The loss of our contract manufacturers.”

 

Research and Development

 

We conduct research and development activities in various locations throughout the world. In fiscal 2007, 2006 and 2005, research and development expenses represented 13.7%, 12.2% and 11.0% of our total revenue, respectively. These costs relate primarily to personnel and related costs incurred to conduct product development activities. Although we develop many of our products internally, we may acquire technology through business combinations or through licensing from third parties when appropriate. Our expenditures on research and development activities in the last three fiscal years are discussed below under Management’s Discussion and Analysis of Financial Condition and Results of Operations — Research and Development. We believe that technical leadership is essential to our success and we expect to continue to commit substantial resources to research and development.

 

The research and development investment in fiscal year 2007 continued to emphasize innovation and enterprise solutions. The storage platform family has been expanded from entry-level solutions through highly scalable clusters. This is represented by the StoreVault S500 at the low end through the FAS3040, FAS3070, FAS6030 and FAS6070 at the high end. The S500, ideally suited for SMBs, can be configured with a minimum of 1TB of storage. The highly clusterable FAS family can exceed a breakthrough 6PB in capacity. NetApp continues to be unique in running a single storage appliance operating system, Data ONTAP, across the breadth of our product line.

 

With the introduction of Data ONTAP GX in June 2006, NetApp delivered its most scalable solutions to date. This system can satisfy the most demanding capacity and I/O requirements found in the high-performance computing and technical application markets. The outstanding performance of this system was demonstrated by its ability to exceed 1 million operations per seconds using the industry standard and audited SPEC benchmark. This is more than triple the performance of the highest previously reported SPEC results.

 

Our software portfolio has grown over the past year. New network and protocol capabilities have been delivered throughout the year. Examples include support for 10 Gigabit Ethernet, iSCSI boot, Microsoft Simple

SAN, and Microsoft multipathing support. We have introduced new versions of SnapManager for Oracle, SnapManager for Microsoft Exchange and SnapManager for SAP. Protection Manager is now available and brings a new level of simplicity to automated backup and replication for disk-to-disk recovery. We have also delivered the next-generation autosupport system that is well integrated with NetApp Global Support services.

 

The V-Series product line has gained traction this year. The V-Series brings the NetApp ease of use and powerful virtualization capabilities to an expanded set of third-party storage arrays that include EMC, IBM, HP, HDS, Fujitsu, and others. Also, in FY07 we added new platforms to the product offering, including the V3040, V3070, V6030, and V6070.

 

The NetApp DataFort FC1020 was recognized as the “Innovation of the Year” by PC Professional in 2006. The unique DataFort approach to encryption of data at rest, authentication, key management, and access control addresses the security requirements in demanding and regulated enterprise environments.

 

The NearStore VTL products experienced healthy growth throughout the year, especially among large enterprise customers, as several important new capabilities were added, including hardware-accelerated data compression, support for the ACSLS protocol required by many high-end tape libraries, and a doubling of both maximum system performance and storage capacity. The development of next-generation technologies such as deduplication is expected to further the adoption of NetApp disk-to-disk backup solutions as customers continue to repurpose and downsize their existing tape backup systems.

 

Our Topio^tm acquisition allows for heterogeneous any-to-any data replication for disaster recovery, application support, and data migration. ReplicatorX^tm enables IT organizations to replicate, recover, and protect data over any distance regardless of the source or target storage solution. Furthermore, due to ReplicatorX and Data ONTAP integration, it allows a broad set of potential customers to quickly and easily benefit from the powerful Data ONTAP capabilities such as FlexVol and FlexClone.

 

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

 

Our operating results have not been significantly affected by seasonality in the past. In the future, as we expand our presence internationally and into other vertical markets, we may experience more seasonality in the sale of our products. For example, sales to European customers tend to be weaker in the summer months and sales to the U.S. government are typically stronger in the third calendar quarter.

 

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.

 

See “Risk Factors — Factors beyond our control could cause our quarterly results to fluctuate.”

 

Competition

 

The storage market is intensely competitive and is characterized by rapidly changing technology and rapidly changing business models.

 

In the storage market, our primary and near-line storage system products and our associated storage software portfolio compete primarily with storage system products and data management software from EMC, HDS, HP, IBM, and Sun Microsystems. We also see Dell, Inc. (“Dell”) as an emerging competitor in the storage marketplace, primarily due to the 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 the Storage Systems Group of LSI Logic Corporation (“LSI Logic”). In the near-line 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.

 

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

 

See “Risk Factors — An increase in competition could materially and 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^®, FlexVol, FilerView, NearStore, NetApp, NetCache, SecureShare, SnapDrive, SnapLock, SnapManager, SnapMirror, SnapRestore, SnapVault, WAFL, and others as trademarks in the U.S.. 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 27, 2007, we had 6,635 employees. Of the total, 2,500 were in sales and marketing, 1,698 in research and development, 759 in finance and administration, and 1,678 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 25, 2007, are as follows:

 

 

Daniel J. Warmenhoven joined Network Appliance 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 equipment 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 Aruba Networks, Inc. Mr. Warmenhoven holds a B.S. degree in electrical engineering from Princeton University.

 

Thomas F. Mendoza joined Network Appliance in 1994 and has served as president since 2000. From 1994 to 2000, he served in various capacities including senior vice president, worldwide sales and marketing, senior vice president, worldwide sales and vice president, North American sales. Mr. Mendoza has more than 30 years of experience as a high-technology and has held executive positions at Auspex Systems, Inc. and Stratus Technologies, Inc. He holds a B.A. 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 in honor of an endowment from Tom and his wife, Kathy.

 

Thomas Georgens joined Network Appliance in October 2005 and has served as the Company’s executive vice president of product operations since January 2007. From October 2005 to January 2007, he served as the Company’s executive vice president and general manager of enterprise storage systems. Prior to joining the Company, Mr. Georgens served in various capacities from 1996 to 2005, including president, chief executive officer, vice president and general manager and a director of LSI Logic. Mr. Georgens graduated from Rensselaer Polytechnic Institute with a B.S. and M.S. degrees in computer and systems engineering, and also holds an M.B.A. from Babson College.

 

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 M.B.A. from Santa Clara University and a B.S. degree in business administration from Oregon State 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 in computer science.

 

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 occurs, 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 intraquarter seasonality patterns weighted toward the back end of the quarter. If we do not achieve bookings in the latter part of a quarter consistent with our quarterly financial targets, our financial results will be adversely impacted. If revenues do not meet our expectations, our operating profit may be negatively impacted because portions of our expenses are fixed and difficult to reduce in a short period of time. If our revenues are lower than expected, our fixed expenses could adversely affect our net income and cash flow until revenues increase or until such fixed expenses are reduced to a level commensurate with revenues.

 

For example, due to macroeconomic conditions and an IT spending slowdown in the U.S., our fourth quarter fiscal 2007 bookings were back-end loaded and finished lower than our forecast. In addition, in the last two weeks of the fourth quarter in fiscal 2007, we experienced a shift in the mix of our bookings towards more deferred elements. As a result, we did not build our normal levels of non-deferred backlog at the end of the fourth quarter, which will impact the first quarter of fiscal 2008. Without the benefit of normal backlog, we do not expect our usual level of growth in first quarter revenue, and as a result, our expense levels as a percentage of our revenue will be above our targeted business model. Given the lack of growth in our non-deferred backlog, we lowered our forecasts for the first quarter of fiscal 2008 in revenues, operating margins and earnings.

 

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.

 

The marketplace 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.

 

Macroeconomic conditions and IT spending slowdown in the U.S as well as variations in our expected operating performance may continue to cause volatility in our stock price. We are unable to predict changes in general economic conditions and when global IT spending rates will be affected. Furthermore, if there are future reductions in either domestic or international IT spending rates, or if IT spending rates do not increase, our revenues, operating results and stock price may continue to be adversely affected.

 

Our forecasts of our revenues and earnings outlook may be inaccurate and could materially and adversely impact our business or our planned results of operations.

 

Our revenues are difficult to forecast. We use a “pipeline” system, a common industry practice, to forecast revenues and trends in our business. Sales personnel monitor the status of potential business and estimate when a customer will make a purchase decision, the dollar amount of the sale and the products or services to be sold. These estimates are aggregated periodically to generate a sales pipeline. Our pipeline estimates may prove to be unreliable either in a particular quarter or over a longer period of time, in part because the “conversion rate” of the pipeline into contracts varies from customer to customer, can be difficult to estimate and requires management judgment. Small deviations from our forecasted conversion rate may result in inaccurate plans and budgets and materially adversely impact our business or our planned results of operations. In particular, a slowdown in IT spending or weak economic conditions or evolving technology generally can reduce the conversion rate in a particular quarter as our customers’ purchasing decisions are delayed, reduced in amount or cancelled. Moreover, even after contracts have been executed, extensive analysis is required before the timing of revenue recognition can be reliably determined; this delay reflects both the complexity of the revenue recognition rules applicable to software and the effect that the multiple element arrangements and other terms and conditions can have when these rules are applied.

 

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, or if we cannot provide the level of service and support for our new 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.

 

As we enter into new or emerging markets, we will likely increase demands on our service and support operations and may be exposed to additional competition. We may not be able to provide products, service, and support to effectively compete for these market opportunities. Further, provision of greater levels of services from us may result in a delay in the timing of revenue recognition.

 

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, HP, IBM, and Sun/StorageTek. We also see Dell, Inc. as a competitor in the storage marketplace, primarily through its business partnership with EMC, allowing Dell to resell EMC storage hardware and software products. We have also historically encountered less-frequent competition from companies including LSI Logic. 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/StorageTek. Our NearStore VTL appliances also compete with traditional tape backup solutions in the broader data backup/recovery space. Additionally, a number of small, new, privately-held companies are currently attempting to enter the storage systems and data management software markets and the near-line and NearStore VTL storage markets, some of which may become significant competitors in the future.

 

There has been a trend toward industry consolidation in our markets for several years. We expect this trend to continue as companies attempt to strengthen or hold their market positions in an evolving industry and as companies are acquired or are unable to continue operations. We believe that industry consolidation may result in stronger competitors that are better able to compete as sole-source vendors for customers. In addition, current and potential competitors have established or may establish 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 for components such as disk drives, computer boards, and microprocessors utilized in the assembly of our products. In recent years, rapid industry consolidation has led to fewer component suppliers, which could subject us to periodic supply constraints and price rigidity.

 

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 and prospective customers and suppliers.

 

In addition, we license certain technology and software from third parties that are 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 27, 2007, 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 U.S. 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.

We are also exposed to unfavorable economic and market conditions and the uncertain geopolitical environment.

 

Our operating results may be adversely affected by unfavorable economic and market conditions and the uncertain geopolitical environment. 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.

 

Recent turmoil in the geopolitical environment in many parts of the world, including terrorist activities and military actions, particularly the continuing tension in and surrounding Iraq, and changes in energy costs may continue to put pressure on global economic conditions. If the economic and market conditions in the U.S. and globally do not improve, or if they deteriorate, we may experience material impacts on our business, operating results, and financial condition.

 

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 and 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 are currently undergoing federal income tax audits in the U.S. and several foreign tax jurisdictions. The rights to some of our intellectual property (“IP”) are owned by certain of our foreign subsidiaries, and payments are made between U.S. and foreign tax jurisdictions relating to the use of this IP. 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 face increased risks and uncertainties related to our current or future acquisitions and nonmarketable securities, 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 to realize anticipated synergies, economies of scale, or other value. Integration risks and issues may include, but are 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.

 

On occasion, we invest in nonmarketable securities of private companies. As of April 27, 2007, the carrying value of our investments in nonmarketable securities totaled $8.9 million. Investments in nonmarketable securities are inherently risky, and some of these companies are likely to fail. Their success (or lack thereof) is dependent on these companies product development, market acceptance, operational efficiency and other key business success factors. In addition, depending on these companies’ future prospects, they may not be able to raise additional funds when needed or they may receive lower valuations, with less favorable investment terms than in previous financings, and our investments in them would likely become impaired. In fiscal 2007, we recorded a $2.1 million write-down relating to our investments in two privately-held companies.

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 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; therefore we cannot assure you that this relationship will contribute any revenue in future years. In addition, we have no control over the products that IBM selects to sell, or their release schedule and timing of those products; nor do we control their pricing. In the event that sales through IBM will increase, 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 that 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 cannot assure you that we are able to maintain existing resellers and 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 (“VAR”), systems integrators, distributors, OEMs, and strategic business partners, and we derive a significant portion of our revenue from these indirect channel partners. In fiscal 2007, our indirect channels accounted for 59.6% of our consolidated revenues.

 

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 effectively manage 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 27, 2007, 44.7% of our total revenues was 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. Conversely, lowering our price in local currency may result in lower U.S.-based revenue. 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 until forecasted transactions occur, at which time such realized gains and losses are recognized in earnings. 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.

 

Our operating results have not been significantly affected by seasonality in the past. In the future, as we expand our presence internationally, we may experience more seasonality in the sale of our products. For example, sales to European customers tend to be weaker in the summer months, which is our first fiscal quarter.

 

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.

 

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, investing in people, facilities and capital equipment, and managing our assets. 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.

In addition, continued expansion 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.

 

As we continue to grow our business, we are likely to incur costs earlier than some of the anticipated benefits, which could harm our operating results. A significant percentage of our expenses are fixed, which could materially and adversely affect our net income.

 

We are increasing our investment in engineering, sales, service support, and other functions to grow our business. We are likely to recognize the costs associated with these increased investments earlier than some of the anticipated benefits and the return on these investments may be lower, or may develop more slowly, than we expect, which could harm our business.

 

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.

 

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 that 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 caused 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, background, 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 errors, 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. Product quality problems could lead to reduced revenue, gross margins, and net income.

 

Our products may contain undetected software errors, 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 fail to remedy a product defect, we may experience a failure of a product line, temporary or permanent withdrawal from a product or market, damage to our reputation, inventory costs, or product reengineering expenses, any of which could have a material impact on our revenue, margins, and net income.

 

In addition, we may be subject to losses that may result or are alleged to result from defects in our products, which could subject us to claims for damages, including consequential damages. Based on our historical experience, we believe that the risk of exposure to product liability claims is currently low. However, should we experience increased exposure to product liability claims, our business could be adversely impacted.

 

We are exposed to various risks related to legal proceedings or claims and protection of intellectual property rights, which could adversely affect our operating results.

 

We are a party to lawsuits in the normal course of our business. Litigation can be expensive, lengthy, and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict. An unfavorable resolution of a particular lawsuit could have a material adverse effect on our business, operating results, or financial condition.

 

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 U.S.. 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 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 27, 2007, 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.

 

Because new and modified laws, regulations, and standards are subject to varying interpretations in many cases due to their lack of specificity, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies. This evolution may result in continuing uncertainty regarding compliance matters and additional costs necessitated by ongoing revisions to our disclosure and governance practices.

 

Our ability to forecast earnings is limited by the impact of new accounting requirements such as SFAS No. 123R.

 

The Financial Accounting Standards Board requires companies to recognize the fair value of stock options and other share-based payment compensation to employees as compensation expense in the statement of income. Option pricing models require the input of highly subjective assumptions, including the expected stock price volatility, expected life, and forfeiture rate. We have chosen to base our estimate of future volatility using the implied volatility of traded options to purchase the Company’s common stock as permitted by SAB No. 107. As of April 29, 2006, the contractual life of our stock options was 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 requires us to use estimated forfeitures, and therefore the adoption of SFAS No. 123R could have a material impact on the timing of and, based on the accuracy of estimates of future actual forfeitures, the amount of stock-based compensation expense. Given the unpredictable nature of the “Black Scholes” variables and other management assumptions such as number of options to be granted, underlying strike price, and associated income tax impacts, it is very difficult to estimate stock-based compensation expense for any given quarter or year. Any changes in these highly subjective assumptions may significantly impact our ability to make accurate forecasts of future earnings and volatility of our stock price. 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.

 

The U.S. government has contributed to our revenue growth and has become an important customer for us.

 

The U.S. government has become an important customer for the storage market and for us; however, government demand is unpredictable, and there is no guarantee of future revenue growth from the U.S. government. 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.

The General Services Administration (“GSA”) is currently auditing our records under the schedule contracts it had with us to verify our compliance with various contract provisions. If the audit determines that we did not comply with such provisions, we may be required to pay the GSA a potential settlement. The exact date for completion of the audit and the subsequent negotiation process is unknown and may not be concluded for some time. Our management does not believe, based upon information currently known to us that the final resolution of our audit will have a material adverse effect upon our consolidated financial position and the results of operations and cash flows.

 

None.

 

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 two lease arrangements with BNP Paribas LLC (“BNP”) for approximately 380,000 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 first lease in October 2007 for a term of five years, and the second lease in September 2008 for a term of five years. We have the option to renew both leases for two consecutive five-year periods upon approval by BNP.

 

We lease other sales offices and research and development facilities throughout the U.S. 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 Global Select Market on November 21, 1995, and is traded under the symbol “NTAP.” As of April 27, 2007 there were 1,234 holders of record of the common stock. The closing price for our common stock on June 22, 2007 was $31.20. 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 Global Select Market.

 

 

The following graph shows a five-year comparison of cumulative total return on our common stock, the NASDAQ Composite Index and the S&P 500 Information Technology Index from April 30, 2002 through April 30, 2007. The past performance of our common stock is no indication of future performance.

 

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among Network Appliance, Inc., The NASDAQ Composite Index
And The S&P Information Technology Index

 

 

 

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 2007 Annual Meeting of Stockholders.

 

Unregistered Securities Sold in Fiscal 2007

 

We did not sell any unregistered shares of our common stock during fiscal 2007.

 

Issuer Purchases of Equity Securities

 

The table below sets forth activity in the fourth quarter of fiscal 2007:

 

 

 

 

On November 15, 2006, the Board of Directors approved a new stock repurchase program in which up to $800,000,000 of additional shares may be purchased.

 

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 27, 2007

 

 

 

 

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. We are experiencing a worldwide data explosion, driven by rapid growth of broadband Internet access, the proliferation of data devices, and the need to protect critical data through replication, the “digital footprints” of everyday life are growing exponentially. As the volume of data grows, so does the complexity of data storage and management. Data ownership and the burdens of managing data continue to challenge our enterprise customers. Data growth, greater global demands on data access, more complex legal requirements, increasing consequences for data outages, and greater data longevity all contribute to the growing burden of responsibility on IT professionals. In response, CIOs and IT professionals are looking for solutions to help simplify data storage, IT administration, improve the capabilities of storage systems 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.

 

We believe that our strategic investments are targeted at some of the strongest growth areas of the storage market, such as modular storage, archive and compliance, data protection, data classification, data discovery, data migration, data permanence, data security and privacy, 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.

 

In fiscal 2007, despite continuous downward pricing pressures and competitive environments, our revenue continued to grow faster than that of our competitors. We expect to continue to experience price declines per petabyte for our hardware products, which may have an adverse impact on our future gross margins if not offset by a product mix with higher software content and higher average selling prices associated with new products. At the same time, we also expect our future gross margins may be negatively affected by factors such as global service investment cost, competition, indirect sales including OEM, and high disk content, partially offset by new product introductions and add-on software mix.

 

While we reported solid fiscal 2007 results with a 36% annual revenue growth, we were not immune to the macroeconomic spending slowdown in the U.S. Our fourth quarter fiscal 2007 bookings were back-end loaded and finished lower than our forecast. In addition, in the last two weeks of the fourth quarter in fiscal 2007, we experienced a shift in the mix of our bookings toward more deferred elements. As a result, we did not build our normal levels of non-deferred backlog at the end of the fourth quarter, which will impact the first quarter of fiscal 2008. Without the benefit of normal backlog, we do not expect our usual level of growth in first quarter revenue, and as a result, our expense levels as a percentage of our revenue will be above our targeted business model. We will slow our rate of hiring and investment spending in order to return to our targeted business model. Given the lack of growth in our non-deferred backlog, we lowered our forecasts for the first quarter of fiscal 2008 in revenues, operating margins and earnings.

 

Although we are faced with a first quarter that does not have the benefit of typical backlog levels, we believe our business fundamentals remain intact. We remain confident in the competitiveness of our products and in our ability to grow our business over the long term. 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 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 new product introductions.

 

Fiscal 2007 Highlights

 

Our fiscal 2007 revenue grew year over year, and the increase was across all major products categories and geographies. The net increase in revenues was attributable to increased software licenses, software upgrade and maintenance arrangements, increased service revenue, an expanded portfolio with new products and solutions for the enterprise customers, and was partially offset by lower cost-per-megabyte disks, and a decline in shipments and lower average selling prices of our older generation products. Some of the key fiscal 2007 highlights included:

 

Increased our penetration into enterprise data centers and enhanced data management and data protection solutions.  From a product perspective, we continued to enhance our data management and data protection portfolios with a key acquisition and several product introductions. We extended our data center portfolio with several additions including new midrange and high-end platforms, broader Fibre Channel storage area network capabilities, significant enhancements in the NetApp Manageability Software Family, and new professional services, all aimed at making enterprise data center management easier for customers who demand high-performance SAN solutions and increased application uptime to meet their business needs. We anticipate the SAN competitiveness of our new midrange, along with the strength of our high-end SAN-configured systems, to continue to contribute to an increase in the block-based protocols component of our business. We also continued to gain momentum in the SAN market while maintaining market leadership in both network-attached storage and iSCSI.

 

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 2007 channel mix demonstrated increased expansion through our partner programs, with approximately 59.6% of our business coming through indirect channels and the remaining 40.4% coming through direct sales. 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 2007 was also driven by increases in professional services. We plan to continue to invest in 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.

 

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 our next-generation scale-out operating system with enhanced storage grid functionality, the disk-to-disk backup solution in the VTL space, and our entry into the small to medium-sized business market. 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 in front of their storage from other vendors. Our acquisition of Topio in December 2006 will also help us expand our heterogeneous data protection portfolio as part of our plan to broaden our total addressable market.

 

Fiscal 2007 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 (SOP No. 97-2), and related interpretations to our product sales, both hardware and software, because our software is essential to the performance of our hardware. We recognize revenue when:

 

 

Our multiple element arrangements include our systems and generally may also include one or more of the following undelivered software-related elements: software upgrade and maintenance arrangements, premium hardware maintenance, and storage review services. Our software upgrade and maintenance arrangements entitle our customers to receive unspecified product upgrades and enhancements on a when-and-if-available basis, bug fixes, and patch releases. Premium hardware maintenance services include contracts for technical support and minimum response times. Revenues from software upgrade and maintenance arrangements, premium hardware maintenance services and storage review services are recognized ratably over the contractual term, generally from

one to three years. Standard hardware warranty costs are considered an obligation under SFAS No. 5, Accounting for Contingencies and expensed as a cost of service when revenue is recognized. We also offer extended service contracts (which extend our standard parts warranty and may include premium hardware maintenance) at the end of the warranty term; revenues from these contracts are recognized ratably over the contract term. We typically sell technical consulting services separately from any of our other revenue elements, either on a time and materials basis or for fixed price standard projects; we recognize revenue for these services as they are performed. Revenue from hardware installation services is recognized at the time of delivery and any remaining costs are accrued, as the remaining undelivered services are considered to be inconsequential and perfunctory. For arrangements with multiple elements, we recognize as revenue the difference between the total arrangement price and the greater of fair value or stated price for any undelivered elements (“the residual method”).

 

For our undelivered software-related elements, we apply the provisions of SOP No. 97-2 and determine fair value of these undelivered elements based on vendor-specific objective evidence (“VSOE”), which for us consists of the prices charged when these services are sold separately either alone, in the case of software upgrade and maintenance arrangements, or as a bundled element which always includes software upgrade and maintenance arrangements and premium hardware maintenance, and may also include storage review services. To determine the fair value of these elements, we analyze both the selling prices when elements are sold separately as well as the concentrations of those prices. We believe those concentrations have been sufficient to enable us to establish VSOE of fair value for the undelivered elements. If VSOE cannot be obtained to establish fair value of the undelivered elements, paragraph 12 of SOP 97-2 would require that revenue from the entire arrangement be initially deferred and recognized ratably over the period these elements are delivered.

 

For income statement presentation purposes, once fair value has been determined for our undelivered bundled elements, we allocate revenue first to software upgrade and maintenance arrangements based on VSOE of its separate fair value, and then the residual is allocated to other service revenues.

 

We record reductions to revenue for estimated sales returns at the time of shipment. Sales returns are estimated based on historical sales returns, current trends, and our expectations regarding future experience. We monitor and analyze the accuracy of sales returns estimates by reviewing actual returns and adjust them for future expectations to determine the adequacy of our current and future reserve needs. Our reserve levels have been sufficient to cover actual returns and have not required material changes in subsequent periods. While we currently have no expectations for significant changes to these reserves, if actual future returns and allowances differ from past experience, 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 current and future allowance. 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 reserve levels have generally been sufficient to cover credit losses. Our allowance for doubtful accounts as of April 27, 2007 was $2.6 million, compared to $2.4 million as of April 28, 2006. During the year ended April 28, 2006, we reduced our reserve by $1.5 million due to overall improvement in our collections history. However, 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. In addition, 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. We currently do not foresee changes to useful lives or write-downs to these assets.

 

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 2007 we performed such evaluation and found no impairment. However, any future write-downs of goodwill would adversely affect our operating margins. As of April 27, 2007, our assets included $601.1 million in goodwill. See Note 14, “Goodwill and Purchased Intangible Assets,” to our Consolidated Financial Statements.

 

During fiscal 2007, we recorded goodwill of $114.7 million in connection with our Topio acquisition and a reduction of goodwill for $1.2 million in connection with the divestiture of certain NetCache assets.

 

Accounting for Income Taxes

 

The determination of our tax provision is subject to judgments and estimates due to the complexity of the tax law that we are subject to in several tax jurisdictions. Earnings derived from our international business are generally taxed at rates that are lower than U.S. rates, resulting in a lower effective tax rate than the U.S. statutory tax rate of 35.0%. 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. In addition, a decrease in the percentage of our total earnings from our international business or a change in the mix of international business among particular tax jurisdictions could increase our overall effective tax rate.

 

We account for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes.” SFAS No. 109 requires that deferred tax assets and liabilities be recognized for the effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. SFAS No. 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some or all of the deferred tax asset will not be realized. We have provided a valuation allowance of $21.0 million as of April 27, 2007, compared to $431.2 million as of April 28, 2006 on certain of our deferred tax assets. We adopted SFAS No. 123R effective the beginning of our fiscal year ended April 27, 2007. Under SFAS No. 123R, tax attributes related to the exercise of employee stock options should not be realized until they result in a reduction of taxes payable. Pursuant to Footnote 82 of SFAS No. 123R, on a prospective basis we no longer include unrealized stock option attributes as components of our gross deferred tax assets and corresponding valuation allowance disclosures. The tax effected amounts of gross unrealized net operating loss and business tax credit carryforwards, and their corresponding valuation allowance excluded under Footnote 82 for the year ended April 27, 2007 are $363.3 million. The valuation allowance at April 28, 2006 related to net operating loss carryforwards, conditional royalty carryforwards, and tax credit carryforwards attributable to the exercise of employee stock options.

 

We are currently undergoing federal income tax audits in the U.S. and several foreign tax jurisdictions. The rights to some of our intellectual property (“IP”) are owned by certain of our foreign subsidiaries, and payments are made between foreign and U.S. 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. 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 in the period of adjustment.

 

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109” (FIN No. 48). FIN No. 48 prescribes a comprehensive model for how a company should recognize, measure, present, and disclose in its financial statements uncertain tax positions that the Company has taken or expects to take on a tax return (including a decision whether to file or not to file a return in a particular jurisdiction). FIN No. 48 is applicable to all uncertain tax positions for taxes accounted for under FASB Statement No. 109, Accounting for Income Taxes (SFAS No. 109), and substantially changes the applicable accounting model. We are required to adopt FIN No. 48 for our fiscal year beginning April 28, 2007. We are currently evaluating the effect that the adoption of FIN No. 48 will have on our consolidated results of operations and financial condition.

 

Inventory Write-Downs

 

Our net inventory balance was $54.9 million as of April 27, 2007, compared to $64.5 million as of April 28, 2006. 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 on 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. During the past few years, our inventory reserves have generally been sufficient to cover excess and obsolete exposure and have not required material changes in subsequent periods.

 

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 27, 2007 and April 28, 2006, we did not have purchase commitment liabilities under such arrangements.

 

We engage in extensive, ongoing 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 are 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 the 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. We estimated our facility and severance restructuring reserve to be $2.1 million as of April 27, 2007. Our fiscal 2006 facility restructuring reserve included a $1.0 million reduction related to the execution of a new sublease agreement for our Tewksbury facility net of related costs.

 

Impairment Losses on Investments

 

As of April 27, 2007, 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 27, 2007. The fair value of our available-for-sale investments reflected in the Consolidated Balance Sheets were $935.7 million and $1,102.8 million as of April 27, 2007 and April 28, 2006, respectively. Included in these balances were short-term restricted investments of $116.0 million, as of April 27, 2007, and short-term and long-term restricted investments of $136.7 million and $104.4 million, respectively, as of April 28, 2006. In addition, our available-for-sale investments also included an investment in a publicly held company of $12.9 million, which was based on quoted market prices on April 27, 2007. We had no investments in publicly held companies as of April 28, 2006. 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 and intent to hold these investments until maturity, we would not expect any significant decline in value of our investments caused by market interest rate changes.

 

All of our available-for-sale investments and nonmarketable 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 and intent 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. For investments in publicly held companies, we recognize an impairment charge when the declines in the fair values of our investments in these companies are below their cost basis are judged to be other-than-temporary. The ultimate value realized on these investments in publicly held companies is subject to market price volatility until they are sold. We have no impairment losses on our available-for-sale investments for fiscal 2007 and 2006.

 

For nonmarketable 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. Our investments in privately-held companies were $8.9 million and $11.0 million as of April 27, 2007 and April 28, 2006, respectively. During fiscal 2007, we recorded impairment of $2.1 million for investments in privately-held companies. We had no impairment losses on our investments in privately-held companies in fiscal 2006.

 

Accounting for Stock-Based Compensation

 

We adopted SFAS No. 123R, Share-Based Payment, 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 have chosen to base our estimate of future volatility using the implied volatility of traded options to purchase the Company’s common stock as permitted by Staff Accounting Bulletin (“SAB”) No. 107. As of April 29, 2006, the contractual life of our stock options was 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 requires us to use estimated forfeitures, and therefore the adoption of SFAS No. 123R could have a material impact on the timing of and, based on the accuracy of estimates of future actual forfeitures, the amount of stock-based compensation expense. Any changes in these highly subjective assumptions may significantly impact the stock-based compensation expense for the future. Likewise, the shortening of the contractual life of our options could change the estimated exercise behavior in a manner other than currently expected.

 

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 2007, 2006, and 2005, 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 February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 159, The Fair Value Option for Financial Assets and Financial Liabilities — Including an Amendment of FASB Statement No. 115. SFAS No. 159 allows measurement at fair value of eligible financial assets and liabilities that are not otherwise measured at fair value. If the fair value option for an eligible item is elected, unrealized gains and losses for that item shall be reported in current earnings at each subsequent reporting date. SFAS No. 159 also establishes presentation and disclosure requirements designed to draw comparison between the different measurement attributes the company elects for similar types of assets and liabilities. This statement is effective for our fiscal year beginning April 27, 2008. We are currently evaluating the effect, if any, that the adoption of SFAS No. 159 will have on our consolidated financial statements

 

In September, 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, Fair Value Measurements. SFAS No. 157 provides a framework for measuring fair value, clarifies the definition of fair value, and expands disclosures regarding fair value measurements. SFAS No. 157 does not require any new fair value measurements and eliminates inconsistencies in guidance found in various prior accounting pronouncements. We are required to adopt SFAS No. 157 for our fiscal year beginning April 27, 2008. We are currently evaluating the effect that the adoption of SFAS No. 157 will have on our consolidated results of operations and financial condition, but do not expect it to have a material impact.

 

In September 2006, the SEC issued Staff Accounting Bulletin (“SAB”) No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. SAB No. 108 provides guidance on how prior year misstatements should be taken into consideration when quantifying misstatements in current year financial statements for purposes of determining whether the current year’s financial statements are materially misstated. SAB No. 108 is effective for fiscal years ending on or after November 15, 2006. We adopted SAB 108 in the fourth quarter of fiscal 2007 and its adoption did not have a material impact on our results of operations or financial condition.

 

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation (“FIN”) No. 48, Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109. FIN No. 48 prescribes a comprehensive model for how a company should recognize, measure, present, and disclose in its financial statements uncertain tax positions that the Company has taken or expects to take on a tax return (including a decision whether to file or not to file a return in a particular jurisdiction). FIN No. 48 is applicable to all uncertain tax

positions for taxes accounted for under FASB Statement No. 109, Accounting for Income Taxes (SFAS No. 109), and substantially changes the applicable accounting model. We are required to adopt FIN No. 48 for our fiscal year beginning April 28, 2007. We are currently evaluating the effect that the adoption of FIN No. 48 will have on our consolidated results of operations and financial condition.

 

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 2007 Compared to Fiscal 2006

 

Product Revenues — Product revenues increased by 32.2% to $2,085.9 million in fiscal 2007, from $1,577.4 million in fiscal 2006. Product revenues growth was across all geographies.

Product revenues were favorably affected by the following factors:

 

 

Product revenues were negatively affected by the following factors:

 

 

Our systems are highly configurable to respond to customer requirements in the open systems storage markets that 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.

 

Software Upgrade and Maintenance Arrangements Revenues — Software upgrade and maintenance arrangements revenues increased by 42.7% to $341.3 million in fiscal 2007, from $239.1 million in fiscal 2006 due primarily to a larger installed base of customers who have purchased or renewed software upgrade and maintenance arrangements, and an increased number of new enterprise customers. Software upgrade and maintenance arrangements revenues represented 12.2% and 11.6% of total revenues for fiscal 2007 and 2006, respectively.

 

Service Revenues — Service revenues, which include hardware support, professional services, and educational services, increased by 50.9% to $377.1 million in fiscal 2007, from $249.9 million in fiscal 2006.

 

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

 

 

While it is an element of our strategy to expand and offer more comprehensive global enterprise support and service solutions, we cannot assure you that service revenue will grow at the current rate in fiscal 2008 or beyond.

 

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. Service revenues represented 13.4% and 12.1% of total revenues for fiscal years 2007 and 2006, respectively.

 

International total revenues — International total revenues (including U.S. exports) increased by 32.9% in fiscal year 2007 compared to fiscal 2006. International total revenues were $1,254.0 million, or 44.7% of total revenues for fiscal 2007, compared to $943.8 million, or 45.7% of total revenues for fiscal 2006. The increase in international sales was primarily driven by the same factors outlined under the Total Revenue discussion, 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 fiscal 2008.

 

Product Gross Margins — Product gross margins were 60.9% for both fiscal 2007 and fiscal 2006.

 

Product gross margins for both fiscal 2007 and 2006 were 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 increases in software revenue and new higher-margin products.

 

Stock-based compensation expense included in cost of product revenues was $3.7 million for fiscal 2007. Amortization of existing technology included in cost of product revenues was $17.6 million and $11.8 million for fiscal 2007 and 2006, respectively. Estimated future amortization of existing technology to cost of product revenues will be $21.1 million for fiscal year 2008, $20.4 million for fiscal year 2009, $15.9 million for fiscal year 2010, $6.3 million for fiscal year 2011, and none thereafter.

 

Software Upgrade and Maintenance Arrangements Gross Margins — Software upgrade and maintenance arrangements gross margins was 97.0% and 96.5% for fiscal 2007 and 2006, respectively, due primarily to improved productivity and a larger installed base renewals, upgrades, and an increasing number of new enterprise customers.

 

Service Gross Margins — Service gross margins increased to 27.4% in fiscal 2007 compared to 25.9% in fiscal 2006. Cost of service revenue increased by 47.9% to $273.6 million in fiscal 2007, from $185.0 million in fiscal 2006. Stock-based compensation expense of $10.1 million was included in the cost of service revenue for fiscal 2007.

 

The change in service gross margins year over year was primarily impacted by an increase in services revenue, improved productivity, and 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 be impacted by factors such as timing of technical support service initiations and renewals and additional investments in our customer support infrastructure. In fiscal 2008, we expect service margins to experience some variability over time as we continue to build out our service capability and capacity to support our growing enterprise customers and new products.

 

Sales and Marketing — Sales and marketing expenses consist primarily of salaries, commissions, advertising and promotional expenses, stock-based compensation expense, and certain customer service and support costs. Sales and marketing expenses increased 49.5% to $895.8 million for fiscal 2007, from $599.1 million for fiscal 2006. These expenses were 32.0% and 28.9% of total revenues for fiscal 2007 and fiscal 2006, 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, the continued worldwide investment in our sales and global service organizations associated with selling complete enterprise solutions, and stock-based compensation expenses recognized under adoption of SFAS No. 123R.

 

The stock-based compensation expenses included in sales and marketing expenses for fiscal 2007 was $71.7 million compared to $4.0 million in fiscal 2006. The increase in stock-based compensation was due to adoption of SFAS No. 123R. Amortization of acquisitions-related trademarks/tradenames and customer contracts and relationships included in sales and marketing expenses was $2.9 million and $2.1 million for fiscal 2007 and fiscal 2006, respectively. Based on identified intangibles related to our acquisitions recorded at April 27, 2007, estimated future amortization such as trademarks and customer relationships included in sales and marketing expenses will be $3.9 million for fiscal 2008, $3.8 million for fiscal 2009, $3.7 million for fiscal 2010, $2.7 million for fiscal 2011, $1.6 million for fiscal 2012, and $0.9 million thereafter.

 

We expect to continue to selectively add sales capacity in an effort to expand domestic and international markets, introduce new products, and establish and expand new distribution channels. 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, stock-based compensation, prototype expenses, nonrecurring engineering charges, fees paid to outside consultants, and amortization of capitalized patents.

 

Research and development expenses increased 53.3% to $385.4 million for fiscal 2007 from $251.3 million for fiscal 2006. These expenses represented 13.7% and 12.2% of total revenues for fiscal 2007 and 2006, 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, higher performance-based payroll expenses due to higher profitability, and stock-based compensation expense recognized under adoption of SFAS No. 123R. For both fiscal 2007 and 2006, no software development costs were capitalized.

 

The stock-based compensation expenses included in research and development expenses for fiscal 2007 was $51.3 million compared to $8.3 million in fiscal 2006. The increase in stock-based compensation was due to adoption of SFAS No. 123R. Included in research and development expenses are capitalized patents amortization of $2.0 million and $2.0 million for fiscal 2007 and 2006, respectively. Based on capitalized patents recorded at April 27, 2007, estimated future capitalized patents amortization expenses will be $2.0 million for fiscal year 2008, $0.5 million in fiscal 2009, $0.2 million in fiscal 2010, and none thereafter.

 

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 to 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 to introduce new products that expand our solutions portfolio.

 

We believe that our research and development expenses will increase in absolute dollars for fiscal 2008, primarily due to ongoing costs associated with the development of new products and technologies, increased headcount, and the operating impact of potential future acquisitions.

 

General and Administrative — General and administrative expenses increased 58.9% to $147.5 million for fiscal 2007, from $92.8 million for fiscal 2006. These expenses represented 5.3% and 4.6% of total revenues for fiscal 2007 and 2006, respectively. This increase in absolute dollars was primarily due to higher performance-based payroll expenses due to higher profitability and increased headcount, higher stock-based compensation expense recognized under SFAS No. 123R, and higher legal expenses and professional fees for general corporate matters.

 

We believe that our general and administrative expenses will increase in absolute dollars for fiscal 2008 due to increased general and administrative headcount. The stock-based compensation expenses included in general and administrative expenses for fiscal 2007 was $26.2 million compared to $1.0 million in fiscal 2006. The increase in

stock-based compensation was due to adoption of SFAS No. 123R. Amortization of covenants not to compete included in general and administrative expenses was $1.0 million and $2.2 million for fiscal 2007 and 2006, respectively. Based on identified intangibles related to our acquisitions recorded at January 26, 2007, estimated future amortization of covenants not to compete relating to our acquisitions will be $0.2 million for fiscal year 2008, and none thereafter.

 

Restructuring Charges — In fiscal 2002, as a result of continuing unfavorable economic conditions and a reduction in information technology (“IT”) spending rates, we implemented two restructuring plans, which included reductions in our workforce and consolidations of our facilities. As of April 27, 2007, 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 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 2007, we did not record any reduction in restructuring reserve resulting from a change in estimate for our third restructuring plan. 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 also 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 27, 2007, $0.5 million was included in other accrued liabilities, and the remaining $1.6 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 restructuring reserve at April 27, 2007 (in thousands):

 

 

Gain on Sale of Assets — We recorded a gain of $25.3 million in fiscal 2007 as a result of the sale of certain assets to Blue Coat Systems, Inc (“Blue Coat”). (see Note 16 of the Consolidated Financial Statements). We recorded revenues of $57.4 million, $71.1 million and $75.5 million from NetCache products for fiscal 2007, 2006, and 2005 respectively. The contribution to operating income from these products was not significant.

 

Interest Income — Interest income was $68.8 million and $41.5 million for fiscal 2007 and 2006, respectively. The increase in interest income was primarily driven by higher average interest rates on our investment portfolio. We expect interest income to increase compared to fiscal 2008 as a result of our cash and invested balances being reinvested in a higher interest rate portfolio environment.

Interest Expense — Interest expense was $11.6 million and $1.3 million in fiscal 2007 and 2006, respectively. The increase in fiscal 2007 was primarily due to interest incurred in connection with our debt.

 

Net Gain (Loss) on Investments — Net gain (loss) on investments included a net write-down of $2.1 million related to the impairment of our investment in privately-held companies in fiscal 2007.

 

Other Income (Expense), Net — Other income was $2.8 million for fiscal 2007. Other income for fiscal 2007 included net exchange gains from foreign currency of $2.4 million and other income of $0.4 million. Other income included net exchange gains from foreign currency of $1.7 million for fiscal 2006. We believe that period-to-period changes in foreign exchange gains or losses will continue to be impacted by hedging costs associated with our forward and option activities and forecast variance.

 

Provision for Income Taxes — For fiscal 2007, our annual effective tax rate was 17.2% versus 23.9% for fiscal 2006, 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 decrease to the effective tax rate for fiscal year 2007 is primarily attributable to the absence of this one-time item and the impact of income taxed at lower tax rates in foreign jurisdiction. The effective tax rate for fiscal 2007 differed from the U.S. statutory rate primarily due to reductions in the rate derived from 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, offset partially by an increase in the rate due to the tax effect of stock compensation under SFAS No. 123R.

 

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. This tax raised our 2006 effective tax rate by 6.4% 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.

 

The 2006 Tax Relief and Health Care Act was signed into law on December 20, 2006. One of the provisions of this law was the retroactive reinstatement of the research and development credit from January 1, 2006 and its extension through December 31, 2007. The effective tax rates for the fiscal 2007 reflected the benefits attributable to the extension of the research and development tax credit provisions.

 

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.

 

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.

 

Software Upgrade and Maintenance Arrangements Revenues — Software upgrade and maintenance arrangements 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 upgrade and maintenance arrangements 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:

 

 

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.

 

Product Gross Margins — Product gross margins decreased to 60.9% for fiscal 2006, from 61.7% for fiscal 2005. 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.

 

Product gross margins were negatively affected by the following factors:

 

 

Product gross margins were favorably affected by the following factors:

 

 

Software Upgrade and Maintenance Arrangements Gross Margins — Software upgrade and maintenance arrangements gross margins increased slightly to 96.5% for fiscal 2006, from 97.0% for fiscal 2005 due primarily to improved productivity 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 productivity 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.

 

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 28.0% to $599.1 million for fiscal 2006, from $468.2 million for fiscal 2005. These expenses were 28.9% and 29.2% 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.

 

Compensation expenses related to stock options and restricted stock assumed in acquisitions were $4.0 million and $2.2 million for fiscal 2006 and fiscal 2005, respectively. 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.

 

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 42.6% to $251.3 million for fiscal 2006 from $176.3 million for fiscal 2005. These expenses represented 12.2% and 11.0% 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. 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. Compensation expenses related to stock options and restricted stock assumed in acquisitions was $8.3 million and $5.2 million for fiscal 2006 and fiscal 2005, respectively.

 

General and Administrative — General and administrative expenses increased 19.6% to $92.8 million for fiscal 2006, from $77.6 million for fiscal 2005. These expenses represented 4.6% and 4.9% 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.

 

Compensation expenses related to stock options and restricted stock assumed in acquisitions were $1.0 million and $0.7 million for fiscal 2006 and fiscal 2005, respectively. 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.

 

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.

 

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 28, 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.

 

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 28, 2006, $0.9 million was included in other accrued liabilities, and the remaining $2.1 million was classified as long-term obligations.

 

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 $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.

 

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%.

 

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 27, 2007, as compared to April 28, 2006, our cash, cash equivalents, and short-term investments decreased by $14.1 million to $1,308.8 million. We derive our liquidity and capital resources primarily from our cash flows from operations and from working capital. Working capital decreased by $62.8 million to $1,053.3 million as of April 27, 2007, compared to $1,116.0 million as of April 28, 2006.

During fiscal 2007, we generated cash flows from operating activities of $864.5 million, as compared with $554.3 million and $462.1 million for fiscal 2006 and fiscal 2005, respectively. We reported net income of $297.7 million for fiscal 2007, as compared to $266.5 million and $225.8 million in fiscal 2006 and fiscal 2005, respectively. A summary of the significant changes in noncash adjustments affecting net income is as follows:

 

 

In addition to net income and noncash adjustments in fiscal 2007 compared to fiscal 2006 and fiscal 2005, the primary factors that impacted the period-to-period change in cash flows relating to operating activities included the following:

 

 

A decrease in income taxes payable in fiscal 2007 compared to fiscal 2006 primarily attributable to income taxes payment of the one-time repatriation incentive under the Jobs Act. During fiscal 2007, we remitted $19.6 million of income taxes relating to the foreign dividend repatriation in connection with the filing of our fiscal 2006 federal income tax return. Increased income taxes payable in fiscal 2006 compared to fiscal 2005, primarily reflecting the $22.5 million of federal and state tax liability relating to repatriation of accumulated foreign earnings under the Jobs Act and higher profitability in fiscal 2006 compared to fiscal 2005.

 

 

The above factors were partially offset by the effects of:

 

 

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 Flows from Investing Activities

 

Capital expenditures for fiscal 2007 were $165.8 million as compared to $132.9 million and $93.6 million in fiscal 2006 and 2005, respectively. We received net proceeds of $60.0 million in fiscal 2007, and used net proceeds of $128.5 million and $266.8 million in fiscal 2006 and 2005, respectively, for net purchases/redemptions of short-term investments. We redeemed $127.9 million of restricted investments and its interest income pledged with JP Morgan Chase in fiscal 2007 to repay the Tranche A term loan with JP Morgan Chase (See Note 6 to the Consolidated Financial Statements) Investing activities in fiscal 2007, 2006, and 2005 also included new investments in privately-held companies of $1.6 million, $9.3 million, and $0.4 million, respectively. In fiscal 2007, we acquired Topio, Inc. for a purchase price of approximately $146.1 million, which consisted of the value of the assumed options, cash payments of $131.2 million, and related transaction costs. In fiscal 2006, we acquired Alacritus and Decru and incurred total cash payments including related transactions costs totaling $53.7 million. In fiscal 2005, we acquired additional patents for a purchase price of approximately $0.9 million. In fiscal 2007, we received $23.9 million in cash in connection with the sale of certain assets to Blue Coat. We received $2.8 million, $0.1 million, and $0.3 million in proceeds from the sale of investments in privately-held companies in fiscal 2007, 2006, and 2005, 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 for fiscal year 2005. In April 2005, our CEO reimbursed us $10.2 million for these premiums.

 

Cash Flows from Financing Activities

 

We used $747.3 million and $12.1 million in fiscal 2007 and 2005, respectively, as compared to cash provided by financing activities of $42.8 million in fiscal 2006. During fiscal 2006, we borrowed $300.0 million to fund the repatriation in cash from foreign earnings and investments under the American Jobs Creation Act of 2004 (“the Jobs Act”). We made a repayment of $214.9 million for our debt in fiscal 2007. During fiscal 2007, 2006, and 2005, we repurchased 22.6 million, 17.4 million, and 7.7 million shares of common stock at a total of $805.7 million, $488.9 million, and $192.9 million, respectively. Other financing activities provided $215.5 million, $232.7 million, and $181.9 million in fiscal 2007, 2006, and 2005, respectively, from sales of common stock related to employee stock option exercises and employee stock purchases. Tax benefits, related to tax deductions in excess of the stock-based compensation expense recognized, of $63.2 million were presented as financing cash flows for fiscal 2007 in accordance with SFAS No. 123R. During fiscal 2007, 2006 and 2005, we withheld $5.3 million, $1.1 million, and $1.1 million in shares, respectively, from certain employees’ exercised shares of their restricted stock to reimburse for federal, state, and local withholding taxes obligations. The increase in the amounts withheld year over year was due to the release of the Decru assumed restricted stock units.

 

The change in cash flow from financing was primarily due to the effects of higher common stock repurchases partially offset by proceeds from the issuance of common stock under employee equity programs compared to the same period 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 flow resulting from the issuance of common stock related to employee participation in employee stock programs will vary.

 

Other Factors Affecting Liquidity and Capital Resources

 

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. Primarily as a result of this one-time repatriation incentive, we remitted $19.6 million of income taxes with the filing of our fiscal year 2006 federal income tax return.

 

For fiscal 2007, 2006, and 2005, the income tax benefit associated with dispositions of employee stock transactions was $175.0 million, $36.6 million, and $27.8 million, respectively. 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.

Stock Repurchase Program

 

On November 15, 2006, the Board of Directors approved a new stock repurchase program in which up to $800.0 million of additional shares may be purchased. At April 27, 2007, $399.9 million remained available for future repurchase. The stock repurchase program may be suspended or discontinued at any time.

 

Debt

 

In March 2006, we received proceeds from the term loans totaling $300.0 million to finance a dividend under the Jobs Act. (See Note 6 to the Consolidated Financial Statements). Loan payments of $85.1 million are due in fiscal 2008. This debt was collateralized by restricted investments totaling $116.0 million as of April 27, 2007. In accordance with the payment terms of the loan agreement, interest payments will be approximately $2.7 million in fiscal 2008. As of April 27, 2007, 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 27, 2007, and the effect such obligations are expected to have on our liquidity and cash flows in future periods:

 

 

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 27, 2007, our financial guarantees of $3.4 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 rent guarantee.

 

As of April 27, 2007, our notional fair values of foreign exchange forward and foreign currency option contracts totaled $368.8 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 two lease arrangements with BNP for approximately 380,000 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, 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 $117.8 million reported under our Note 4, “Commitments and Contingencies”.

 

As of April 27, 2007, 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 for at least the next twelve months.

 

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 Risk and Market Interest Risk

 

Investment and Interest Income — As of April 27, 2007, we had available-for-sale investments of $935.7 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 investments, consisting primarily of corporate bonds, corporate securities, government, municipal debt securities, 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 percent increase in market interest rates from levels at April 27, 2007, would cause the fair value of these available-for-sale investments to decline by approximately $4.1 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.

 

Our investment policy is to limit the amount of credit exposure through diversification and investment in highly rated securities. We further mitigate concentrations of credit risk in our investments by limiting our investments in the debt securities of a single issuer and by diversifying risk across geographies and type of issuer. We have not experienced any material losses on our available-for-sale investments.

 

Our investment portfolio also includes common stock holdings in Blue Coat (see Note 16 of the Consolidated Financial Statements). We are exposed to fluctuations in the market price of our investment in this company. At the same time, we are precluded from selling these shares until September 2007. As a result of these factors, the amount of income and cash flow that we ultimately realize from this investment may vary materially from the current unrealized amount. A hypothetical 10 percent decrease in the fair market value from fair market value at April 27, 2007 would cause the fair value of this investment to decrease by approximately $1.3 million.

 

Lease Commitments — As of April 27, 2007, we have two arrangements with BNP to lease our land for a period of 50 years to construct approximately 380,000 square feet of office space and a parking structure costing up to $103.5 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 first lease in October 2007 for a term of five years, and the second lease in September 2008 for a term of five years. We have the option to renew both leases for two consecutive five-year periods upon approval by BNP. A hypothetical 10 percent increase in market interest rates from levels at April 27, 2007 would increase our total lease payments under the initial five-year term by approximately $2.8 million. We do not currently hedge against market interest rate increases. As cash from operating cash flows is 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 $85.1 million as of April 27, 2007. Under terms of these arrangements, we expect to pay interest payments at LIBOR plus a spread. A hypothetical 10 percent increase in market interest rates from levels at April 27, 2007 would increase our total interest payments by approximately $0.4 million. We do not currently use derivatives to manage interest rate risk.

 

Non-Marketable 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 nonmarketable 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 nonmarketable 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. We do not currently engage in any hedging activities to reduce or eliminate equity price risk with respect to such nonmarketable investment. Accordingly, we could lose all or part of this investment if there is an adverse change in the market price of the company we invest in. Our investments in nonmarketable securities had a carrying amount of $8.9 million as of April 27, 2007 and $11.0 million as of April 28, 2006. If we determine that an other-than-temporary decline in fair value exists for a nonmarketable 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. In fiscal 2007, we recorded a noncash,

other-than-temporary write-down of $2.1 million related to impairment of our investment in two privately-held companies.

 

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 27, 2007, 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 27, 2007 (in thousands):

 

 

The following table provides information about our foreign exchange forward contracts and currency options contracts outstanding on April 28, 2006 (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 subsidiaries (the “Company”) as of April 27, 2007 and April 28, 2006, and the related consolidated statements of income, cash flows and stockholders’ equity and comprehensive income (loss) for the years ended April 27, 2007, April 28, 2006, and April 29, 2005. Our audits also included the consolidated financial statement schedule listed in the Index at 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 the 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 subsidiaries as of April 27, 2007 and April 28, 2006, and the results of their operations and their cash flows for the years ended April 27, 2007, April 28, 2006, and April 29, 2005 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.

 

As discussed in Note 1 to the consolidated financial statements, in fiscal year 2007, the Company changed its method of accounting for stock-based compensation in accordance with guidance provided in Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment.

 

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 27, 2007, 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 June 25, 2007 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.

 

 

San Jose, California

June 25, 2007

NETWORK APPLIANCE, INC.

 

CONSOLIDATED BALANCE SHEETS

 

 

See notes to consolidated financial statements.

NETWORK APPLIANCE, INC.

 

CONSOLIDATED STATEMENTS OF INCOME