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

 

 

 

 

Form 10-Q

 

 

 

 

Commission file number 0-27130

Network Appliance, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

495 East Java Drive,

Sunnyvale, California 94089

(Address of principal executive offices, including zip code)

 

Registrant’s telephone number, including area code:

(408) 822-6000

 

 

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

 

Indicate by check mark whether the Registrant is 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 Act).  Yes o     No þ

 

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

 

 

 

TABLE OF CONTENTS

 

 

TRADEMARKS

 

2008 Network Appliance, Inc. All rights reserved. Specifications subject to change without notice. NetApp, the Network Appliance logo, NearStore, and NetCache are registered trademarks and Network Appliance, and FlexClone, is a trademark of Network Appliance, Inc. in the United States and other countries. Windows is a registered trademark of Microsoft Corporation. Oracle is a registered trademark of Oracle Corporation. Symantec is a trademark of Symantec Corporation. 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.

 

PART I. FINANCIAL INFORMATION

 

 

NETWORK APPLIANCE, INC.

 

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands - Unaudited)

 

 

See accompanying notes to unaudited condensed consolidated financial statements.

NETWORK APPLIANCE, INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share amounts - Unaudited)

 

 

See accompanying notes to unaudited condensed consolidated financial statements.

NETWORK APPLIANCE, INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

 

 

See accompanying notes to unaudited condensed consolidated financial statements.

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per-share data)

(Unaudited)

 

 

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

 

 

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

 

In the first quarter of fiscal 2008, we began to classify sales-related tax receivable balances from our customers within prepaid expenses and other current assets. These balances were included in accounts receivable, net, in previous periods ($43,075 at April 27, 2007) and such amounts have been reclassified in the accompanying financial statements to conform to the current period classification. This reclassification had no effect on the reported amounts of net income or cash flow from operations for any period presented. In addition, we have chosen to use the term “software entitlements and maintenance” in our statements of income to describe the arrangements under which we provide our customers the right to receive unspecified software product upgrades and enhancements on a when-and-if-available basis, bug fixes and patch releases; these were previously described as “software upgrade and maintenance arrangements.”

 

We operate on a 52-week or 53-week year ending on the last Friday in April. The first quarters of fiscal 2007 and 2006 were both 13-week fiscal periods.

 

These financial statements should be read in conjunction with the audited consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the year ended April 27, 2007. The results of operations for the quarter ended July 27, 2007, are not necessarily indicative of the operating results to be expected for the full fiscal year or future operating periods.

 

 

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

 

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

4.  Stock-Based Compensation, Equity Incentive Programs and Stockholders’ Equity

 

Effective April 29, 2006, we adopted the fair value recognition provision of Statement of Financial Accounting Standards (“SFAS”) No. 123R, Share-Based Payments (SFAS No. 123R) under the modified prospective method.

 

Stock-Based Compensation Expense

 

The stock-based compensation expenses included in the Condensed Consolidated Statement of Income for the quarter ended July 27, 2007, and July 28, 2006, are as follows:

 

 

The following table summarizes stock-based compensation associated with each type of award:

 

 

Income Tax Benefits Recorded in Stockholders Equity

 

For the first quarters of fiscal 2008 and 2007, the total income tax benefit associated with employee stock transactions was $20,702 and $29,987, respectively.

 

Income Tax Effects on Statements of Cash Flows

 

In accordance with SFAS No. 123R, we have presented tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options as financing cash flows. As such, the tax benefits related to tax deductions in excess of the compensation cost recognized, of $8,339 and $4,489 has been presented as financing cash flows for the first quarters of fiscal 2008 and fiscal 2007, respectively.

 

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Valuation Assumptions

 

In compliance with SFAS No. 123R, we estimated the fair value of stock options using the Black-Scholes model on the date of the grant. Assumptions used in the Black-Scholes valuation model were as follows:

 

 

 

 

As required by SFAS No. 123R, we estimate our forfeiture rates based on historical voluntary termination behavior and recognized compensation expense only for those equity awards expected to vest.

 

Stock Options

 

A summary of the combined activity under our stock option plans and agreements is as follows:

 

 

The intrinsic value represents the difference between the exercise price of stock options and the market price of our stock on that day for all in-the-money options. The weighted-average fair value for the first quarter fiscal 2008

 

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

grants as of the grant date was $10.76. The total intrinsic value of options exercised was $32,619 and $26,382 for the first quarters of fiscal 2008 and 2007, respectively. We received $26,395 and $19,320 from the exercise of stock options for the first quarters of fiscal 2008 and 2007, respectively.

 

The following table summarizes our nonvested shares (restricted stock awards) as of July 27, 2007:

 

 

Although nonvested shares are legally issued, they are considered contingently returnable shares subject to repurchase by the Company when employees terminate their employment. The total fair value of shares vested during the first quarters of fiscal 2008 and 2007 was $585 and $1,516, respectively. There was $45,755 of total unrecognized compensation as of July 27, 2007 related to restricted stock awards. The unrecognized compensation will be amortized on a straight-line basis over a weighted-average period of 2.9 years.

 

Employee Stock Purchase Plan

 

 

The total intrinsic value of employee stock purchases was $5,044 and $10,942 for the first quarters of fiscal 2008 and 2007, respectively. The compensation cost for options purchased under the ESPP plan was $3,876 and $3,383 for the first quarters of fiscal 2008 and 2007, respectively. This compensation cost will be amortized on a straight-line basis over a weighted-average period of approximately 0.35 years.

 

The following table shows the shares issued and their purchase price per share for the employee stock purchase plan for the six-month period ended May 31, 2007:

 

 

Stock Repurchase Program

 

Common stock repurchase activities for the quarter ended July 27, 2007, and July 28, 2006, were as follows:

 

 

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Since the inception of the stock repurchase program through July 27, 2007, we have purchased a total of 61,115 shares of our common stock at an average price of $29.84 per share for an aggregate purchase price of $1,823,691. At July 27, 2007, $199,948 remained available for repurchases under the plan. The stock repurchase program may be suspended or discontinued at any time.

 

 

On March 31, 2006, Network Appliance Global LTD. (“Global”), a subsidiary of the Company, entered into a loan agreement (the “Loan Agreement”), with the lenders and JPMorgan Chase Bank, National Association, as administrative agent. The Loan Agreement provides for a term loan available in two tranches, a tranche of $220,000 (“Tranche A”) and a tranche of $80,000 (“Tranche B”), for an aggregate borrowing of $300,000. The proceeds of the term loan have been used to finance a dividend from Global to the Company under the American Jobs Creation Act. The Tranche A term loan, together with accrued and unpaid interest, is due in full on the maturity date of March 31, 2008. During the three-month period ended July 27, 2007, we made repayments of $15,960 on the term loan. The Tranche A term loan is secured by certain investments totaling $101,467 as of July 27, 2007, held by Global. The Tranche B term loan was fully repaid as of January 26, 2007. Loan repayments of $69,150 are due in the remainder of fiscal 2008.

 

Interest for the Tranche A term loan accrues at a floating rate based on the base rate in effect from time to time, plus a margin, which totaled 5.45% at July 27, 2007.

 

As of July 27, 2007, Global was in compliance with all debt covenants as required by the Loan Agreement.

 

 

The following is a summary of investments at July 27, 2007:

 

 

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The following is a summary of investments at April 27, 2007:

 

 

 

 

Marketable equity securities consisted of 360 shares of common stock in Blue Coat Systems, Inc. (“Blue Coat”) received in connection with the sale of assets of NetCache^®. On August 13, 2007, we sold all of these shares of common stock of Blue Coat and received net proceeds of approximately $18,256. (See Note 16.)

 

We record net unrealized gains or losses on available-for-sale securities in stockholders’ equity. Realized gains or losses are reflected in income which have not been material for all years presented. The following table shows the gross unrealized losses and fair values of our investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at July 27, 2007:

 

 

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The unrealized losses on our investments in Corporate Bonds and U.S. government agencies were caused by interest rate increases. We believe that we will be able to collect all principal and interest amounts due to us at maturity given the high credit quality of these investments. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because we have the ability and intent to hold those investments until a recovery of fair value, which may be maturity, we do not consider these investments to be other-than temporarily impaired at July 27, 2007.

 

 

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

 

 

 

Under SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill attributable to each of our reporting units is required to be tested for impairment by comparing the fair value of each reporting unit with its carrying value. Our reporting units are the same as our operating units. Goodwill is reviewed annually for impairment (or more frequently if indicators of impairment arise). As of July 27, 2007, and April 27, 2007, respectively, there had been no impairment of goodwill and intangible assets.

 

Intangible assets are summarized as follows:

 

 

Amortization expense for identified intangible assets is summarized below:

 

 

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Based on the identified intangible assets recorded at July 27, 2007, the future amortization expense of identified intangibles for the remainder of fiscal 2008 and the next four fiscal years and thereafter is as follows:

 

 

 

The carrying values of cash and cash equivalents, and restricted cash and investments reported in the Condensed Consolidated Balance Sheets approximate their fair value. Our short-term investments and foreign exchange contracts are carried at fair value based on quoted market prices. Other investments in nonmarketable securities are included in other assets at July 27, 2007, and April 27, 2007, with total carrying value of $12,948 and $8,932, which approximate their fair values. The fair value of our debt also approximates its carrying value as of July 27, 2007, and April 27, 2007.

 

We do not use derivative financial instruments for speculative or trading purposes. We enter into forward foreign exchange and currency option contracts to hedge trade and intercompany receivables and payables as well as future sales and operating expenses against future movement in foreign exchange rates.

 

Foreign currency forward contracts obligate us to buy or sell foreign currencies at a specified future date. Option contracts give us the right to buy or sell foreign currencies and are exercised only when economically beneficial. As of July 27, 2007, we had $336,126 of outstanding foreign exchange contracts (including $22,444 of option contracts) as indicated below that all had remaining maturities of five months or less. As of April 27, 2007, we had $367,479 of outstanding foreign exchange contracts (including $21,703 of option contracts). For the balance sheet hedges, these contracts are adjusted to fair value at the end of each month and are included in earnings. The premiums paid on the foreign currency option contracts are recognized as a reduction to other income when the contract is entered into. For cash flow hedges, the related gains or losses are included in other comprehensive income. Gains and losses on these foreign exchange contracts are offset by losses and gains on the underlying assets and liabilities. At July 27, 2007, and April 27, 2007 the estimated notional fair values of forward foreign exchange contracts were $335,700 and $368,807, respectively. The fair value of foreign exchange contracts is based on prevailing financial market information. For the quarter ended July 27, 2007, net gains generated by hedged assets and liabilities totaled $681 and were offset by losses on the related derivative instruments of $70.

 

 

During all periods presented, we had certain options outstanding, which could potentially dilute basic earnings per share in the future, but were excluded in the computation of diluted earnings per share in such periods, as their effect would have been antidilutive. These certain options were antidilutive in the quarters ended July 27, 2007, and July 28, 2006, as these options’ exercise prices were above the average market prices in such periods. For quarters ended July 27, 2007, and July 28, 2006, 30,402 and 25,857 shares of common stock options with a weighted average exercise price of $42.57 and $42.72, respectively, were excluded from the diluted net income per share computation.

 

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

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

 

 

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

 

 

The components of comprehensive income were as follows:

 

 

The components of accumulated other comprehensive income were as follows:

 

 

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

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 July 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. Of the reserve balance at July 27, 2007, $542 was included in other accrued liabilities, and the remaining $1,389 was classified as long-term obligations.

 

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. During the quarter ended July 27, 2007, we did not record any reduction or charges in the restructuring reserve.

 

 

 

The following summarizes our commitments and contingencies at July 27, 2007, and the effect such obligations may have on our future periods:

 

 

 

 

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

As of July 27, 2007, we had entered into two financing, construction, and leasing arrangements with BNP for office space to be located on land currently owned by us in Sunnyvale, California. These arrangements require us to lease our land to BNP for a period of 50 years to construct approximately 380,000 square feet of office space costing up to $113,500. After completion of construction, we will pay minimum lease payments, which vary based on the London Interbank Offered Rate (“LIBOR”) plus a spread (5.72% at July 27, 2007) on the cost of the facilities. We expect to begin making lease payments on the completed buildings in January and September 2008 for terms of five years. We have the option to renew the leases for two consecutive five-year periods upon approval by BNP. Upon expiration (or upon any earlier termination) of the lease terms, we must elect one of the following options: We may (i) purchase the buildings from BNP for $48,500 and $65,000, respectively; (ii) if certain conditions are met, arrange for the sale of the buildings by BNP to a third party for an amount equal to at least $41,225 and $55,250, respectively, and be liable for any deficiency between the net proceeds received from the third party and such amounts; or (iii) pay BNP supplemental payments of $41,225 and $55,250, respectively, in which event we may recoup some or all of such payment by arranging for a sale of either or both buildings by BNP during the ensuing two-year period.

 

On July 17, 2007, we entered into additional financing, construction, and leasing arrangements with BNP for facility space to be located on land currently owned by us in Research Triangle Park, North Carolina. These arrangements require us to lease our land to BNP for a period of 99 years to construct approximately 120,000 square feet of data center costing up to $61,000. After completion of construction, we will pay minimum lease payments, which vary based on LIBOR plus a spread (5.72% at July 27, 2007) on the cost of the facility. We expect to begin making lease payments on the completed buildings in September 2008 for a term of five and half years. We have the option to renew the lease for two consecutive five-year periods upon approval by BNP. Upon expiration (or upon any earlier termination) of the lease term, we must elect one of the following options: We may (i) purchase the building from BNP for $61,000; (ii) if certain conditions are met, arrange for the sale of the building by BNP to a third party for an amount equal to at least $51,850, and be liable for any deficiency between the net proceeds received from the third party and $51,850; or (iii) pay BNP a supplemental payment of $51,850, in which event we

 

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

may recoup some or all of such payment by arranging for a sale of the building by BNP during the ensuing two-year period.

 

All leases require us to maintain specified financial covenants with which we were in compliance as of July 27, 2007. Such specified financial covenants include a maximum ratio of Total Debt to Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”) and a Minimum Unencumbered Cash and Short Term Investments.

 

As of July 27, 2007, the notional fair value of our foreign exchange forward and foreign currency option contracts totaled $335,700. 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 on purchased options only.

 

We have both recourse and nonrecourse lease financing arrangements with third-party leasing companies through preexisting relationships with the customers. We sell our products directly to the leasing company, and the lease arrangement is made between our customer and the leasing company. Under the terms of recourse leases, which are generally three years or less, we remain liable for the aggregate unpaid remaining lease payments to the third-party leasing company in the event that any customers default. For these recourse arrangements, revenues on the sale of our product to the leasing company are deferred and recognized into income as payments to the leasing company come due. As of July 27, 2007, and April 27, 2007, the maximum recourse exposure under such leases totaled approximately $11,831 and $10,262, respectively. Under the terms of the nonrecourse leases, we do not have any continuing obligations or liabilities. To date, we have not experienced significant losses under this lease financing program.

 

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

 

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

 

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

 

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.

 

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

In June 2006, the FASB issued FIN No. 48, which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109. This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN No. 48 also provides guidance on derecognition of tax benefits, classification on the balance sheet, interest and penalties, accounting in interim periods, disclosure, and transition.

 

The total amount of unrecognized tax benefits upon the adoption of FIN No. 48, on April 28, 2007, was $58,326. There was no cumulative effect from the adoption of FIN No. 48, however, certain amounts were reclassified among our consolidated balance sheet accounts as follows:

 

 

The entire portion of the $58,326 balance of unrecognized tax benefits at April 28, 2007, if recognized, would affect our effective tax rate.

 

We recognize accrued interest and penalties related to unrecognized tax benefits in the income tax provision. During the fiscal years ended 2005-2007, we recognized total accrued interest and penalties of approximately $170 and have included this accrual in our FIN No. 48 disclosure balances.

 

We are subject to taxation in the United States, various states and several foreign jurisdictions. Our federal income tax returns are currently being examined for the fiscal years 2003-2004. We are effectively subject to federal tax examination adjustments for tax years ending on or after fiscal year 2000, in that we have net operating loss carryforwards from these years that could be subject to adjustment, if and when utilized.

 

As we are in the early stages of the federal tax return and foreign jurisdiction audit process, at this time we can not make a determination as to whether or not recognition of any unrecognized tax benefits will occur within the next 12 months.

 

The tax years that remain subject to examination for our major tax jurisdictions are shown below:

 

Tax Years Subject to Examination for Major Tax Jurisdictions at July 27, 2007

 

 

The above table excludes the net operating loss carryover risk identified above with respect to federal and state tax returns.

 

NETWORK APPLIANCE, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Effective April 28, 2007, we adopted 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 we have taken or expect 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. There was no cumulative effective from the adoption of FIN No. 48. As a result of the implementation of FIN No. 48, we recognize the tax liability for uncertain income tax positions on the income tax return based on the two-step process prescribed in the interpretation. The first step is to determine whether it is more likely than not that each income tax position would be sustained upon audit. The second step is to estimate and measure the tax benefit as the amount that has a greater than 50% likelihood of being realized upon ultimate settlement with the tax authority. Estimating these amounts requires us to determine the probability of various possible outcomes. We evaluate these uncertain tax positions on a quarterly basis. See “Note 14, Income Taxes,” for further discussion.

 

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 the first quarter of fiscal 2009. 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 in the first quarter of fiscal 2009. 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.

 

 

On August 13, 2007, we sold 360 shares of common stock of Blue Coat in a private transaction pursuant to Rule 144 under the Securities Act of 1933. We received net proceeds of approximately $18,256, after deducting the purchaser’s discount. These shares were acquired on September 11, 2006, in connection with the sale of our NetCache assets to Blue Coat.

 

On August 14, 2007, the Board of Directors approved a new stock repurchase program in which up to $1,000,000 worth of additional common stock may be purchased in addition to $199,948 remaining from all prior authorizations. On August 20, 2007, we repurchased $225,000 in common stock pursuant to our existing and new stock repurchase programs.

 

 

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and is subject to the safe harbor provisions set forth in the Exchange Act. Forward-looking statements usually contain the words “estimate,” “intend,” “plan,” “predict,” “seek,” “may,” “will,” “should,” “would,” “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) the continued softness in enterprise storage spending; (2) our programs to develop more new accounts; (3) our intention to continue to penetrate the largest storage buyers; (4) our plan to restrict discretionary expense; (5) our business fundamentals, our confidence in the competitiveness of our products, and our ability to grow our business over the long term; (6) our plan to invest in the people, processes and systems necessary to best optimize our revenue growth; our belief that we are well positioned in the fastest growth segments of the storage market; (7) higher disk content associated with high-end and mid-range storage systems and its impact on our gross margin in the future; (8) our service margin may experience some variability; (9) our estimate of the impact that adopting SFAS No. 123R will have on our earnings per share; (10) our estimates of future amortization of patents, trademarks, tradenames, customer contracts, and relationships; (11) our expectation to continue to selectively add sales capacity in an effort to expand domestic and international markets; (12) our expectation that our sales and marketing expenses will increase commensurate with future revenue growth; (13) 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; (14) our expectation to continuously support current and future product development and enhancement efforts and to incur corresponding charges; (15) our intention to continuously broaden our existing product offerings and introduce new products; (16) our belief regarding our research and development and general and administrative expenses will increase in absolute dollars for the remainder of fiscal 2008; (17) our estimates regarding future amortization of covenants not to compete; (18) our expectation that interest income may vary; (19) 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; (20) our expectation that cash provided by operating activities may fluctuate in future periods; (21) the possibility we may receive less cash from stock option exercises if stock option exercise patterns change; (22) our expectations regarding our contractual cash obligations and other commercial commitments at July 27, 2007, for future periods; (23) 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; (24) our expectation that capital expenditures will increase consistent with our business growth; (25) our expectation that our existing facilities and those currently being developed will be sufficient for our needs for at least the next two years and that our contractual commitments, and any required capital expenditures over the next few years, will be funded through cash from operations and existing cash and investments; (26) our expectation that we will incur higher capital expenditures in the near future; (27) our belief 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 through at least the next 12 months; (28) our belief that, based upon information available to us, that any current litigation and claims including our audits will not have a material adverse impact on our operating results; and (29) our belief that the results of our GSA and income tax audits 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. 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.

 

First Quarter Fiscal 2008 Overview

 

Revenues for the first quarter of fiscal 2008 were $689.2 million, reflecting an increase of 10.9% year over year but a decreased of 14.0% sequentially over the previous quarter. We believe the principal factor impacting our

revenue was the continued softness in enterprise storage spending, most notably in our existing commercial enterprise customer accounts in the United States and parts of Europe. The slowdown was not across all geographies and verticals. We reported increased revenue from the Federal business and regions such as Northeast Europe and Asia Pacific.

 

While we are not immune to the macroeconomic environment that is beyond our control, we believe that we are well positioned in the fastest growth segments of the storage market to capitalize on an IT spending recovery. We will continue to expand our programs to develop more new accounts, deepen our penetration in our current enterprise accounts, and broaden our vertical coverage. We intend to accelerate our revenue growth by penetrating the largest buyers of storage in the world, and will continue to invest in go-to-market partnerships, specifically through our channel programs and partnerships. At the same time, we will continue to restrict discretionary expense and slow down the rate of hiring in order to return to our targeted business model. However, if any storage market trends and emerging standards on which we are basing our assumptions do not materialize as anticipated, and if there is reduced or no demand for our products, our expected revenue growth rate could be materially affected.

 

Despite the revenue decrease from the fourth quarter of fiscal 2007, we believe our business fundamentals remain intact, and we are confident in the competitiveness of our products and in our ability to grow our business over the long term. We do not believe that this shortfall is the result of changes in the competitive environment. However, continued revenue growth depends on the introduction and market acceptance of our new products and solutions and continued market demand for our products. We will continue to invest in the people, processes, and systems necessary to best optimize our revenue growth and long-term profitability. However, we cannot assure you that such investments will achieve our financial objectives.

 

First Quarter Fiscal 2008 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.

With the exception of the changes required by FIN No. 48 on Accounting for Income Taxes, there have been no significant changes during the first quarter of fiscal 2008 to the items that we disclosed as our critical accounting policies and estimates in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of our Annual Report on Form 10-K for the year ended April 27, 2007.

 

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 on existing tax laws in both the United States 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 July 27, 2007, compared to $21.0 million as of April 27, 2007, on certain of our deferred tax assets.

 

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

 

On April 28, 2007, we adopted FIN No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109” (FIN No. 48). FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS 109). This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. As a result of the implementation of FIN No. 48, we recognize the tax liability for uncertain income tax positions on the income tax return based on the two-step process prescribed in the interpretation. The first step is to determine whether it is more likely than not that each income tax position would be sustained upon audit. The second step is to estimate and measure the tax benefit as the amount that has a greater than 50% likelihood of being realized upon ultimate settlement with the tax authority. Estimating these amounts requires us to determine the probability of various possible outcomes. We evaluate these uncertain tax positions on a quarterly basis. This evaluation is based on the consideration of several factors, including changes in facts or circumstances, changes in applicable tax law, settlement of issues under audit, and new exposures. If we later determine that our exposure is lower or that the liability is not sufficient to cover our revised expectations, we adjust the liability and effect a related change in our tax provision during the period in which we make such determination.

New Accounting Standards

 

See Note 15 of the Condensed Consolidated Financial Statements for a full description of new accounting pronouncements, including the respective expected dates of adoption and effects on results of operations and financial condition.

 

Results of Operations

 

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