NETWORK APPLIANCE INC - 10-Q Quarterly Report

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

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

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

See accompanying notes to unaudited condensed consolidated financial statements.

Based in Sunnyvale, California, Network Appliance was incorporated in California in April 1992, and reincorporated in Delaware in November 2001. Network Appliance offers unified storage solutions for the data-intensive enterprise. NetApp® network storage solutions and service offerings provide data-intensive enterprises with consolidated storage, improved data center operations, economical business continuance, and efficient remote data access across the distributed enterprise.

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.

We operate on a 52-week or 53-week year ending on the last Friday in April. For presentation purposes we have indicated in the accompanying interim unaudited condensed consolidated financial statements that our fiscal year end is April 30. The first quarters of fiscal 2005 and 2004 were 13-week and 14-week fiscal periods, respectively.

These financial statements should be read in conjunction with the audited consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the year ended April 30, 2004. The results of operations for the three-month period ended July 30, 2004 are not necessarily indicative of the operating results to be expected for the full fiscal year or future operating periods. In the following notes to our interim condensed consolidated financial statements, Network Appliance Inc. is also referred to as “we”, “our” and “us”.

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

We adopted Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities” as amended by SFAS No. 149, “Amendment of SFAS No. 133 on Derivative Instruments and Hedging Activities.” Derivatives that are not designated as hedges are adjusted to fair value through earnings. If the derivative is designated as a hedge, depending on the nature of the exposure being hedged, changes in fair value will either be offset against the change in fair value of the hedged

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asset or liability through earnings, or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of the hedge is recognized in earnings immediately.

As a result of our significant international operations, we are subject to risks associated with fluctuating exchange rates. We use derivative financial instruments, principally currency forward contracts and currency options, to attempt to minimize the impact of exchange rate movements on our balance sheet relating to certain foreign currency assets and liabilities and operating results. We have established transaction and balance sheet risk management programs to protect against reductions in fair value and volatility of future cash flows caused by changes in exchange rates. Factors that could have an impact on the effectiveness of our hedging program include the accuracy of forecasts and the volatility of foreign currency markets. These programs reduce, but do not always entirely eliminate, the impact of currency exchange movements. The maturities of these instruments are generally less than one year.

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


	Balance Sheet. We utilize currency forward contracts and currency options to hedge currency exchange rate fluctuations related to certain foreign currency assets and liabilities. Gains and losses on these derivatives offset gains and losses on the assets and liabilities being hedged and the net amount is included in earnings. For the three-month periods ended July 30, 2004 and August 1, 2003, net gains generated by hedged assets and liabilities totaled $1,288 and $2,447, respectively, and were offset by losses on the related derivative instruments of $2,216 and $2,618, respectively.

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

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

	If the underlying forecasted transactions do not occur, or it becomes probable that they will not occur, the gain or loss on the related cash flow hedge is recognized immediately in earnings. For the three-month periods ended July 30, 2004 and August 1, 2003, we did not record any gains or losses related to forecasted transactions that did not occur or became improbable.

	We measure the effectiveness of hedges of forecasted transactions on at least a quarterly basis by comparing the fair values of the designated currency forward contracts with the fair values of the forecasted transactions. No ineffectiveness was recognized in earnings during the three-month periods ended July 30, 2004 and August 1, 2003.

	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.

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

During the first quarter of fiscal 2005, as part of our expansion efforts, we purchased three buildings in Research Triangle Park (“RTP”), North Carolina, for $24,095 and was included in Land and Construction-in-progress at July 30, 2004.

Goodwill is reviewed annually for impairment (or more frequently if indicators of impairment arise). We completed our annual impairment assessment on February 27, 2004 and concluded that goodwill was not impaired. From the period subsequent to February 27, 2004 through July 30, 2004, there was no impairment of goodwill and intangible assets.

Goodwill and identified intangible assets relate to our acquisitions of Spinnaker Networks, Inc. (“Spinnaker”) in February 2004, WebManage Technologies, Inc. (“WebManage”) in November 2000, and

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Orca Systems, Inc. (“Orca”) in June 2000. Balances as of July 30, 2004 and April 30, 2004 are summarized as follows:

Capitalized patents are amortized over an estimated useful life of five years as research and development expenses. Existing technology is amortized as cost of product revenue. Existing technology from the WebManage acquisition is fully amortized at April 30, 2004. Trademarks and tradenames as well as customer contracts and relationships are amortized as sales and marketing expenses. Covenants not to compete are amortized as general and administrative expenses.

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Based on the identified intangible assets (including patents) recorded at July 30, 2004, the future amortization expense of identified intangibles for the next five fiscal years is as follows:

We account for stock-based compensation in accordance with the provisions of Accounting Principle Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” and comply with the disclosure provisions of SFAS No. 123 as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosures.” Deferred compensation recognized under APB No. 25 is amortized ratably to expense over the vesting periods. We account for stock options issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force (“EITF”) No. 96-18 “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services” under the fair value based method.

Had compensation expense been determined based on the fair value at the grant date for awards, consistent with the provisions of SFAS No. 123, our pro forma net income (loss) and pro forma net income (loss) per share would be as follows (in thousands, except per share data):

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

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We recorded $2,027 and $519 of compensation expense for the three-month periods ended July 30, 2004 and August 1, 2003, respectively, primarily related to the amortization of deferred stock compensation from unvested options assumed in the WebManage and Spinnaker acquisitions, the retention escrow shares relative to Spinnaker, the grant of stock options to certain highly compensated employees below fair value at the date of grant and the award of restricted stock to certain employees. We reversed $687 and $60 of deferred compensation to deferred stock compensation and common stock in the three-month periods ended July 30, 2004 and August 1, 2003, all due to employee terminations.

Estimated future deferred stock compensation amortization for fiscal 2005, 2006, 2007 and 2008 are expected to be $5,483, $6,578, $5,032 and $3,682, respectively, and none thereafter.

We recorded $77 and $135 in compensation expense in the three-month periods ending July 30, 2004 and August 1, 2003, respectively, for the fair value of options granted to a member of the Board of Directors in recognition for services performed outside of the normal capacity of a board member.

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

During all periods presented, we had certain options outstanding, which could potentially dilute basic earnings per share in the future, but were excluded in the computation of diluted earnings per share in such periods, as their effect would have been antidilutive. These certain options were antidilutive in the three-month periods ended July 30, 2004 and August 1, 2003 as these options’ exercise prices were above the average market prices in such periods. For the three-month periods ended July 30, 2004 and August 1, 2003, 27,992 and 30,278 shares of common stock options with a weighted average exercise price of $38.88 and $38.21, respectively, were excluded from the diluted net income per share computation.

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

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The components of accumulated other comprehensive income (loss) net of related tax effects were as follows:

In fiscal 2002, as a result of continuing unfavorable economic conditions and a reduction in IT spending rates, we implemented two restructuring plans, which included reductions in workforce and consolidations of facilities. As a result of the restructuring in August 2001, we recorded a charge of $7,980. The restructuring charge included $4,796 of severance-related amounts, $2,656 of committed excess facilities and facility closure expenses, and $528 in fixed assets write-offs. The reserve balance related to this restructuring charge was $854 at July 30, 2004 was included in other accrued liabilities.

In the event that the foreign facilities are not subleased, we will be obligated for additional total lease payments of approximately $366 as of July 30, 2004 to be payable through January 2006.

As of July 30, 2004, we have $722 outstanding in our accrued and unpaid severance-related restructuring costs due to changes in estimated costs of certain severance-related matters. We expect to pay or adjust the remaining severance-related restructuring costs pending the outcome of the ultimate resolution of these matters in the next twelve months.

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The following analysis sets forth the significant components of the second quarter fiscal 2002 restructuring at July 30, 2004:

In April 2002, we completed a restructuring related to the closure of an engineering facility and consolidation of resources to the Sunnyvale headquarters. As a result of this restructuring, we incurred a charge of $5,850. The restructuring charge included $813 of severance-related amounts, $4,564 of committed excess facilities and facility closure expenses, and $473 in fixed assets write-offs. Of the reserve balance at July 30, 2004, $653 was included in other accrued liabilities and the remaining $4,375 was classified as long-term obligations.

In fiscal 2003 and 2004, we updated our assumptions and estimates based on certain triggering events, which resulted in additional net charges of $923 and $1,327 respectively, primarily relating to sublease assumptions for our engineering facility lease. Our restructuring estimates are reviewed and revised periodically and may result in a substantial charge to restructuring expense should different conditions prevail than were anticipated in previous management estimates. Such estimates included various assumptions such as the time period over which the facilities will be vacant, expected sublease terms, and expected sublease rates. In the event that the engineering facility is not subleased as anticipated, we will be obligated for additional total lease payments of $1,761 as of July 30, 2004 to be payable through November 2010.

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The following analysis sets forth the significant components of the restructuring reserve at July 30, 2004:

All our investments are classified as available for sale at July 30, 2004 and April 30, 2004. Available-for-sale investments with original maturities of greater than three months are classified as short-term investments, as these investments generally consist of highly marketable securities that are intended to be available to meet current cash requirements. Investment securities classified as available-for-sale are reported at fair market value, and net unrealized gains or losses are recorded in accumulated other comprehensive loss, a separate component of stockholders’ equity, net of taxes. Any gains or losses on sales of investments are computed based upon specific identification. For all periods presented, realized gains and losses on available-for-sale investments were not material. Management evaluates investments on a regular basis to determine if an other-than-temporary impairment has occurred. Our investments in publicly held companies are generally considered impaired when a decline in the fair value of an investment as measured by quoted market prices is less than its carrying value and such a decline is not considered temporary. We adopted the provisions of EITF No. 03-01 on other-than-temporary impairments on debt and equity investments, the adoption did not have a significant impact on our carrying value of our investment at July 30, 2004.

The Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities,” in January 2003, and a revised interpretation of FIN No. 46 (“FIN 46-R”) in December 2003. FIN No. 46 requires certain variable interest entities (“VIEs”) to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The provisions of FIN No. 46 are effective immediately for all arrangements entered into after January 31, 2003. Since January 31, 2003, the Company has not invested in any entities it believes are variable interest entities for which the Company is the primary beneficiary. For all arrangements entered into after January 31, 2003, the Company is required to continue to apply FIN No. 46 through April 30, 2004. The Company is required to adopt the provisions of FIN No. 46-R for those arrangements on May 1, 2004. For arrangements entered into prior to February 1, 2003, the Company is required to adopt the provisions of FIN No. 46-R on May 1, 2004.

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The Company does not expect the adoption of FIN No. 46-R to have an impact on the financial position, results of operations or cash flows of the Company.

In November 2003, the EITF reached an interim consensus on EITF No. 03-01, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments,” to require additional disclosure requirements for securities classified as available-for-sale or held-to-maturity for fiscal years ending after December 15, 2003. In March 2004, the EITF reached a final consensus on this Issue, to provide additional guidance which companies must follow in determining whether investment securities have an impairment which should be considered other-than-temporary. The guidance is applicable for reporting periods after June 15, 2004. Adoption of the consensus did not have a significant impact on the carrying value of its investments at July 30, 2004. The Company will continue to monitor the carrying value of its investments under this new guidance in fiscal 2005.

The following summarizes our commitments and contingencies at July 30, 2004, and the effect such obligations may have on our future periods, (in thousands):


(1)	We lease sales offices and research and development facilities throughout the U.S. and internationally. These sales offices are also leased under operating leases which expire through fiscal 2019. We are responsible for certain maintenance costs, taxes, and insurance under these leases. Substantially all lease agreements have fixed payment terms based on the passage of time. Some lease agreements provide us with the option to renew the lease. Our future operating lease obligations would change if we were to exercise these renewal options and if we were to enter into additional operating lease agreements. Certain real estate operating sub-lease income of $271 has been included as a reduction of the payment amounts shown in the table. Rent operating lease payments in the table exclude the leases impacted by the restructurings and include only rent lease commitments that are over one year.

(2)	Venture capital funding commitments includes a quarterly committed management fee based on a percentage of our committed funding to be payable through June 2011.

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(3)	Purchase commitments represent agreements to purchase component inventory from our suppliers and contract manufacturers that are enforceable and legally binding against us. Other commitments include facilities-related and utilities usage minimum commitment. Purchase commitments and other excludes purchases of good and services we expect to consume in the ordinary course of business in the next twelve months. It also excludes costs that are not reasonably estimable at this time.

(4)	Under certain communications contracts with major telephone companies as well as maintenance contracts with multiple vendors, we are required to pay based on a minimum volume. Such obligations expire in January 2009.

(5)	As a result of headcount reductions and a restructuring in fiscal 2002, we are not currently utilizing certain existing space at our California headquarters site. Additionally, we have also exited office space under non-cancellable leases in certain locations both in the U.S. and Europe. If we are unable to successfully sublease our vacated and unoccupied office space under operating leases, we would be obligated to pay $2,127 million in excess of the liability recorded in our restructuring reserves. See “Note 10 — Restructuring Charges.”

(6)	The amounts outstanding under these letters of credit relate to workers’ compensation, customs guarantee and a foreign lease.

(7)	Restricted cash arrangements relate to facility lease requirements, service performance guarantees, customs and duties guarantees, and VAT requirements and are included under Prepaid Expenses and Other and Other Assets on our Consolidated Balance Sheets.

In May 2000, we entered into a split dollar insurance arrangement with Daniel J. Warmenhoven. Under the arrangement, we will pay the annual premiums on several insurance policies on the life of the survivor of Mr. Warmenhoven and his wife Charmaine Warmenhoven, and Mr. Warmenhoven will pay us each year for a portion of those premiums equal to the economic value of the term insurance coverage provided him under the policies. For each of the 2001, 2002, 2003, 2004 and 2005 fiscal years, we paid an aggregate net annual premium on these split dollar polices in the amount of approximately $2,050. Under the arrangement, we will be reimbursed for all premium payments made on those policies, and it is intended that we will be reimbursed not later than May 2005. Accordingly, such balances have been reclassified from Other Assets to Prepaid Expenses and Other at July 30, 2004. The policies are owned by a family trust established by Mr. Warmenhoven, and upon the death of the survivor of Mr. Warmenhoven and his wife or any earlier cash-out of the policies, we will be entitled to a portion of the insurance proceeds or cash surrender value of the policies equal to the net amount of cumulative premiums paid on those policies by us, and the balance will be paid to the trust. We have obtained a collateral assignment of the policies as a security interest for our portion of the proceeds or cash surrender value payable to us under the policies, and neither Mr. Warmenhoven nor the trust may borrow against the policies while that security interest remains in effect. The arrangement is terminable by us upon thirty (30)-days prior notice, and such termination will trigger a refund of the net cumulative premiums paid by us on the policies.

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

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

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As of July 30, 2004, our financial guarantees consisted of standby letters of credit outstanding, bank guarantee, and restricted cash, which were related to facility lease requirements, service performance guarantees, customs and duties guarantees, VAT requirements, and workers’ compensation plans. The maximum amount of potential future payments under these arrangements was $4,633 and $4,338 as of July 30, 2004 and April 30, 2004, respectively. Of this maximum exposure, $2,873 and $2,736 of restricted cash was classified under Prepaid Expense and Other Assets on our balance sheet at July 30, 2004 and April 30, 2004, respectively. We have not recorded any liability at July 30, 2004 and April 30, 2004, respectively, related to these guarantees.

As of July 30, 2004, our notional fair values of foreign exchange forward and foreign currency option contracts totaled $145,985. 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 offer both recourse and non-recourse lease financing arrangements to our customers. 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 were to default. We defer 100% of the recourse lease obligation and recognize revenue over the term of the lease as the lease payments become due. As of July 30, 2004 and April 30, 2004, the maximum recourse exposure under such leases totaled approximately $6,711 and $6,755, respectively. Under the terms of the non-recourse leases we do not have any continuing obligations or liabilities. To date, we have not experienced significant losses under this lease financing program.

We do not maintain a general warranty reserve for estimated costs of product warranties at the time revenue is recognized due to our extensive product quality program and processes and because our global customer service inventories utilized to correct product failures are carried at zero cost.

We enter into standard indemnification agreements in the ordinary course of business. Pursuant to these agreements, we agree to defend and indemnify the other party, primarily our customers or business partners or subcontractors for damages and reasonable costs incurred in any suit or claim brought against them alleging that our products sold to them infringe any U.S. patent, copyright, trade secret or similar right. If a product becomes the subject of an infringement claim, we may, at our option: (i) replace the product with another non-infringing product that provides substantially similar performance; (ii) modify the infringing product so that it no longer infringes but remains functionally equivalent; (iii) obtain the right for the customer to continue using the product at our expense and for the reseller to continue selling the product; (iv) take back the infringing product and refund to customer the purchase price paid less depreciation amortized on a straight line basis. We have not been required to make material payments pursuant to these provisions historically. We have not identified any losses that are probable under these provisions and, accordingly, we have not recorded a liability related to these indemnification provisions.

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and are subject to the safe harbor provisions set forth in the Exchange Act. Forward-looking statements usually contain the words “estimate,” “intend,” “plan,” “predict,” “seek,” “may,” “will,” “should,” “would,” “anticipate,” “expect,” “believe,” or similar expressions and variations or negatives of these words. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. All forward-looking statements, including, but not limited to, (1) our plans to continue to leverage our product capabilities to enhance our storage grid architectures; (2) the possibility that we may engage in future acquisitions; (3) our expectation that we will increasingly rely on our indirect sales channel for a significant portion of our revenue; (4) our expectation that the ultimate costs to resolve any outstanding legal claims or proceedings will not be material to our business; (5) our expectation that we will see strong demand for storage in many areas; (6) our belief that our unified storage architecture provides for a complete and flexible solution across all tiers of storage; (7) our intent to regularly introduce new products and product enhancements and our intent to support current and new products and product enhancements; (8) our expectation that our expenditures on expanding our current product offerings and introducing new products in order to capitalize on growth opportunities will increase in absolute dollars; (9) the possibility that we may need to increase our materials purchases, contract manufacturing capacity and internal test and quality functions to meet anticipated demand; (10) our belief that our products currently compete favorably with our competitors; (11) our intention to continue to establish and maintain business relationships with technology companies; (12) our belief that our existing facilities and those currently being developed, will be sufficient for our needs for at least the next two years; (13) our expectation that we will continue to add sales capacity; (14) our expectation that we will increase sales and marketing expenses commensurate with future revenue growth; (15) our belief that our general and administrative expenses will increase in absolute terms in fiscal 2005; (16) our belief that our existing liquidity and capital resources are sufficient to fund our operations for at least the next twelve months; (17) our expectation that interest income will increase in fiscal 2005; (18) our expectation that the value of our investments will not decline significantly because of changes in market interest rates; (19) the expected impact of recent accounting pronouncements on our financial condition and results of operations; (20) our belief that our forward currency contracts will not subject us to undue risk; (21) our expectation regarding estimated future deferred stock compensation amortization expenses; (22) the possibility that we may be obligated for additional lease payments to be payable through November 2010 in the event that our vacated facilities are not subleased; (23) our expectation that there will be a further decline in the price per petabyte; (24) our estimates of future intangibles and stock compensation amortization expense relating to the Spinnaker acquisition; (25) our expectation that service margins will improve; (26) our estimates regarding future capitalized patents amortization expenses; (27) our expectation that we will continuously support current and future product development and enhancement efforts and incur corresponding charges; (28) our intention to continuously broaden our existing product offerings and introduce new products; (29) our belief that our research and development expenses will increase in absolute dollars for fiscal 2005; (30) our expectation that capital expenditures will increase consistent with our business growth; and (31) our expectations regarding our contractual cash obligations and other commercial commitments at July 30, 2004 for fiscal years 2005 through 2009 and thereafter, which we anticipate will equal no more than $91.1 million in the aggregate; (32) our belief that our strategic investments are targeted at some of the strongest growth areas of the storage market 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 margin levels; (4) our ability to successfully introduce new products; (5) our ability to achieve and capitalize on changes in market demand; (6) acceptance of, and demand for, our products; (7) our ability to identify and respond to significant market trends and emerging standards; (8) our ability to

realize our financial objectives through increased investment in people, process and systems; (9) acceptance of, and demand for, our products; (10) our ability to maintain our supplier and contract manufacturer relationships; (11) the ability of our competitors to introduce new products that compete successfully with our products; (12) the general economic environment and the continued growth of the storage and content delivery markets; (13) our ability to sustain and/or improve our cash and overall financial position; (14) our ability to generate future income to utilize our deferred tax assets; and (15) those factors discussed under “Risk Factors” elsewhere in this Quarterly Report on Form 10-Q. 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.

Based in Sunnyvale, California, Network Appliance was incorporated in California in April 1992, and reincorporated in Delaware in November 2001. Network Appliance offers unified storage solutions for the data-intensive enterprise. Network Appliance^TM network storage solutions and service offerings provide data-intensive enterprises with consolidated storage, improved data center operations, economical business continuance, and efficient remote data access across the distributed enterprise. Network Appliance solutions are the data management and storage foundation for enterprises, government agencies, and universities worldwide.

Throughout the first quarter of fiscal year 2005, we deployed our tier-one storage solutions for the most demanding customers, expanded partnerships, and enhanced our storage grid architecture. Enterprise customers have chosen to deploy Network Appliance solutions to reduce complexity, achieve a low total cost of ownership (TCO), and utilize our advanced storage and software management capabilities.. We expect to continue to see strong demand for storage in many areas, including mission-critical tier-one environments, distributed enterprise, disk-to-disk backup, compliance, disaster recovery, and unified SAN and NAS solutions.

Customers across all geographies deploy our solutions for a variety of database, collaborative, and other data center and mission-critical applications. Customers are increasingly moving towards storage solutions that support multiple applications. Our customers are adopting our technology to build storage infrastructures that support all tiers of data — creating a multi-purpose storage utility, similar in concept to their network utility which is independent of the applications it supports, and therefore much more flexible. For example, in our SAN business, customers are using both IP SAN and fibre channel SAN together in the systems they purchase. Many of our systems are purchased along with multiple protocols and interfaces to support a variety of access types and data structures. We believe it is our unified architecture, based on one operating system with interoperability across all of our product lines, that provides for a complete and flexible solution for our customers across all of their tiers of storage.

Our year-over-year quarterly revenue growth was driven by strong demand for our new products across all major product lines, as well as increased sales of our software and services products, however, we cannot assure you that revenue will continue to grow at previous rates. In addition, we also broadened our channel strategy with the addition of distributors such as, Arrow and Avnet to expand our storage businesses and gain greater market penetration opportunities. This revenue growth has occurred while the market for our storage products and solutions has grown more competitive with downward pricing pressures that could negatively impact our revenue growth rate. At the same time, we anticipate and continue to experience further price decline per petabyte for our products which may have an adverse impact on our gross margin if not offset by favorable software mix and higher average selling prices associated with new products. We continue to expect our gross margin to be impacted by factors such as new product introductions and enhancements, add-on software and product mix, discount level, competition and global service investment. Revenue growth in fiscal 2005 is dependent on the introduction of our new products, including but not limited to the incorporation of new advanced distributed storage technologies from our Spinnaker acquisition into our existing products. As with

any product introduction, we face risks in the design, testing, qualification and market acceptance of our new products. If we fail to timely introduce new products, or if there is no or reduced demand for these or our current products, we may experience a decline in revenue. We believe that our strategic investments are targeted at some of the strongest growth areas of the storage market. 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. Additionally, we plan to invest in the people, processes, and systems necessary to best optimize these growth opportunities. However, we cannot assure you that such investments will achieve our financial objectives. See “Risk Factors” under Item 2.


	•	Our revenues for the first quarter of fiscal 2005 were $358.4 million, a 37.6% increase over the same period a year ago. While all product areas contributed to revenue growth, NearStore, FAS 980 and the FAS 270 were significant contributors.

	•	Our overall gross margins improved to 60.0% in the first quarter of fiscal 2005 from 59.9% in the same period in fiscal 2004. The slight improvement in our gross margin was attributable to a favorable change in product and add-on software mix, partially offset by the continued investment in our service infrastructure.

	•	Net income for the first quarter increased 73.1% to $46.9 million compared to net income of $27.1 million for the same period a year ago.

	•	Our balance sheet as of July 31, 2004 remains debt-free, with cash, cash equivalents and investments of $826.6 million (net of $47.7 million of cash repurchases of our common stock in the first quarter of fiscal 2005), due primarily to our net income and the related cash generated from operations. Days Sales Outstanding decreased to 51 days as of July 30, 2004 from 54 days as of August 1, 2003, reflecting more linear quarterly sales and solid credit management. Inventory turns were 16.4 times, improved 54.4% from a year ago. Deferred revenue increased 63.3% to $309.2 million from $189.3 million reported a year ago. Capital purchases of plant, property and equipment were $33.3 million, which included the $24.1 million site purchase in Research Triangle Park, North Carolina.

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

The following table presents the components of revenues, stated as a percentage of total revenues:

Product Revenues — Product revenues increased by 37.7% to $324.6 million for the first quarter of fiscal 2005, from $235.8 million for the first quarter of fiscal 2004. Product revenues growth was across all geographies. This increase in product revenues was specifically attributable to increased software licenses and software subscriptions and an increase in units shipped, as compared to the same period in the prior year.


	•	increased revenues from our current product portfolio, such as: FAS980, FAS270, and FAS250 filer products; NearStore® R200 nearline storage systems; and NetCache® C2100 and C6200 appliances;

	•	increased revenues from our solutions portfolio, which consists of multiple access types and multiple applications under one common architecture;

	•	increased sales of software subscription upgrades representing 10.2% of total revenues for the first quarter of fiscal 2005 compared to 9.2% of total revenue for the same period in fiscal 2004;

	•	increased demand for NetApp’s mission-critical tier-one storage environments, distributed enterprise, disk-to-disk backup, compliance, disaster recovery, and unified SAN and NAS solutions;

	•	increased sales through indirect channels in absolute dollars, including sales through our resellers, distributors and OEM partners, representing 45.9% and 51.7% of total revenues for the first quarters of fiscal 2005 and fiscal 2004, respectively.


	•	lower-cost-per-megabyte disks;

	•	declining average selling price and unit sales of our older filer and caching products, and


	•	incremental revenue due to an extra week of business in the first quarter of fiscal 2004 compared to the same quarter in fiscal 2005.

The Spinnaker acquisition did not have a significant impact on our first quarter fiscal 2005 revenue. We cannot assure you that we will be able to maintain or increase market demand for our products.

Service Revenues — Service revenues, which include hardware support, professional services, and educational services, increased by 36.7% to $33.8 million in the first quarter of fiscal 2005, from $24.7 million in the first quarter of fiscal 2004. Service revenues are generally deferred and, in most cases, recognized ratably over the service obligation periods, which are typically one to three years. Service revenues represented 9.4% and 9.5% of total revenues for the first quarters of fiscal 2005 and fiscal 2004, respectively. The increase in absolute dollars was due to an increasing number of enterprise customers, which typically purchase more complete and generally longer-term service packages than our non-enterprise customers. Higher service revenues were also related to a growing installed base resulting in new customer support contracts in addition to support contract renewals by existing customers. While it is an element of our strategy to expand and offer a more comprehensive, global enterprise support and service solution, we cannot assure you that service revenue will grow at the current rate in the remainder of fiscal 2005.

International total revenues — International total revenues (including United States exports) increased by 37.6% for the first quarter of fiscal 2005 as compared to the same period of fiscal 2004. International total revenues were $149.3 million, or 41.6% of total revenues and $108.5 million, or 41.6% of total revenues for the first quarters of fiscal 2005 and fiscal 2004, respectively. The increase in international sales was primarily a result of European and Asia Pacific net revenues growth, driven by larger storage implementations, increased demand for our current product portfolio and higher storage spending in certain geographic regions, as compared to the same period in the prior fiscal year. We cannot assure you that we will be able to maintain or increase international revenues in the remainder of fiscal 2005.

Product Gross Margin — Product gross margin increased to 64.8% for the first quarter of fiscal 2005, from 63.9% for the first quarter of fiscal 2004. Amortization of existing technology included in cost of product revenues was $0.9 million and $1.4 million for the first quarters of fiscal 2005 and 2004, respectively. Estimated future amortization of existing technology to cost of product revenues relating to the Spinnaker acquisition will be $2.6 million for 2005 and $3.4 million for each of fiscal years 2006, 2007, 2008; $2.8 million for fiscal year 2009; and none thereafter.


	•	favorable product and add-on software mix;

	•	competitive pricing solutions with our bundled software and solutions set;

	•	higher average selling prices for our newer products;

	•	growth in software subscription upgrades and software licenses due primarily to a larger installed base and an increasing number of new enterprise customers;

	•	lower cost of components; and

	•	transitional expenses incurred in the first quarter of fiscal 2004 associated with the initial implementation of a new Enterprise Resource Planning (“ERP”) system, which we did not incur in the first quarter of fiscal 2005.


	•	increased sales through certain indirect channels, which carry a lower gross margin than our direct sales;

	•	higher disk content with an expanded storage capacity for the higher-end filers and Nearstore systems, as resale of disk drives generates lower gross margin;


	•	sales price reductions due to competitive pricing pressure and selective pricing discounts;

	•	lower average selling price of certain add-on software options.

Service Gross Margin — Service gross margin decreased to 13.5% in the first quarter of fiscal 2005 as compared to 21.7% in the first quarter of fiscal 2004. Investments in customer service increased by 51.2% to $29.2 million in the first quarter of fiscal 2005, from $19.3 million in the first quarter of fiscal 2004. The decrease in service gross margin was primarily due to the continued investment in our service infrastructure to support our increasing enterprise customer base partially offset by improved headcount utilization. These investments included additional professional support engineers, increased support center activities and global service partnership programs. Service gross margin will typically experience some variability over time due to the timing of technical support service initiations and renewals and additional investments in our customer support infrastructure. We expect service margin to improve as we begin to see service revenue growth and improved headcount utilization, partially offset by major investments in headcount and logistics as we continue to build out our service capability and capacity.

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 30.2% to $103.3 million for the first quarter of fiscal 2005, from $79.4 million for the first quarter of fiscal 2004. These expenses were 28.8% and 30.4% of total revenues for the first quarters of fiscal 2005 and fiscal 2004, respectively. The increase in absolute dollars was attributed to increased sales kick off expenses, increased commission expenses resulting from increased revenues, higher performance-based payroll expenses due to higher profitability, and the continued worldwide investment in our sales and global service organizations associated with selling complete enterprise solutions and scaling our sales infrastructure, offset by a 14-week quarter in the first quarter of fiscal 2004 as compared to a 13-week quarter in the same period in fiscal 2005. Amortization of Spinnaker trademarks/tradenames and customer contracts/relationships included in sales and marketing expenses was $0.2 million for the first quarter of fiscal 2005 and none in the first quarter of fiscal 2004, respectively. Estimated future amortization of trademarks, tradenames, customer contracts and relationships relating to the Spinnaker acquisition will be $0.6 million for the remainder of fiscal year 2005 and $0.4 million for fiscal 2006, respectively, and none thereafter.

Sales and marketing headcount increased to 1,515 at July 30, 2004 from 1,188 at August 1, 2003. We expect to continue to selectively add sales capacity in an effort to expand domestic and international markets, introduce new products, establish and expand new distribution channels, and increase product and company awareness. We expect to increase our sales and marketing expenses commensurate with future revenue growth.

Research and Development — Research and development expenses consist primarily of salaries and benefits, prototype expenses, non-recurring engineering charges, fees paid to outside consultants and amortization of capitalized patents. Included in research and development expenses is capitalized patents amortization of $0.5 million for the three-month period ending July 30, 2004, as compared to $0.2 million for the same period in the prior year. Estimated future capitalized patents amortization expenses for fiscal 2005 will be $1.4 million, $1.8 million for each of the fiscal years 2006, 2007 and 2008 and $0.3 million thereafter.

Research and development expenses increased 22.7% to $38.7 million for the first quarter of fiscal 2005 from $31.5 million for the first quarter of fiscal 2004. These expenses represented 10.8% and 12.1% of total revenues for the first quarters of fiscal 2005 and 2004, respectively. The increase in research and development expenses was primarily a result of increased headcount, increased ongoing impact of the Spinnaker acquisition, ongoing support of current and future product development and enhancement efforts, higher performance-based payroll expenses due to higher profitability, offset by an extra week of expenses in the first quarter of fiscal 2004 compared to the same period in fiscal 2005, cost control and reduction in discretionary spending efforts. Research and development headcount increased to 687 as of July 30, 2004 compared to 540 as of August 1, 2003. For both the first quarters of fiscal 2005 and 2004, no software development costs were capitalized.

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

We believe that our research and development expenses will increase in absolute dollars for the remainder of fiscal 2005, primarily due to ongoing costs associated with the development of new products and technologies, projected headcount growth and the operating impact of the Spinnaker acquisition as compared to the comparable period in the prior year.

General and Administrative — General and administrative expenses increased 37.6% to $16.9 million for the first quarter of fiscal 2005, from $12.3 million for the first quarter of fiscal 2004. These expenses represented 4.7% and 4.7% of total revenues for the first quarters of fiscal 2005 and 2004, respectively. This increase in absolute dollars was primarily due to expenses associated with expanded regulatory requirements, higher legal expenses and professional fees for general corporate matters, higher performance-based payroll expenses due to higher profitability, partially offset by reduced expenses as a result of one less week of expenses in the first quarter of fiscal 2005 compared to the same period in fiscal 2004 and higher expenses associated with investments in our enterprise-wide ERP system and back-office infrastructure in the first quarter of fiscal 2004.

General and administrative headcount increased to 348 at July 30, 2004 from 282 at August 1, 2003. We believe that our general and administrative expenses will increase in absolute dollars for the remainder of fiscal 2005 due to additional expenses related to expanded regulatory requirements as compared to the same period in the prior year. Amortization of Spinnaker covenants not to compete included in general and administrative expenses was $1.3 million for the first quarter of fiscal 2005 and none in the first quarter of fiscal 2004. Estimated future amortization of covenants not to compete relating to the Spinnaker acquisition will be $3.8 million in the remainder of fiscal 2005 and $1.5 million for fiscal year 2006, respectively, and none thereafter.

Stock Compensation — Stock compensation expenses were $2.1 million and $0.7 million for the first quarters of fiscal 2005 and 2004, respectively. This net increase in stock compensation expenses reflected primarily higher stock compensation relating to the Spinnaker acquisition and restricted stock awards offset by forfeitures of unvested options assumed in the Spinnaker and WebManage acquisitions. Estimated future deferred stock compensation amortization expenses are $5.5 million in the remainder of fiscal 2005, $6.6 million in fiscal 2006, $5.0 million in fiscal 2007 and $3.7 million in fiscal 2008 and none thereafter.

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.

In August 2001, we implemented the first restructuring plan, which included a reduction in workforce by approximately 200 employees and a consolidation of facilities. The action was required to properly align and manage the business commensurate with our revenue at that time. All functional areas of the Company were affected by the reduction. We completed our actions during the second quarter of fiscal 2002. As a result of this restructuring, we recorded a charge of $8.0 million. The restructuring charge included $4.8 million of severance-related amounts, $2.7 million of committed excess facilities and facility closure expenses, including certain facilities in foreign countries, and $0.5 million in fixed assets write-offs. The reserve balance related to this restructuring charge was $0.9 million at July 30, 2004 was included in other accrued liabilities.

In the event that the foreign facilities that we vacated are not subleased, we will be obligated for additional total lease payments of approximately $0.4 million as of July 30, 2004 to be payable through January 2006.

As of July 30, 2004, we have $0.7 million outstanding in our accrued and unpaid severance-related restructuring costs due to changes in estimated costs of certain severance-related matters. We expect to pay or adjust the remaining severance-related restructuring costs pending the outcome of the ultimate resolution of these matters in the next twelve months.

The following analysis sets forth the significant components of the second quarter fiscal 2002 restructuring at July 30, 2004 (in thousands):

In April 2002, we completed a restructuring related to the closure of an engineering facility and consolidation of resources to the Sunnyvale headquarters. As a result of this restructuring, we recorded a charge of $5.9 million. The restructuring charge included $0.8 million of severance-related amounts, $4.6 million of committed excess facilities and facility closure expenses, and $0.5 million in fixed assets write- offs. Of the reserve balance at July 30, 2004, $0.7 million was included in other accrued liabilities and the remaining $4.3 million was classified as long-term obligations.

In fiscal 2003 and 2004, we updated our assumptions and estimates based on certain triggering events, which resulted in additional net charges of $0.9 million and $1.3 million, respectively, primarily relating to sublease assumptions for our engineering facility. Our estimates are reviewed and revised periodically and may result in a substantial charge to restructuring expense should different conditions prevail than were anticipated in previous management estimates. Such estimates included various assumptions such as the time period over which the facilities will be vacant, expected sublease terms, and expected sublease rates. In the event that the engineering facility is not subleased as anticipated, we will be obligated for an additional total lease payments of $1.8 million as of July 30, 2004 to be payable through November 2010.

The following analysis sets forth the significant components of the fourth quarter fiscal 2002 restructuring at July 30, 2004 (in thousands):

Interest Income — Interest income was $4.1 million and $3.0 million for the first quarters of fiscal 2005 and 2004, respectively. The increase in interest income was primarily driven by higher cash and investment balances provided by operating activities and higher average interest rates on our investment portfolio. We expect interest income to increase for fiscal 2005 as a result of higher cash and invested balances in a higher interest-rate portfolio environment as we reinvest our securities in longer-term investments and rising average interest rates.

Other Expenses, Net — The first quarters of fiscal 2005 and 2004 included net exchange losses from foreign currency transactions of $0.9 million and $0.2 million, respectively. The increase in net exchange loss in the first quarter of fiscal 2005 was a result of volatility of the currency exchange market and increased hedging costs associated with our forward and option activities compared to the same period a year ago.

Net Gain on Investments — Our investments in publicly held companies are generally considered impaired when a decline in the fair value of an investment as measured by quoted market prices is less than its carrying value, and such a decline is not considered temporary. In the first quarter of fiscal 2004, we realized a net gain of $0.1 million on the sale of previously impaired investments.

Provision for Income Taxes — For the first quarter of fiscal 2005, we applied an annual tax rate of 18.0% to pretax income. Our estimate is based on existing tax laws and our current projections of income (loss) and distributions of income (loss) among different entities and tax jurisdictions, and is subject to change, based primarily on varying levels of profitability.

Provision for income taxes for fiscal 2004 included a nonrecurring income tax benefit of $16.8 million or approximately $0.05 per share associated with a favorable foreign tax ruling, which occurred during the second quarter of fiscal 2004. This favorable ruling from the Netherlands provides for retroactive benefits dating back to fiscal year 2001 as well as current and future tax rate benefits. This Dutch tax ruling, however, will expire at the end of calendar 2005. There are uncertainties associated with securing a new Dutch tax ruling. As such, we cannot assure you that we will be able to extend this ruling or secure any new favorable rulings, the absence of which may have an adverse impact on the results of our international operations.

As of July 30, 2004, as compared to April 30, 2004, our cash, cash equivalents, and short-term investments increased by $18.7 million to $826.6 million. We derive our liquidity and capital resources

In addition to higher net income in the first quarter of fiscal 2005, the primary factors that impacted the period-to-period change in cash flows relating to operating activities included the following:


	•	Increase in deferred revenues from higher software subscription and service billings attributable to our continuing shift toward larger enterprise customers;

	•	Increased income taxes payable, primarily reflecting higher profitability in the first quarter of fiscal 2005 as compared to the same period in fiscal 2004; partially offset by higher worldwide tax payments.


	•	Increased accounts receivable balances due to higher revenues offset by more linear quarterly sales resulting in more collections in the first quarter of fiscal 2005 compared to the same period in the prior year;

	•	Decreased accrued compensation and related benefits due to the payout of higher commission and other profit dependent payroll-related expenses accrued in fiscal 2004 and paid in the first quarter of fiscal 2005 as compared to the same period a year ago.

Capital expenditures for the first quarter of fiscal 2005 were $33.3 million, which included the $24.1 million site purchase in Research Triangle Park (RTP), North Carolina, as compared to $12.3 million in the same period a year ago. We used net proceeds of $33.6 million in the first quarter of fiscal 2005 and received net proceeds of $3.4 million in first quarter of fiscal 2004 respectively, for net purchases/redemptions of short-term investments. In the first quarter of fiscal 2004, we acquired additional patents for a purchase price of approximately $9.0 million. Investing activities in the first quarter of fiscal 2004 also included new investments in privately held companies of $0.3 million. We received $0.3 million and $0.4 million in sales proceeds from sales of short and long-term investments in the first quarters of fiscal 2005 and fiscal 2004, respectively.

We used $24.5 million and $2.6 million in the first quarters of fiscal 2005 and fiscal 2004 from net financing activities, which included sales of common stock related to employee stock transactions net of common stock repurchases. We repurchased 2.5 million shares of common stock at a total of $47.7 million during the first quarter of fiscal 2005. During the first quarter of fiscal 2004, we repurchased 2.2 million shares at a total of $34.8 million, of which we paid cash of $26.8 million and the remaining $8.0 million was included in other accrued liabilities. Other financing activities provided $23.2 million and $24.3 million in the first quarters of fiscal 2005 and fiscal 2004, respectively, which related to sales of common stock related to employee stock transactions. The change in cash flow from financing was primarily due to the effects of higher common stock repurchases partially offset by proceeds from issuance of common stock under employee programs compared to the same 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.

On May 18, 2004, we announced that the Board authorized an expansion of our stock repurchase program to purchase up to $200.0 million of outstanding common stock in the open market. Any repurchases under our stock repurchase program may be made from time to time in the open market subject to market conditions. The stock repurchase program may be suspended or discontinued at any time. The stock repurchases will be funded from available working capital. The shares repurchased have been taken in as treasury shares and will be held as treasury shares until our Board of Directors designates that these shares be retired or used for some other purpose.

For the first quarters of fiscal 2005 and 2004, we recorded tax benefits, in the form of reduced payments, of $5.7 million and $9.9 million, respectively, associated with disqualifying dispositions of employee stock options. If stock option exercise patterns change, we may receive less cash from stock option exercises and

In August 2004, we received a tax refund of $9.0 million and $1.3 million of interest income, in connection with a carryback of net operating losses generated in fiscal 2000. These losses are being carried back into tax years fiscal 1996, 1997, 1998, and 1999.

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 infrastructure. We expect that our existing facilities and those being developed in Sunnyvale, California and RTP, North Carolina are adequate for our requirements over at least the next two years and that additional space will be available as needed. During the first quarter of fiscal 2005, we purchased three buildings in RTP, North Carolina, for $24.1 million. We expect to finance these construction projects through cash from operations and existing cash and investments. In July 2004, we announced that we are the recipient of an award under the new state Job Development Investment Grant (JDIG) program from the state of North Carolina to assist in our expansion of newly acquired offices in RTP, North Carolina.

Under the split dollar insurance arrangement with Daniel J. Warmenhoven (see Note 13) , we will be reimbursed for all premium payments made on these policies. We expect to be reimbursed $10.2 million no later than May 2005.

Our capital and liquidity requirements depend on numerous factors, including risks relating to fluctuating operating results, continued growth in the network storage and content delivery markets, customer and market acceptance of our products, dependence on new products, rapid technological change, dependence on qualified technical and sales personnel, risk inherent in our international operations, competition, reliance on a limited number of suppliers and contract manufacturers, relationships with strategic partners and resellers, dependence on proprietary technology, intellectual property rights, the value of our investments in equity securities and real estate, and other factors. We believe that our existing liquidity and capital resources are sufficient to fund our operations for at least the next twelve months.

The following summarizes our contractual cash obligations and commercial commitments at July 30, 2004, and the effect such obligations are expected to have on our liquidity and cash flow in future periods, (in thousands):

For purposes of the above table, contractual obligations for the purchase of goods and services are defined as agreements that are enforceable, legally binding on us, and subject us to penalties if we cancel the agreement.


(1)	We enter into facilities operating leases in the normal course of business. Substantially all lease agreements have fixed payment terms based on the passage of time. Some lease agreements provide us with the option to renew the lease. Our future operating lease obligations would change if we were to exercise these renewal options and if we were to enter into additional operating lease agreements. Certain facilities operating sublease income of $271 has been included as a reduction of the payment amounts shown in the table. Facilities operating lease payments exclude the leases impacted by the restructurings. The amounts for the leases impacted by the restructurings are included in sub-paragraph (5) below.

(2)	Venture capital funding commitments includes a quarterly committed management fee based on a percentage of our committed funding to be payable through June 2011.

(3)	Purchase commitments represent agreements to purchase component inventory from our suppliers and contract manufacturers that are enforceable and legally binding against us. Other commitments include facilities-related and utilities usage minimum commitment. Purchase commitments and other excludes purchases of good and services we expect to consume in the ordinary course of business in the next twelve months. It also excludes costs that are not reasonably estimable at this time.

(4)	Under certain communication contracts with major telco companies as well as maintenance contracts with multiple vendors, we are required to pay based on a minimum volume. Such obligations expire through January 2009.

(5)	These amounts are included on our Consolidated Balance Sheets under Long-term Obligations and Other Accrued Liabilities which is comprised of committed lease payments, operating expenses net of committed and estimated sublease income. The restructuring estimated sublease income included various assumptions such as the time period over which the facilities will be vacant, expected sublease terms, and expected sublease rates. The actual amount paid, if the facility is not subleased, would be increased by $2,127 to be payable through November 2010.

(6)	The amounts outstanding under these letters of credit relate to workers’ compensation, customs guarantee and a foreign lease.

(7)	Restricted cash arrangements relate to facility lease requirements, service performance guarantees, customs and duties guarantees, and VAT requirements and are included under Prepaid Expenses and Other and Other Assets on our Consolidated Balance Sheets.

lease payments to the third-party leasing company in the event that any customers were to default. We defer 100% of the recourse lease obligation and recognize revenue over the term of the lease as the lease payments become due. As of July 30, 2004 and April 30, 2004, the maximum recourse exposure under such leases totaled approximately $6,711 and $6,755, respectively. Under the terms of the non-recourse leases we do not have any continuing obligations or liabilities. To date, we have not experienced significant losses under this lease financing program.

Our consolidated financial statements 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 the Notes to the Consolidated Financial Statements, which are included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2004.

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;

	•	valuation of goodwill and intangibles;

	•	accounting for income taxes;

	•	inventory write-down;

	•	restructuring accruals;

	•	impairment losses on investments;

	•	accounting for stock-based compensation; and

	•	loss contingencies.

These accounting estimates and policies should be read in conjunction with the audited consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the year ended April 30, 2004.

The FASB issued FIN No. 46, “Consolidation of Variable Interest Entities,” in January 2003, and a revised interpretation of FIN 46 (“FIN 46-R”) in December 2003. FIN 46 requires certain variable interest entities (“VIEs”) to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The provisions of FIN 46 are effective immediately for all arrangements entered into after January 31, 2003. Since January 31, 2003, the Company has not invested in any entities it believes are variable interest entities for which the Company is the primary beneficiary. For all arrangements entered into after January 31, 2003, the Company is required to continue to apply FIN 46 through April 30, 2004. The Company is required to adopt

the provisions of FIN 46-R for those arrangements on May 1, 2004. For arrangements entered into prior to February 1, 2003, the Company is required to adopt the provisions of FIN 46-R on May 1, 2004. The Company does not expect the adoption of FIN 46-R to have an impact on the financial position, results of operations or cash flows of the Company.

The following risk factors and other information included in this Form 10-Q 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. If any of the following risks actually occur, our business, operating results, and financial condition could be materially adversely affected.

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:


	•	changes in general economic conditions and specific economic conditions in the computer, storage, and networking industries;

	•	general decrease in global corporate spending on information technology leading to a decline in demand for our products;

	•	the effects of terrorist activity and international conflicts, which could lead to business interruptions and difficulty in forecasting;

	•	the level of competition in our target product markets;

	•	the size, timing, and cancellation of significant orders;

	•	product configuration and mix;

	•	the extent to which our customers renew their service and maintenance contracts with us;

	•	market acceptance of new products and product enhancements;

	•	announcements, introductions, and transitions of new products by us or our competitors;

	•	deferrals of customer orders in anticipation of new products or product enhancements introduced by us or our competitors;

	•	changes in pricing by us in response to competitive pricing actions;

	•	our ability to develop, introduce, and market new products and enhancements in a timely manner;

	•	supply constraints;

	•	technological changes in our target product markets;


	•	the levels of expenditure on research and development and sales and marketing programs;

	•	our ability to achieve targeted cost reductions;

	•	excess facilities;

	•	future accounting pronouncements and changes in accounting policies; and

	•	seasonality.

In addition, sales for any future quarter may vary and accordingly be inconsistent with our plans. 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 network storage market is rapidly evolving and our sales cycle varies substantially from customer to customer.

Due to all of the foregoing factors, it is possible that in one or more future quarters our results may fall below the expectations of public market analysts and investors. In such event, the trading price of our common stock would likely decrease.

We derive a significant portion of our sales from the resale of disk drives as components of our filers, 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 filer products. 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:


	•	demand for storage and content delivery products;

	•	discount levels and price competition;

	•	direct versus indirect sales;

	•	product and add-on software mix;

	•	the mix of services as a percentage of revenue;

	•	the mix and average selling prices of products;

	•	the mix of disk content;

	•	new product introductions and enhancements;

	•	excess inventory purchase commitments as a result of changes in demand forecasts and possible product and software defects as we transition our products; and

	•	the cost of components, manufacturing labor, and quality.

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

Our 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 have experienced growth in fiscal 2004 and the first quarter of fiscal 2005. 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 infrastructure and systems and managing our assets. In addition, an unexpected decline in the growth rate of revenues without a corresponding and timely reduction in expense growth or a failure to manage other aspects of growth could materially adversely affect our operating results.

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

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

In addition, our business also depends on general economic and business conditions. A reduction in demand for network storage and content delivery caused by weakening economic conditions and decreases in corporate spending have resulted in decreased revenues and lower revenue growth rates. In prior years, the network storage and content delivery market growth declined significantly causing both our revenues and operating results to decline. If the network storage and content delivery 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 adversely affected.

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:


	•	fluctuations in our operating results;

	•	fluctuations in the valuation of companies perceived by investors to be comparable to us;

	•	economic developments in the network storage market as a whole;

	•	international conflicts and acts of terrorism;

	•	a shortfall in revenues or earnings compared to securities analysts’ expectations;

	•	changes in analysts’ recommendations or projections;

	•	announcements of new products, applications or product enhancements by us or our competitors;

	•	changes in our relationships with our suppliers, customers, channel and strategic partners; and

	•	general market conditions.

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.

Our future growth depends upon the successful development and introduction of new hardware and software products. Due to the complexity of storage subsystems and Internet caching devices, and the difficulty in gauging the engineering effort required to produce new products, such products are subject to significant technical risks. However, we cannot assure you that any of our new products will 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 adversely affected.

In particular, in conjunction with the introduction of our product offerings in the fabric-attached storage market, we introduced products with new features and functionality that address the storage area network market. During fiscal 2003, we introduced iSCSI-enabled unified storage solutions. We also introduced Direct Access File System (“DAFS”) protocol-capable products and NearStore backup and recovery products during fiscal 2002. We face risks relating to these product introductions, including risks relating to forecasting of demand for such products, as well as possible product and software defects and a potentially different sales and support environment associated with selling these new systems. If any of the foregoing occur, our operating results could be 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.

Our operations, including our suppliers’ and contract manufacturers’ operations, are susceptible to outages due to fire, floods, power loss, power shortages, telecommunications failures, break-ins, and similar events. 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.

Weak economic conditions or terrorist actions could lead to significant business interruptions. If such disruptions result in cancellations of customer orders, a general decrease in corporate spending on information technology, or direct impacts on our marketing, manufacturing, financial functions, or our suppliers’ logistics function, our results of operations and financial condition could be adversely affected.

Our continued success depends, in part, on our ability to identify, attract, motivate, and retain qualified technical and sales personnel. Because our future success is dependent on our ability to continue to enhance and introduce new products, we are particularly dependent on our ability to identify, attract, motivate, and retain qualified engineers with the requisite education, backgrounds, and industry experience. Competition for qualified engineers, particularly in Silicon Valley, can be intense. The loss of the services of a significant

We conduct business internationally. For first quarter of fiscal year 2005, approximately 41.6% of our total revenues was from international customers (including U.S. exports). Accordingly, our future operating results could be materially adversely affected by a variety of factors, some of which are beyond our control, including regulatory, political, or economic conditions in a specific country or region, trade protection measures and other regulatory requirements, government spending patterns, and acts of terrorism and international conflicts.

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

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

Potentially adverse tax consequences could also negatively impact the operating and financial results from international operations. International operations currently benefit from a tax ruling concluded in the Netherlands. The Dutch tax ruling, however, will expire at the end of calendar 2005. There are uncertainties associated with securing a new Dutch tax ruling.

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

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

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

In the storage market, our FAS appliances and associated storage software portfolio compete primarily with storage system products and data management software from EMC Corporation, Hitachi Data Systems, Hewlett-Packard Company (including the integrated Compaq Computer Corporation), IBM Corporation, and Sun Microsystems, Inc. We have also historically encountered less-frequent competition from companies including Dell, Engenio Information Technologies, Inc. (formerly the Storage Systems Group of LSI Logic Corp.), StorageTek Technology Corporation, Silicon Graphics, Inc., and Xiotech Corporation. In the nearline storage market, which includes the disk-to-disk backup and regulated data storage segments, our NearStore appliances compete primarily against products from EMC and StorageTek. Our NearStore appliances also compete indirectly with traditional tape backup solutions in the broader data backup/recovery space.

In the content delivery market, our NetCache appliances and content delivery software compete against caching appliance and content delivery software vendors including BlueCoat Systems (formerly CacheFlow, Inc.), and Cisco Systems, Inc. Our NetCache business is also subject to indirect competition from content delivery service products such as those offered by Akamai Technologies.

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

We believe that the principal competitive factors affecting the storage and content delivery markets include product benefits such as response time, reliability, data availability, scalability, ease of use, price, multiprotocol capabilities, and global service and support. To date, we have been able to compete successfully with our principal competitors in large part based on the product benefits that we believe result from the superior technology of our products. We must continue to maintain and enhance this technological advantage over our competitors. Otherwise, if those competitors with greater financial, marketing, service, support, technical and other resources were able to offer products that matched or surpassed the technological capabilities of our products, these competitors would, by virtue of these greater resources, gain a competitive advantage over us that could lead to greater sales for these competitors at the expense of our own market share, which would have a material adverse effect on our business, financial condition and results of operations.

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

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


	•	a potential inability to obtain an adequate supply of required components because we do not have long-term supply commitments;

	•	supplier capacity constraints;

	•	price increases;

	•	timely delivery; and

	•	component quality.

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 for 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 adversely affect our operating results. Such delays could also damage relationships with current and prospective customers.

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

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 July 30, 2004, we have no such purchase commitment.

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.

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. A number of these strategic partners are industry leaders that offer us expanded access to segments of the storage market. There is intense competition for attractive strategic partners, and even if we can establish strategic relationships with these partners, we cannot assure you that these partnerships will generate significant revenue or that the partnerships will continue to be in effect for any specific period of time.

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

From time to time, we make equity investments for the promotion of business and strategic objectives. We have already made strategic investments in a number of network storage-related technology companies. Equity investments may result in the loss of investment capital. The market price and valuation of our equity investments in these companies may fluctuate due to market conditions and other circumstances over which

we have little or no control. To the extent that the fair value of these securities is less than our cost over an extended period of time, our results of operations and financial position could be negatively impacted.

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 have acquired three companies since the beginning of fiscal 2001, including the acquisition of Spinnaker Networks, Inc., for approximately $306.0 million. We completed the Spinnaker acquisition during the fourth quarter of fiscal 2004 and have completed integrating the acquired operations and products from this acquisition into our operations. We may engage in future acquisitions that dilute our stockholders’ investments and cause us to use cash, to incur debt, or to assume contingent liabilities.

Acquisitions of companies entail numerous risks, and we may not be able to successfully integrate acquired operations and products or realize anticipated synergies, economies of scale, or other value. In addition, we may experience a diversion of management’s attention, the loss of key employees of acquired operations, or the inability 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 operations.

In addition, we adopted SFAS No. 142 “Goodwill and Other Intangible Assets,” which changes the accounting for goodwill from an amortization method to an impairment-only approach. As of July 30, 2004, the fair value for each of our reporting units exceeded the reporting unit’s carrying amount and no impairment was recognized. On an ongoing basis, goodwill is reviewed annually for impairment (or more frequently if indicators of impairment arise). There had been no impairment of goodwill and intangible assets as of the end of the first quarter of fiscal 2005. There can be no assurance that future impairment tests will not result in a charge to earnings.

We market and sell our storage solutions directly through our worldwide sales force and indirectly through channels such as value-added resellers (“VARs”), systems integrators, distributors and strategic business partners and derive a significant portion of our revenue from these indirect channel partners. 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 develop and offer products of their own that are competitive to ours. Or, because our reseller partners generally offer products from several different companies, including products of our competitors, these resellers may give higher priority to the marketing, sales and support of our competitors’ products than ours. If we fail to manage effectively our relationships with these indirect channel partners to minimize channel conflict and continue to evaluate and meet our indirect sales partners’ needs with respect to our products, we will not be able to maintain or increase our revenue as we have forecasted, which would have a materially adverse affect on our business, financial condition, and results of operations.

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

The preparation of the consolidated financial statements and related disclosure in conformity with accounting principles generally accepted in the United States of America requires management to establish policies that contain estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Note 2 of the Notes to Consolidated Financial Statements of the Annual Report on Form 10-K for the year ended April 30, 2004 describes the significant accounting policies essential to preparing our consolidated financial statements. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. We base our estimates on historical experience and assumptions that we believe to be reasonable under the circumstances. Actual future results may differ materially from these estimates. We evaluate, on an ongoing basis, our estimates and assumptions. In addition, see our Critical Accounting Estimates and Policies under Item 7 of the Annual Report on Form 10-K for the year ended April 30, 2004.

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 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 adversely affect our operating results. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all.

We are exposed to market risk related to fluctuations in interest rates, market prices and foreign currency exchange rates. We use certain derivative financial instruments to manage these risks. We do not use

Interest and Investment Income — As of July 30, 2004, we had short-term investments of $598.6 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, and investment in marketable equity securities in primarily technology companies. These highly liquid investments, consisting primarily of government and corporate debt 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 July 30, 2004 would cause the fair value of these short-term investments to decline by approximately $1.3 million. By policy, we limit our exposure to longer term investments, and a substantial majority of our investment portfolio has maturities of less than three years. 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.

Equity Securities — We are also exposed to market price risk on our equity securities included in our short-term investments, which are primarily in publicly traded companies in the volatile high-technology industry sector.

We do not attempt to reduce or eliminate our market exposure on these securities and, as a result, the amount of income and cash flow that we ultimately realize from our investment in future periods may vary materially from the current fair value. A 50% adverse change in the equity price would result in an immaterial decrease in the fair value of our equity security as of July 30, 2004.

The hypothetical changes and assumptions discussed above will be different from what actually occurs in the future. Furthermore, such computations do not anticipate actions that may be taken by management, should the hypothetical market changes actually occur over time. As a result, the effect on actual earnings in the future will differ from those described above.

We hedge risks associated with foreign currency transactions in order 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, the gains or losses were included in other comprehensive income at July 30, 2004.

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 credit worthy multinational commercial banks. All contracts have a maturity of less than one year.

The following table provides information about our foreign exchange forward and option contracts outstanding on July 30, 2004 (in thousands):

Disclosure Controls are procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act, such as this Quarterly Report, is recorded, processed, summarized and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms. Disclosure Controls are also designed to ensure that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this report (the “Evaluation Date”). Based on this evaluation, our principal executive officer and principal financial officer concluded as of the Evaluation Date that our disclosure controls and procedures were effective such that the information relating to Network Appliance, including our consolidated subsidiaries, required to be disclosed in our Securities and Exchange Commission (“SEC”) reports (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to Network Appliance’s management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

On May 13, 2003, we announced that the Board of Directors approved a $150.0 million stock repurchase program to purchase shares of our outstanding common stock in the open market. During fiscal 2004, we repurchased 6.9 million shares of our common stock at an aggregate cost of $136.2 million. The repurchases were recorded as treasury stock and resulted in a reduction of stockholders’ equity. On May 18, 2004, we announced that the Board authorized an expansion of the program to purchase an additional $200.0 million of outstanding common stock. Total authorized stock purchase spending may be up to $350.0 million. The stock repurchase program may be suspended or discontinued at any time. The duration of the repurchase program is open-ended. Under the program, we may purchase shares of common stock through open market transactions at prices deemed appropriate by management. The timing and amount of repurchase transactions under this program will depend on market conditions and corporate and regulatory considerations. The purchases will be funded from available working capital.

The following table sets forth common stock repurchases by Network Appliance for the periods indicated:

The information required by this item is incorporated by reference from our Proxy Statement for the 2004 Annual Meeting of Stockholders.


(1)	Previously filed as an exhibit with the Company’s Current Report on Form 8-K dated December 4, 2001.

(2)	Previously filed as an exhibit with the Company’s Quarterly Report on Form 10-Q dated September 3, 2003.

(3)	Previously filed as an exhibit with the Company’s Current Report on Form 8-K dated February 27, 2004.

(4)	Previously filed as an exhibit with the Company’s Form S-8 registration statement dated March 1, 2004.

(5)	Previously filed as an exhibit with the Company’s Annual Report on Form 10-K dated June 29, 2004.

On May 18, 2004, we furnished (but did not file) a report on Form 8-K relating to financial information for Network Appliance for the quarter and year ended April 30, 2004 and forward-looking statements relating to fiscal year 2005, as presented in a press release of May 18, 2004.

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


	NETWORK APPLIANCE INC.
	(Registrant)

	/s/ STEVEN J. GOMO

	Steven J. Gomo
	Senior Vice President of Finance
	and Chief Financial Officer


(1)	Previously filed as an exhibit with the Company’s Current Report on Form 8-K dated December 4, 2001.

(2)	Previously filed as an exhibit with the Company’s Quarterly Report on Form 10-Q dated September 3, 2003.

(3)	Previously filed as an exhibit with the Company’s Current Report on Form 8-K dated February 27, 2004.

(4)	Previously filed as an exhibit with the Company’s Form S-8 registration statement dated March 1, 2004.

(5)	Previously filed as an exhibit with the Company’s Annual Report on Form 10-K dated June 29, 2004.


(Mark One)
þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT of 1934

		For the quarterly period ended July 30, 2004

or

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT of 1934

		For the transition period from to


Delaware		77-0307520
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)
495 East Java Drive, Sunnyvale, California 94089
(Address of principal executive offices, including zip code)


	Outstanding at
Class	July 30, 2004

Common Stock		357,676,696


		Page No.

PART I — FINANCIAL INFORMATION
Item 1.	Condensed Consolidated Financial Statements (Unaudited)		2
	Condensed Consolidated Balance Sheets as of July 30, 2004 (Unaudited) and April 30, 2004		2
	Condensed Consolidated Statements of Income for the three-month periods ended July 30, 2004 and August 1, 2003 (Unaudited)		3
	Condensed Consolidated Statements of Cash Flows for the three-month periods ended July 30, 2004 and August 1, 2003 (Unaudited)		4
	Notes to Condensed Consolidated Financial Statements (Unaudited)		5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		17
Item 3.	Quantitative and Qualitative Disclosures About Market Risk		38
Item 4.	Controls and Procedures		40
PART II — OTHER INFORMATION
Item 1.	Legal Proceedings		41
Item 2.	Changes in Securities		41
Item 3.	Defaults Upon Senior Securities		41
Item 4.	Submission of Matters to Vote of Securityholders		41
Item 5.	Other Information		41
Item 6.	Exhibits and Reports on Form 8-K		42
SIGNATURE			43
EXHIBIT 10.2
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2


			July 30,			April 30,
			2004			2004

ASSETS
Current Assets:
	Cash and cash equivalents		$	228,045		$	241,149
	Short-term investments			598,596			566,816
	Accounts receivable, net of allowances of $4,917 at July 30, 2004 and $5,071 at April 30, 2004			199,746			193,942
	Inventories			34,710			34,109
	Prepaid expenses and other			39,290			29,057
	Deferred income taxes			24,719			24,163

		Total current assets		1,125,106			1,089,236
Property and Equipment, net				392,588			370,717
Goodwill				291,816			291,816
Intangible Assets, net				28,935			31,718
Other Assets				82,642			93,779

			$	1,921,087		$	1,877,266

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
	Accounts payable		$	51,691		$	52,719
	Income taxes payable			15,172			16,033
	Accrued compensation and related benefits			50,866			65,186
	Other accrued liabilities			46,775			43,683
	Deferred revenue			182,801			166,602

		Total current liabilities		347,305			344,223
Long-Term Deferred Revenue				126,355			112,337
Long-Term Obligations				4,787			4,858

		Total liabilities		478,447			461,418

Stockholders’ Equity:
	Common stock			367			364
	Additional paid-in capital			1,166,580			1,138,158
	Deferred stock compensation			(20,775	)		(23,348	)
	Treasury stock			(183,914	)		(136,172	)
	Retained earnings			483,086			436,224
	Accumulated other comprehensive loss			(2,704	)		622

		Total stockholders’ equity		1,442,640			1,415,848

			$	1,921,087		$	1,877,266



			Three Months Ended

			July 30,			August 1,
			2004			2003

Revenues:
	Product revenue		$	324,627		$	235,786
	Service revenue			33,794			24,723

		Total revenues		358,421			260,509

Cost of Revenues:
	Cost of product revenue			114,215			85,039
	Cost of service revenue			29,248			19,347

		Total cost of revenues		143,463			104,386

	Gross margin			214,958			156,123

Operating Expenses:
	Sales and marketing			103,311			79,356
	Research and development			38,703			31,541
	General and administrative			16,882			12,265
	Stock compensation(1)			2,104			654

		Total operating expenses		161,000			123,816

Income from Operations				53,958			32,307
Other Income (Expense), net:
	Interest income			4,082			3,045
	Other expenses, net			(912	)		(47	)
	Net gain on investments			—			145

		Total other income, net		3,170			3,143

Income before Income Taxes				57,128			35,450
Provision for Income Taxes				10,266			8,377

Net Income			$	46,862		$	27,073

Net Income per Share:
	Basic		$	0.13		$	0.08

	Diluted		$	0.13		$	0.08

Shares Used in per Share Calculations:
	Basic			356,743			341,687

	Diluted			372,974			358,497


Sales and marketing	$	510	$	358
Research and development		1,384		192
General and administrative		210		104

	$	2,104	$	654



		July 30, 2004

		Amortization
		Period		Gross		Accumulated			Net
		(Years)		Assets		Amortization			Assets


				(In thousands)
Intangible assets:
	Patents		5	$	9,145	$	(2,084	)	$	7,061
	Existing technology		5		33,525		(17,938	)		15,587
	Trademarks/ Tradenames		3		280		(42	)		238
	Customer Contracts/ Relationships		1.5		1,100		(336	)		764
	Covenants Not to Compete		1.5		7,610		(2,325	)		5,285

Total Intangible assets, net				$	51,660	$	(22,725	)	$	28,935



		April 30, 2004

		Amortization
		Period		Gross		Accumulated			Net
		(Years)		Assets		Amortization			Assets


				(In thousands)
Intangible assets:
	Patents		5	$	9,145	$	(1,633	)	$	7,512
	Existing technology		5		33,525		(17,080	)		16,445
	Trademarks/ Tradenames		3		280		(19	)		261
	Customer Contracts/ Relationships		1.5		1,100		(153	)		947
	Covenants Not to Compete		1.5		7,610		(1,057	)		6,553

Total Intangible assets, net				$	51,660	$	(19,942	)	$	31,718


Year ending April,	Amount

2005	$	8,351
2006		7,022
2007		5,309
2008		5,235
2009		3,018
Thereafter		—

Total	$	28,935


	Severance-			Fixed Assets
	related amounts			write-off			Facility			Total

Restructuring charge	$	4,796		$	528		$	2,656		$	7,980
Cash payments and others		(4,508	)		—			(803	)		(5,311	)
Non-cash portion		—			(528	)		(37	)		(565	)
Adjustments		(95	)		—			(1,509	)		(1,604	)

Reserve balance at April 30, 2002		193			—			307			500
Cash payments and others		64			—			(82	)		(18	)
Non-cash portion		—			—			(9	)		(9	)
Adjustments		410			—			(76	)		334

Reserve balance at April 30, 2003		667			—			140			807
Cash payments and others		50			—			(9	)		41

Reserve balance at April 30, 2004		717			—			131			848
Cash payments and others		5			—			1			6

Reserve balance at July 30, 2004	$	722		$	—		$	132		$	854



	Payments Due by Period

	2005		2006		2007		2008		2009		Thereafter		Total

Commitments & Contingencies:
Rent operating lease payments(1)	$	9,404	$	11,176	$	7,494	$	6,667	$	6,584	$	9,533	$	50,858
Equipment operating lease payments		1,970		2,465		1,505		203		73		—		6,216
Venture capital funding commitments(2)		423		564		564		552		539		1,077		3,719
Purchase commitments and other(3)		10,186		720		600		—		—		—		11,506
Communications & Maintenance(4)		4,352		3,735		170		29		12		—		8,298
Estimated contingent lease payments(5)		78		125		374		385		427		738		2,127

Total Commitments & Contingencies:	$	26,413	$	18,785	$	10,707	$	7,836	$	7,635	$	11,348	$	82,724



	Amount of Commitment Expiration Per Period

	2005		2006		2007		2008		2009		Thereafter		Total

Other Commercial Commitments:
Letters of Credit(6)	$	1,423	$	—	$	—	$	—	$	—	$	337	$	1,760
Restricted Cash(7)		875		675		508		439		277		99		2,873

Total Commercial Commitments	$	2,298	$	675	$	508	$	439	$	277	$	436	$	4,633


Item 2.	*Management’s Discussion and Analysis of Financial Condition and Results of Operations*


	*Contractual Cash Obligations and Other Commercial Commitments*


1.	The Company


2.	Condensed Consolidated Financial Statements


3.	Use of Estimates


4.	Derivative Instruments


	*Factors beyond our control could cause our quarterly results to fluctuate.*


	*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.*


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


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


	Our future financial performance depends on growth in the network storage and content delivery 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.


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


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


	*Our business could be materially adversely affected as a result of a natural disaster, terrorist acts, or other catastrophic events.*


	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.


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


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


	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.


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


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


	We rely and will increasingly rely on our indirect sales channel for a significant portion of our revenue. If we are unable to effectively manage this sales channel, we will not be able to maintain or increase our revenue as we have forecasted, which would have a material adverse impact on our business, financial condition and results of operations.


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


	If actual results or events differ materially from our estimates and assumptions, our reported financial condition and results of operations for future periods could be materially affected.


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


Item 3.	*Quantitative and Qualitative Disclosures About Market Risk*


				Foreign		Contract Value		Fair Value
Currency		Buy/Sell		Currency Amount		USD		in USD

Forward contracts:
	CAD		Sell		4,829	$	3,623	$	3,650
	CHF		Sell		2,882	$	2,246	$	2,246
	EUR		Sell		64,707	$	77,777	$	77,838
	GBP		Sell		18,830	$	34,042	$	34,113
	ZAR		Sell		23,304	$	3,687	$	3,687
	AUD		Buy		1,915	$	1,332	$	1,332
	DKK		Buy		7,252	$	1,173	$	1,173
	EUR		Buy		7,534	$	9,049	$	9,062
	GBP		Buy		1,809	$	3,265	$	3,277
	SEK		Buy		6,359	$	827	$	827

Option contracts:
	EUR		Sell		5,000	$	6,017	$	6,085
	GBP		Buy		1,500	$	2,722	$	2,695