e10vq

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q


(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 29, 2005

or

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

		For the transition period from to

Commission file number 0-27130

Network Appliance, Inc.

(Exact name of registrant as specified in its charter)


Delaware		77-0307520
(State or other jurisdiction of		(IRS Employer
incorporation or organization)		Identification No.)

495 East Java Drive,

Sunnyvale, California 94089

(Address of principal executive offices, including zip code)

Registrant’s telephone number, including area code:

(408) 822-6000

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

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

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

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


Class		Outstanding at July 29, 2005

Common Stock		367,932,522

TABLE OF CONTENTS


		Page
		No.

PART I — FINANCIAL INFORMATION
Item 1.	Condensed Consolidated Financial Statements (Unaudited)		3
	Condensed Consolidated Balance Sheets as of July 29, 2005 (Unaudited) and April 30, 2005		3
	Condensed Consolidated Statements of Income for the three-month periods ended July 29, 2005 and July 30, 2004 (Unaudited)		4
	Condensed Consolidated Statements of Cash Flows for the three-month periods ended July 29, 2005 and July 30, 2004 (Unaudited)		5
	Notes to Condensed Consolidated Financial Statements (Unaudited)		6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		17
Item 3.	Quantitative and Qualitative Disclosures About Market Risk		39
Item 4.	Controls and Procedures		40
PART II — OTHER INFORMATION
Item 1.	Legal Proceedings		41
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		41
Item 3.	Defaults Upon Senior Securities		41
Item 4.	Submission of Matters to a Vote of Security holders		41
Item 5.	Other Information		41
Item 6.	Exhibits		41
SIGNATURE			43
EXHIBIT 2.3
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

PART I. FINANCIAL INFORMATION


Item 1.	*Condensed Consolidated Financial Statements (Unaudited)*

NETWORK APPLIANCE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands — unaudited)


			July 29,			April 30,
			2005			2005

ASSETS
Current Assets:
	Cash and cash equivalents		$	231,585		$	193,542
	Short-term investments			983,153			976,423
	Accounts receivable, net of allowances of $5,037 at July 29, 2005 and $5,445 at April 30, 2005			239,015			296,885
	Inventories			40,343			38,983
	Prepaid expenses and other			32,663			32,472
	Deferred income taxes			35,558			37,584

		Total current assets		1,562,317			1,575,889
Property and Equipment, net				443,760			418,749
Goodwill				297,661			291,816
Intangible Assets, net				23,982			21,448
Other Assets				68,943			64,745

			$	2,396,663		$	2,372,647

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
	Accounts payable		$	80,579		$	83,572
	Income taxes payable			14,251			20,823
	Accrued compensation and related benefits			66,839			100,534
	Other accrued liabilities			55,414			53,262
	Deferred revenue			278,705			261,998

		Total current liabilities		495,788			520,189
Long-Term Deferred Revenue				206,705			187,180
Long-Term Obligations				3,340			4,474

		Total liabilities		705,833			711,843

Stockholders’ Equity:
	Common stock (385,761 shares at July 29, 2005 and 381,509 shares at April 30, 2005)			386			381
	Additional paid-in capital			1,418,974			1,347,352
	Deferred stock compensation			(17,633	)		(15,782	)
	Treasury stock (17,828 shares at July 29, 2005 and 14,566 shares at April 30, 2005)			(424,618	)		(329,075	)
	Retained earnings			722,098			661,978
	Accumulated other comprehensive loss			(8,377	)		(4,050	)

		Total stockholders’ equity		1,690,830			1,660,804

			$	2,396,663		$	2,372,647

See accompanying notes to unaudited condensed consolidated financial statements.

NETWORK APPLIANCE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share amounts — unaudited)


			Three Months Ended

			July 29,			July 30,
			2005			2004

Revenues:
	Product revenue		$	394,630		$	324,627
	Service revenue			53,773			33,794

		Total revenues		448,403			358,421

Cost of Revenues:
	Cost of product revenue			133,755			114,215
	Cost of service revenue			41,162			29,248

		Total cost of revenues		174,917			143,463

	Gross margin			273,486			214,958

Operating Expenses:
	Sales and marketing			137,299			103,311
	Research and development			50,802			38,703
	General and administrative			21,041			16,882
	Stock compensation(1)			2,028			2,104
	Restructuring recoveries			(1,256	)		—

		Total operating expenses		209,914			161,000

Income from Operations				63,572			53,958
Other Income (Expense), net:
	Interest income			9,048			4,082
	Other expenses, net			(272	)		(912	)
	Net gain on investments			33			—

		Total other income, net		8,809			3,170

Income before Income Taxes				72,381			57,128
Provision for Income Taxes				12,261			10,266

Net Income			$	60,120		$	46,862

Net Income per Share:
	Basic		$	0.16		$	0.13

	Diluted		$	0.16		$	0.13

Shares Used in per Share Calculations:
	Basic			367,438			356,743

	Diluted			386,383			372,974

(1) Stock compensation includes:
		Sales and marketing	$	515		$	510
		Research and development		1,358			1,384
		General and administrative		155			210

			$	2,028		$	2,104

See accompanying notes to unaudited condensed consolidated financial statements.

NETWORK APPLIANCE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands — unaudited)


					Three Months Ended

					July 29,			July 30,
					2005			2004

Cash Flows from Operating Activities:
	Net income				$	60,120		$	46,862
	Adjustments to reconcile net income to net cash provided by operating activities:
		Depreciation				14,756			13,242
		Amortization of intangible assets				2,671			2,333
		Amortization of patents				495			450
		Stock compensation				2,028			2,104
		Net gain on investments				(33	)		(29	)
		Net loss on disposal of equipment				404			7
		Allowance for doubtful accounts				(379	)		(154	)
		Deferred rent				48			90
		Changes in assets and liabilities:
			Accounts receivable			57,892			(5,757	)
			Inventories			(4,998	)		(3,331	)
			Prepaid expenses and other assets			(3,997	)		(1,429	)
			Accounts payable			(2,691	)		(1,075	)
			Income taxes payable			9,648			4,851
			Accrued compensation and related benefits			(32,418	)		(14,535	)
			Other accrued liabilities			(1,302	)		2,697
			Deferred revenue			36,716			30,342

				Net cash provided by operating activities		138,960			76,668

Cash Flows from Investing Activities:
	Purchases of investments					(222,787	)		(148,646	)
	Redemptions of investments					213,977			139,045
	Increase in restricted cash					(1,504	)		—
	Purchases of property and equipment					(33,538	)		(32,265	)
	Proceeds from sales of investments					62			298
	Purchases of equity securities					(275	)		—
	Purchase of business, net of cash acquired					(11,831	)		—

				Net cash used in investing activities		(55,896	)		(41,568	)

Cash Flows from Financing Activities:
	Proceeds from sale of common stock related to employee stock transactions					50,763			23,202
	Tax withholding payments reimbursed by restricted stock					(419	)		—
	Repurchases of common stock					(95,543	)		(47,742	)

				Net cash used in financing activities		(45,199	)		(24,540	)

Effect of Exchange Rate Changes on Cash and Cash Equivalents						178			334
Net Increase in Cash and Cash Equivalents						38,043			10,894
Cash and Cash Equivalents:
	Beginning of period					193,542			92,328

	End of period				$	231,585		$	103,222

Noncash Investing and Financing Activities:
	Conversion of evaluation inventory to fixed assets				$	3,638		$	2,729
	Deferred stock compensation, net of reversals				$	2,634		$	(546	)
	Income tax benefit from employee stock transactions				$	16,289		$	5,692
	Acquisition of property and equipment on account				$	3,561		$	—
	Options assumed for acquired business				$	2,314		$	—
Supplemental cash flow information:
	Income taxes paid				$	2,014		$	6,826

See accompanying notes to unaudited condensed consolidated financial statements.

NETWORK APPLIANCE, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollar and share amounts in thousands, except per-share data)

(Unaudited)


1.	The Company

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


2.	Condensed Consolidated Financial Statements

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

We operate on a 52-week or 53-week year ending on the last Friday in April. For presentation purposes we have indicated in the accompanying interim unaudited condensed consolidated financial statements that our fiscal year end is April 30. The first quarters of fiscal 2006 and 2005 were both 13-week fiscal periods.

These financial statements should be read in conjunction with the audited consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the year ended April 30, 2005. The results of operations for the three-month period ended July 29, 2005 are not necessarily indicative of the operating results to be expected for the full fiscal year or future operating periods. In the following notes to our interim condensed consolidated financial statements, Network Appliance Inc. is also referred to as “we”, “our” and “us”.


3.	Use of Estimates

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


4.	Stock Compensation

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

NETWORK APPLIANCE, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

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 under the fair value based method.

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

We recorded $1,982 and $2,027 of deferred compensation expense for the three-month periods ended July 29, 2005 and July 30, 2004, respectively, primarily related to the amortization of deferred stock compensation from unvested options assumed in the acquisitions, the retention escrow shares relative to Spinnaker, the grant of stock options to certain highly compensated employees below fair value at the date of grant (discontinued as of December 31, 2004) and the award of restricted stock to certain employees.

Based on deferred stock compensation recorded at July 29, 2005, estimated future deferred stock compensation amortization for the remainder of fiscal year 2006, fiscal years 2007, 2008 and 2009 are expected to be $5,981, $6,550, $4,385 and $718, respectively, and none thereafter.

We recorded $46 and $77 in compensation expense in the three-month periods ending July 29, 2005 and July 30, 2004, for the fair value of options granted to a member of the Board of Directors in recognition for services performed outside of the normal capacity of a board member.

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


		Three Months Ended

		July 29,			July 30,
		2005			2004

Net income as reported		$	60,120		$	46,862
Add: stock based employee compensation expense included in reported net income under APB No. 25, net of related tax effects			1,217			1,216
Deduct: total stock based compensation determined under fair value based method for all awards, net of related tax effects			(24,648	)		(18,551	)

	Pro forma net income	$	36,689		$	29,527

Basic net income per share, as reported		$	0.16		$	0.13

Diluted net income per share, as reported		$	0.16		$	0.13

Basic net income per share, pro forma		$	0.10		$	0.08

Diluted net income per share, pro forma		$	0.09		$	0.08

NETWORK APPLIANCE, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


5.	Inventories

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


	July 29,		April 30,
	2005		2005

Purchased components	$	18,642	$	15,784
Work in process		1,063		686
Finished goods		20,638		22,513

	$	40,343	$	38,983


6.	Goodwill and Intangible Assets

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

During May 2005, we acquired Alacritus Inc. (“Alacritus”) and recorded goodwill of $5,845 and intangible assets of $5,700 resulting from the allocation of the purchase price. See Note 14, “Business Combination.”

Balances as of July 29, 2005 and April 30, 2005 are summarized as follows:


				July 29, 2005							April 30, 2005

		Amortization Period		Gross		Accumulated					Gross		Accumulated			Net
		(Years)		Assets		Amortization			Net Assets		Assets		Amortization			Assets

Intangible Assets:
	Patents		5	$	10,040	$	(3,962	)	$	6,078	$	10,040	$	(3,467	)	$	6,573
	Existing technology		5		38,525		(21,620	)		16,905		33,525		(20,512	)		13,013
	Trademarks/tradenames		3		280		(134	)		146		280		(111	)		169
	Customer Contracts/ relationships		1.5		1,100		(1,069	)		31		1,100		(885	)		215
	Covenants Not to Compete		1.5 — 2		8,310		(7,488	)		822		7,610		(6,132	)		1,478

Total Intangible Assets, Net				$	58,255	$	(34,273	)	$	23,982	$	52,555	$	(31,107	)	$	21,448

Amortization expense for identified intangible assets is summarized below:


	Three Months Ended

	July 29,		July 30,
	2005		2004

Patents	$	495	$	450
Existing technology		1,108		858
Other identified intangibles		1,563		1,475

	$	3,166	$	2,783

NETWORK APPLIANCE, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Based on the identified intangible assets recorded at July 29, 2005, the future amortization expense of identified intangibles for the remainder of fiscal 2006 and the next four fiscal years and thereafter is as follows:


Year Ending April,	Amount

Remainder of Fiscal 2006	$	5,385
2007		6,838
2008		6,414
2009		4,196
2010		1,149
Thereafter		—

Total	$	23,982


7.	Derivative Instruments

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

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


	Balance Sheet Exposures. We utilize foreign currency forward and options contracts to hedge exchange rate fluctuations related to certain foreign assets and liabilities. Gains and losses on these derivatives offset gains and losses on the assets and liabilities being hedged and the net amount is included in earnings. For the three-month period ended July 29, 2005, net gains generated by hedged assets and liabilities totaled $3,450 and were offset by losses on the related derivative instruments of $3,713. For the three-month period ended July 30, 2004, net gains generated by hedged assets and liabilities totaled $1,288, and were offset by losses on the related derivative instruments of $2,216.

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

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

	If the underlying forecasted transactions do not occur, or it becomes probable that they will not occur, the gain or loss on the related cash flow hedge is recognized immediately in earnings. For the three-month periods ended July 29, 2005 and July 30, 2004, we did not record any gains or losses related to forecasted transactions that did not occur or became improbable.

NETWORK APPLIANCE, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

As of July 29, 2005, our notional fair values of foreign exchange forward and foreign currency option contracts totaled $224,220. 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.


8.	Earnings Per Share

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

During all periods presented, we had certain options outstanding, which could potentially dilute basic earnings per share in the future, but were excluded in the computation of diluted earnings per share in such periods, as their effect would have been antidilutive. These certain options were antidilutive in the three-month periods ended July 29, 2005 and July 30, 2004 as these options’ exercise prices were above the average market prices in such periods. For the three-month periods ended July 29, 2005 and July 30, 2004, 17,969 and 27,992 shares of common stock options with a weighted average exercise price of $49.80 and $38.88, 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:


		Three Months Ended

		July 29,			July 30,
		2005			2004

Net Income (Numerator):
	Net income, basic and diluted	$	60,120		$	46,862

Shares (Denominator):
	Weighted average common shares outstanding		367,842			357,290
	Weighted average common shares outstanding subject to repurchase		(404	)		(547	)

	Shares used in basic computation		367,438			356,743
	Weighted average common shares outstanding subject to repurchase		404			547
	Common shares issuable upon exercise of stock options		18,541			15,684

	Shares used in diluted computation		386,383			372,974

Net Income Per Share:
	Basic	$	0.16		$	0.13

	Diluted	$	0.16		$	0.13

NETWORK APPLIANCE, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


9.	Stockholders’ Equity


	*Stock Repurchase Program*

In the first quarter of fiscal 2006, our Board of Directors approved an increase in the amount authorized to be used to repurchase common shares from $350,000 to $650,000. Share repurchase activities for the first quarters of fiscal 2006 and 2005, were as follows:


	Three Months Ended

	July 29,		July 30,
	2005		2004

Shares repurchased		3,262		2,460
Cost of shares repurchased	$	95,543	$	47,742
Average price per share	$	29.29	$	19.41

Since the inception of the stock repurchase program through July 29, 2005, we have purchased a total of 17,828 shares of our common stock at an average price of $23.82 per share for an aggregate purchase price of $424,618. At July 29, 2005, $225,382 remained available for repurchases under the plan.


	*Comprehensive Income*

The components of comprehensive income, were as follows:


	Three Months Ended

	July 29,			July 30,
	2005			2004

Net income	$	60,120		$	46,862
Currency translation adjustment		(1,838	)		(1,363	)
Unrealized loss on investments		(4,106	)		(1,307	)
Unrealized gain (loss) on derivatives		1,617			(656	)

Comprehensive income	$	55,793		$	43,536

The components of accumulated other comprehensive loss were as follows:


	July 29,			April 30,
	2005			2005

Accumulated translation adjustments	$	(556	)	$	1,283
Accumulated unrealized loss on available-for-sale investments		(9,549	)		(5,444	)
Accumulated realized gain on derivatives		1,728			111

Total accumulated other comprehensive loss	$	(8,377	)	$	(4,050	)


10.	Restructuring Charges

In fiscal 2002, as a result of continuing unfavorable economic conditions and a reduction in IT spending rates, we implemented two restructuring plans, which included reductions in workforce and consolidations of facilities. As of July 29, 2005, we have no outstanding balance in our restructuring liability for the first restructuring. The second restructuring related to the closure of an engineering facility and consolidation of resources to the Sunnyvale headquarters. 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 restructuring reserve balance at July 29,

NETWORK APPLIANCE, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

2005, $566 was included in other accrued liabilities and the remaining $2,591 was classified as long-term obligations, all relating to the facility charges for the second restructuring.

Our restructuring estimates are reviewed and revised periodically and may result in a substantial charge to restructuring expense should different conditions prevail than were anticipated in previous management estimates. Such estimates included various assumptions such as the time period over which the facilities will be vacant, expected sublease terms, and expected sublease rates. During the first quarter of fiscal 2006, we recorded a reduction in restructuring reserve of $1,256 resulting from the execution of new sublease agreement for our Tewksbury facility.

The following analysis sets forth the changes in the restructuring reserve for the three months ended July 29, 2005 (in thousands):


	Facility
	Accrual

Reserve balance at April 30, 2004	$	5,208
Cash payments		(705	)
Reserve balance at April 30, 2005		4,503
Cash payments		(90	)
Adjustments		(1,256	)

Reserve balance at July 29, 2005	$	3,157


11.	Short-Term Investments

All our investments are classified as available for sale at July 29, 2005 and April 30, 2005. Available-for-sale investments with original maturities of greater than three months are classified as short-term investments, as these investments generally consist of highly marketable securities that are intended to be available to meet current cash requirements. Investment securities classified as available-for-sale are reported at fair market value, and net unrealized gains or losses are recorded in accumulated other comprehensive loss, a separate component of stockholders’ equity. Realized gains or losses on sales of investments are computed based upon specific identification and are included in interest income and other, net. For all periods presented, realized gains and losses on available-for-sale investments were not material. Management evaluates investments on a regular basis to determine if an other-than-temporary impairment has occurred and there were none as of July 29, 2005. The unrealized losses on these investments at July 29, 2005 were primarily due to interest rate fluctuations. We have the ability and intent to hold these investments until recovery of their carrying values. We also believe that we will be able to collect all principal and interest amounts due to us at maturity given the high credit quality of these investments. Accordingly, we do not consider these investments to be other-than-temporarily impaired at July 29, 2005.

Beginning in the third quarter of fiscal 2005, we have classified all investments in auction rate securities as short-term investments. To conform to current period presentation, we have reclassified $124,823 of auction rate securities from cash equivalents to short-term investments for the first quarter of fiscal 2005. The impact on the Consolidated Statements of Cash Flows was a decrease in cash used for investing activities of $25,019 for the first quarter of fiscal 2005. The reclassification had no impact on the Consolidated Statements of Income or Cash Flows from Operations for any of the periods presented.


12.	New Accounting Pronouncements

In March 2005, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations.” Interpretation No. 47 clarifies that an entity must record a liability for a “conditional” asset retirement obligation if the fair value of the obligation can be

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

reasonably estimated. Interpretation No. 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. Interpretation No. 47 is effective no later than the end of the fiscal year ending after December 15, 2005. We are currently evaluating the provision and do not expect that our adoption in the fourth quarter of fiscal 2006 will have a material impact on our results of operations or financial condition.

In March 2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 107, which provides guidance on the implementation of Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payments” (see discussion below). In particular, SAB No. 107 provides key guidance related to valuation methods (including assumptions such as expected volatility and expected term), the accounting for income tax effects of share-based payment arrangements upon adoption of SFAS No. 123R, the modification of employee share options prior to the adoption of SFAS No. 123R, the classification of compensation expense, capitalization of compensation cost related to share-based payment arrangements, first-time adoption of SFAS No. 123R in an interim period, and disclosures in Management’s Discussion and Analysis subsequent to the adoption of SFAS No. 123R. SAB No. 107 became effective on March 29, 2005. It did not have a material impact on our consolidated financial statements.

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

SFAS 123R permits public companies to adopt its requirements using one of two methods: (1) a “modified prospective” method under which compensation cost is recognized beginning with the effective date based on the requirements of SFAS 123R for all share-based payments granted after the effective date and based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS 123R that are unvested on the effective date; or (2) a “modified retrospective” method which includes the requirements of the modified prospective method and also permits companies to restate either all prior periods presented or prior interim periods of the year of adoption using the amounts previously calculated for pro forma disclosure under SFAS 123. We have not yet determined which method we will select for our adoption of SFAS 123R.

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

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

In December 2004, the FASB issued FASB Staff Position (FSP) No. 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004.”

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The American Jobs Creation Act introduces a special one-time dividends received deduction on the repatriation of certain foreign earnings to U.S. companies, provided certain criteria are met. FSP No. 109-2 provides accounting and disclosure guidance on the impact of the repatriation provision on a company’s income tax expense and deferred tax liability. We are currently studying the impact of the one-time favorable foreign dividend provision and intend to complete the analysis during the third quarter of fiscal 2006. Accordingly, we have not adjusted income tax expense or deferred tax liability to reflect the tax impact of any repatriation of non-U.S. earnings.

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

In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF Issue No. 03-01 provides guidance on evaluating and recording impairment losses on debt and equity investments and requires additional disclosures for those investments. In September 2004, the FASB delayed the measurement and recognition provisions of EITF Issue No. 03-01; however, the disclosure requirements remain effective. We will evaluate the impact of EITF Issue No. 03-01 once final guidance is issued.


13.	Commitments and Contingencies

The following summarizes our commitments and contingencies at July 29, 2005, and the effect such obligations may have on our future periods:


Contractual Obligations:	2006		2007		2008		2009		2010		Thereafter		Total

Rent operating lease payments(1)	$	11,480	$	12,367	$	12,399	$	12,149	$	9,691	$	30,075	$	88,161
Equipment operating lease payments		3,778		3,628		2,674		1,291		10		—		11,381
Venture capital funding commitments(2)		389		519		507		494		482		508		2,899
Purchase commitments and other(3)		552		605		5		2		—		—		1,164
Capital Expenditures(4)		14,291		319		—		—		—		—		14,610
Communications & Maintenance(5)		4,383		1,716		675		67		29		—		6,870

Total Contractual Cash Obligations	$	34,873	$	19,154	$	16,260	$	14,003	$	10,212	$	30,583	$	125,085


Other Commercial Commitments:	2006		2007		2008		2009		2010		Thereafter		Total

Lines of Credit(6)	$	450	$	—	$	—	$	—	$	—	$	337	$	787
Restricted Cash(7)		1,674		532		642		455		42		2,224		5,569

Total Commercial Commitments	$	2,124	$	532	$	642	$	455	$	42	$	2,561	$	6,356


(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 2015. We are

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)


	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 or terminate the lease. Our future operating lease obligations would change if we were to exercise these options and if we were to enter into additional operating lease agreements. Sublease income of $120 has been included as a reduction of the payment amounts shown in the table. Rent operating lease payments in the table exclude lease payments which are accrued as part of our 2002 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.

(3)	Purchase commitments and other represent agreements to purchase component inventory from our suppliers and/or contract manufacturers that are enforceable and legally binding against us. Other examples include minimum cash commitments relating to facilities and utilities. Purchase commitments and other excludes (a) purchases of goods and services we expect to consume in the ordinary course of business in the next 12 months; (b) open purchase orders that represent an authorization to purchase rather than a binding agreement; (c) agreements that are cancelable without penalty and costs that are not reasonably estimable at this time.

(4)	Capital expenditures include worldwide contractual commitments to purchase equipment and to construct building and leasehold improvements, which will be recorded as Property and Equipment.

(5)	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 April 2010.

(6)	The amounts outstanding under these letters of credit relate to workers’ compensation, a customs guarantee, a corporate credit card program, 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.

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

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


14.	Business Combinations

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

In accordance with FASB Interpretation No. 44, “Accounting for Certain Transactions involving Stock Compensation”, we recorded the intrinsic value, measured as the difference between the grant price and fair market value on the acquisition consummation date, of unvested options and restricted stock units assumed in

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

the Alacritus acquisition as deferred stock compensation. Such deferred stock compensation which aggregated $1,199, is recorded as a separate component of stockholders’ equity in the accompanying condensed consolidated balance sheet and will be amortized over the vesting term of the related options.

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


	Alacritus

Total Purchase Price:
Cash consideration	$	11,000
Value of options assumed		2,314
Transaction costs		337

	$	13,651

The total purchase price was allocated to the estimated fair value of assets acquired and liabilities assumed based on independent appraisals and management estimates as follows:


					Amortization
					Period (Years)

Purchase Price Allocation:
Fair value of tangible assets acquired		$	67
Intangible assets:
	Existing/ Core Technology		5,000			5
	Covenants Not to Compete		700			2
Goodwill			5,844
Fair value of liabilities assumed			(810	)
Deferred stock compensation			1,199
Deferred income taxes			1,651

		$	13,651


15.	Subsequent Events

On August 26, 2005, Network Appliance, Inc. completed its acquisition of Decru, Inc. (“Decru”), a Delaware corporation that develops and sells encryption software and appliances to secure network data storage, pursuant to an Agreement and Plan of Merger and Reorganization, by and among Network Appliance Inc., Decru, Dolphin Acquisition Corp., a wholly-owned subsidiary of the Registrant, and certain other parties, dated June 15, 2005 (the “Merger”).

In connection with the closing of the Merger, we issued to the stockholders of Decru 8,245 shares of Common Stock, par value $0.001 per share, and assumed all options to purchase Decru common stock granted under the Decru, Inc. 2001 Equity Incentive Plan that were outstanding at the closing of the Merger, which options shall be exercisable for an aggregate of 1,926 shares of our Common Stock. In addition, we paid to the Decru stockholders approximately $54,480 in cash, of which approximately $34,049 has been placed in escrow to secure the Decru stockholders’ indemnification obligations to us pursuant to the Agreement and Plan of Merger and Reorganization.


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

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and are subject to the safe harbor provisions set forth in the Exchange Act. Forward-looking statements usually contain the words “estimate,” “intend,” “plan,” “predict,” “seek,” “may,” “will,” “should,” “would,” “anticipate,” “expect,” “believe,” or similar expressions and variations or negatives of these words. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. All forward-looking statements, including, but not limited to, (1) our belief that our new FAS3000 will be a very competitive product; (2) our expectation that units shipped of the FAS3000 will increase and FAS960 and R200 units will continue to decline; (3) our expectation that the FAS960 and R200 products will be gradually replaced by the FAS3000 series and next-generation products for the remainder of fiscal 2006; (4) our expectation to see growth in the number of units shipped for our next-generation R210 NearStore products; (5) our belief in the competitiveness of our products and our ability to grow our business; (6) our belief that our products continue to offer the best price-performance value in the industry; (7) our expectation to continue to introduce new products and to deliver our next-generation operating systems and data protection solutions; (8) our plan to invest in the people, processes and systems necessary to best optimize our revenue growth; (9) our expectation that higher discount associated with high-end storage systems will negatively affect our gross margin; (10) our estimates of future intangibles and stock compensation amortization expense relating to our acquisitions; (11) our expectation that service margins will vary over time; (12) our expectation that we will continue to add sales capacity; (13) our expectation that we will increase sales and marketing expenses commensurate with future revenue growth; (14) our intention to continuously broaden our existing product offerings and introduce new products; (15) our estimates regarding future capitalized patents amortization expenses and future amortization of existing technology; (16) our expectation that we will continuously support current and future product development and enhancement efforts and incur corresponding charges; (17) our belief that our research and development expenses will increase in absolute dollars for the remainder of fiscal 2006; (18) our belief that our general and administrative expenses will increase in absolute terms in the remainder of fiscal 2006; (19) our expectation that we may repatriate foreign earnings and pay taxes under the Jobs Act; (20) our expectation regarding estimated future deferred stock compensation amortization expenses and future covenants not to compete; (21) our expectation that interest income will increase for the remainder of fiscal 2006; (22) our expectations regarding our contractual cash obligations and other commercial commitments at July 29, 2005 for the remainder of fiscal 2006 and fiscal years 2007 through 2010 and thereafter, which we anticipate will be approximately $134.6 million in the aggregate; (23) our expectation that capital expenditures will increase consistent with our business growth; (24) our expectation that our existing facilities and those currently being developed, will be sufficient for our needs for at least the next two years and that our contractual commitments, including operating leases, and any required capital expenditures over the next few years will be funded through cash from operations and existing cash and investments; (25) our belief that our existing liquidity and capital resources are sufficient to fund our operations for at least the next twelve months; (26) our belief that foreign currency hedging contracts will not subject us to significant credit risk; (27) our belief that we have been able to compete successfully with our principal competitors based on the superior technology of our products; (28) our intent to regularly introduce new products and product enhancements; (29) the possibility that we may need to increase our materials purchases, contract manufacturing capacity and internal test and quality functions to meet anticipated demand; (30) our intention to continue to establish and maintain business relationships with technology companies; (31) the possibility that we will continue to engage in future acquisitions; (32) our expectation that we will increasingly rely on our indirect sales channel for a significant portion of our revenue; (33) our expectation that the ultimate costs to resolve any outstanding legal claims or proceedings will not be material to our business; (34) our expectation that companies in the appliance market will increasingly be subject to infringement claims as the industry grows; (35) our expectation that the value of our investments will not decline significantly because of changes in market interest rates, (36) our expectation regarding ATA’s future impact on the storage market; (37) our expectation that our investments in emerging technologies will contribute to our long term growth; (38) cash

from operating activities may fluctuate in future periods, and (39) our expectation that we will acquire products and businesses complementary to our business, are inherently uncertain as they are based on management’s current expectations and assumptions concerning future events, and they are subject to numerous known and unknown risks and uncertainties. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof and are based upon information available to us at this time. These statements are not guarantees of future performance. We disclaim any obligation to update information in any forward-looking statement.

First Quarter Fiscal 2006 Overview

Revenues for the first quarter of fiscal 2006 were $448.4 million, which grew 25.1% year over year and decreased 0.8% sequentially over the previous quarter. We experienced a revenue shortfall relative to the targets we stated on our May 25, 2005 earnings conference call. We believe the principal factor impacting our revenue was the product transition to our new midrange FAS3000 series. The launch of our new midrange products impacted our revenues in two main ways. First, the May 23, 2005 introduction of the FAS3000 products caused evaluation periods for many of our sales engagements to be extended. We experienced delays in customer purchase decisions while our customers evaluated these new products, both competitively and compared to our other product lines. Approximately 90% of the FAS3000 Series orders came in the last month of the quarter, with a significant number of orders for the FAS3000 series received in the last few days of the quarter. As a result, many of these orders could not be recognized before the quarter ended, causing a large concentration of FAS3000 units in our backlog coming into the second quarter of fiscal 2006. Secondly, the FAS3000 caused a greater decline in units shipped of both our FAS960 and NearStore products than we had anticipated, which also contributed to the shortfall.

Our new FAS3000 series delivers the best value and cost per megabyte to our customers by utilizing lower-cost ATA drives combined with our patented RAID-DP protection and our FlexVol^tm technology. This combination allows more cost-effective Advanced Technology Attachment (“ATA”) drives to be used safely in primary storage applications, which we believe will be a competitive product in the marketplace.

As a result, we expect units shipped of the FAS3000 to increase and units of the FAS960 and Nearstore R200 to continue to decline in the second quarter of fiscal 2006. We expect the FAS960 and low-capacity NearStore products to be gradually replaced by the FAS3000 series products. However, this shift to the FAS3000 may continue to negatively impact our revenue in the near term as the dollar value of deals will be lower compared to the FAS960 and R200 products. We expect to see growth in the number of NearStore units shipped when we introduce the next-generation R210 with a lower entry price and upgradeability to cluster failover capabilities later in fiscal 2006.

Despite the revenue shortfall resulting from transitional issues affecting our short-term performance, we believe our business fundamentals remain intact. We remain confident in the competitiveness of our products and in our ability to grow our business over the long term. We continue to make progress across many areas of the organization, including broadening and enhancing our enterprise solutions, supporting our channel/partners, and deepening our professional services coverage. We believe our products continue to offer the best price-performance value in the industry, and we further extended our ability to help customers do “more-with-less” with the introduction of our FAS 3000 midrange series.

Continued revenue growth is dependent on the introduction and market acceptance of our new products. In fiscal 2006, we expect to continue to introduce new products, deliver our next-generation operating system with enhanced storage grid functionality and offer a comprehensive suite of data protection solutions. If we fail to timely introduce new products or successfully integrate acquired technology into our existing architecture, or if there is no or reduced demand for these or our current products, we may experience a decline in revenue. We plan to invest in the people, processes, and systems necessary to best optimize our revenue growth and long-term profitability. However, we cannot assure you that such investments will achieve our financial objectives.

First Quarter Fiscal 2006 Financial Performance


	•	Our revenues for the first quarter of fiscal 2005 were $448.4 million, a 25.1% increase over the same period a year ago. This represented a decrease of 0.8% sequentially over the last quarter. This year-over-year increase in revenue from our new mid-range FAS3020, FAS3050 products, FAS980 and FAS270 products was partially offset by a decline in revenue of our FAS960, FAS940 and NearStore R200 products compared to the same quarter a year ago.

	•	Our overall gross margins improved to 61.0% in the three-month period ended July 29, 2005 from 60.0% in the same period a year ago. The improvement in our gross margin was primarily attributable to a favorable change in product and add-on software mix and improved services margin.

	•	Net income for the first quarter of fiscal 2005 increased 28.3% to $60.1 million compared to net income of $46.9 million for the same period a year ago.

	•	With the exception of long-term restructuring and deferred rent liabilities totaling $3.3 million, our balance sheet as of July 29, 2005 remains debt-free, with cash, cash equivalents and investments of $1,214.7 million due primarily to our net income and the related cash generated from operations partially offset by cash repurchases of our common stock of $95.5 million. Days Sales Outstanding decreased to 49 days as of July 29, 2005 compared to 60 days as of April 30, 2005. Inventory turns were 17.2 times and 17.9 times as of July 29, 2005 and April 30, 2005, respectively. Deferred revenue increased to $485.4 million as of July 29, 2005 from $449.2 million reported as of April 30, 2005 due to higher software subscription and service billings attributable to our continuing shift toward larger enterprise customers. Capital purchases of plant, property and equipment for the three-month period ended July 29, 2005 were $33.5 million.

Results of Operations

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


			Three Months
			Ended

			July 29,			July 30,
			2005			2004

Revenues:				100.0	%		100.0	%
	Product revenue			88.0			90.6
	Service revenue			12.0			9.4
Cost of Revenues:
	Cost of product revenue			29.8			31.8
	Cost of service revenue			9.2			8.2

		Gross margin		61.0			60.0

Operating Expenses:
	Sales and marketing			30.6			28.8
	Research and development			11.3			10.8
	General and administrative			4.7			4.7
	Stock compensation			0.5			0.6
	Restructuring recoveries			(0.3	)		—

		Total operating expenses		46.8			44.9


			Three Months
			Ended

			July 29,			July 30,
			2005			2004

Income from Operations				14.2			15.1
Other Income (Expense), net:
	Interest income			2.0			1.1
	Other expenses, net			(0.1	)		(0.2	)
	Net gain on investments			—			—

		Total other income, net		1.9			0.9

Income before Income Taxes				16.1			16.0
Provision for Income Taxes				2.7			2.9

Net Income				13.4	%		13.1	%


	*Discussion and Analysis of Results of Operations*

Product Revenues — Product revenues increased by 21.6% to $394.6 million for the first quarter of fiscal 2006, from $324.6 million for the first quarter of fiscal 2005. Product revenues growth was primarily in the U.S. and Europe. The increase in product revenues year over year was specifically attributable to increased software licenses and software subscriptions partially offset by lower average selling prices caused by a mix shift towards ATA in primary storage, enabled by our new mid-range FAS3000 series compared to our FAS960 and R200 products.

Product revenues were favorably impacted by the following factors:


	•	increased revenues from our new and current product portfolio, such as: FAS3020 and FAS3050, FAS980, and FAS270 filer products and add-on software;

	•	increased sales of software subscriptions representing 12.0% and 10.2% of total revenues for the three-month periods ended July 29, 2005 and July 30, 2004, respectively; and

	•	increased sales through indirect channels in absolute dollars, including sales through our resellers, distributors and OEM partners, representing 50.4% and 45.9% of total revenues for the three-month periods ended July 29, 2005 and July 30, 2004, respectively.

Product revenues were negatively impacted by the following factors:


	•	a mix shift to ATA in primary storage enabled by our new midrange FAS 3000 series, driving down units shipped and revenues from our FAS960, FAS940 and NearStore R200 products;

	•	longer evaluation periods with our new mid-range products causing delays in customer purchase decisions;

	•	lower average selling prices associated with the new FAS3000 series using a mix of ATA and fibre channel drives;

	•	lower-cost-per-megabyte disks; and

	•	declining average selling prices and unit sales of our older products.

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 59.1% to $53.8 million in the first quarter of fiscal 2006, from $33.8 million in the first quarter of fiscal 2005.

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


	•	an increasing number of enterprise customers, which typically purchase more complete and generally longer-term service packages than our non-enterprise customers;


	•	a growing installed base resulting in new customer support contracts in addition to support contract renewals by existing customers; and

	•	growth in professional services revenue.

While it is an element of our strategy to expand and offer a more comprehensive, global enterprise support and service solution, we cannot assure you that service revenue will grow at the current rate in the remainder of fiscal 2006.

Service revenues are generally deferred and, in most cases, recognized ratably over the service obligation periods, which are typically one to three years. Service revenues represented 12.0% and 9.4% of total revenues for the three-month periods ended July 29, 2005 and July 30, 2004, respectively.

International total revenues — International total revenues (including United States exports) increased by 21.7% for the three-month period ended July 29, 2005 as compared to the same period in fiscal 2005. International total revenues were $181.6 million, or 40.5% of total revenues for the three-month periods ended July 29, 2005. International total revenues were $149.3 million, or 41.6% of total revenues for the three-month period ended July 30, 2004. The increase in international sales was primarily a result of European net revenues growth, driven by increased demand for our solutions portfolio, new customers and higher storage spending in certain geographic regions, as compared to the same periods in the prior fiscal year. We cannot assure you that we will be able to maintain or increase international revenues in the remainder of fiscal 2006.

Product Gross Margin — Product gross margin increased to 66.1% for the first quarter of fiscal 2006, from 64.8% for the first quarter of fiscal 2005.

Product gross margin was favorably impacted by:


	•	favorable product and add-on software mix;

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

Product gross margin was negatively impacted by:


	•	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; and

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

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

Amortization of existing technology included in cost of product revenues was $1.1 million and $0.9 million for the three-month periods ended July 29, 2005 and July 30, 2004, respectively. Estimated future amortization of existing technology to cost of product revenues relating to our Spinnaker and Alacritus acquisitions will be $3.3 million for the remainder of fiscal 2006, $4.4 million for fiscal years 2007 and 2008, $3.7 million for fiscal year 2009; $1.0 million for fiscal year 2010; and none thereafter.

Service Gross Margin — Service gross margin increased to 23.5% in the first quarter of fiscal 2006 as compared to 13.5% in the first quarter of fiscal 2005. Cost of service revenue increased by 40.7% to $41.2 million in the first quarter of fiscal 2006, from $29.2 million in the first quarter of fiscal 2005.

The improvement in service gross margin for the first quarter of fiscal 2006 compared to the same quarter in fiscal 2005 was primarily due to an increase in services revenue and improved headcount utilization partially offset by the continued spending in our service infrastructure to support our increasing enterprise customer base. This spending included additional professional support engineers, increased support center activities, and global service partnership programs. Service gross 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. In fiscal 2006, we expect service margin to be in the mid 20% range, as we

continue to build out our service capability and capacity to support our growing enterprise customers and new products.

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 32.9% to $137.3 million for the first quarter of fiscal 2006, from $103.3 million for the first quarter of fiscal 2005. These expenses were 30.6% and 28.8% of total revenues for the first quarters of fiscal 2006 and fiscal 2005, respectively. The increase in absolute dollars was attributed to increased commission expenses resulting from increased revenues, higher performance-based payroll expenses due to higher profitability, higher partner program expenses, and the continued worldwide investment in our sales and global service organizations associated with selling complete enterprise solutions.

Amortization of Spinnaker trademarks/tradenames and customer contracts/relationships included in sales and marketing expenses was $0.2 million for both three-month periods ended July 29, 2005 and July 30, 2004. Estimated future amortization of trademarks, tradenames, customer contracts and relationships relating to the Spinnaker acquisition and included in sales and marketing expenses will be $0.1 million for the remainder of fiscal 2006, and $0.1 million for fiscal 2007 and none thereafter.

Sales and marketing headcount increased to 2,010 at July 29, 2005 from 1,515 at July 30, 2004. 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.

Research and development expenses increased 31.3% to $50.8 million for the first quarter of fiscal 2006 from $38.7 million for the first quarter of fiscal 2005. These expenses represented 11.3% and 10.8% of total revenues for the first quarters of fiscal 2006 and 2005, respectively. The increase in research and development expenses was primarily a result of increased headcount, ongoing operating impact of the acquisitions, ongoing support of current and future product development and enhancement efforts, higher performance-based payroll expenses due to higher profitability, partially offset by cost control, and reduction in discretionary spending efforts. Research and development headcount increased to 886 as of July 29, 2005 compared to 687 as of July 30, 2004. For both the three-month periods ended July 29, 2005 and July 30, 2004, no software development costs were capitalized.

Included in research and development expenses is capitalized patents amortization of $0.5 million for both the three-month periods ended July 29, 2005 and July 30, 2004, respectively. Based on capitalized patents recorded at July 29, 2005, estimated future capitalized patents amortization expenses for the remainder of fiscal 2006 will be $1.5 million, $2.0 million for fiscal years 2007, 2008, $0.5 million in fiscal 2009, $0.2 million in fiscal 2010, and none thereafter.

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

We believe that our research and development expenses will increase in absolute dollars for fiscal 2006, primarily due to ongoing costs associated with the development of new products and technologies, projected headcount growth and the operating impact of potential future acquisitions as compared to fiscal 2005.

General and Administrative — General and administrative expenses increased 24.6% to $21.0 million for the first quarter of fiscal 2006, from $16.9 million for the first quarter of fiscal 2005. These expenses represented 4.7% of total revenues for both the first quarters of fiscal 2006 and 2005. This increase in absolute dollars was primarily due to higher legal expenses and professional fees for general corporate matters including patents, higher performance-based payroll expenses due to higher profitability and higher headcount growth.

General and administrative headcount increased to 457 at July 29, 2005 from 348 at July 30, 2004. We believe that our general and administrative expenses will increase in absolute dollars for fiscal 2006 due to projected general and administrative headcount growth. Amortization of covenants not to compete included in general and administrative expenses was $1.4 million and $1.3 million for the three-month periods ended July 29, 2005 and July 30, 2004, respectively. Estimated future amortization of covenants not to compete relating to our acquisitions will be $0.5 million in the remainder of fiscal 2006 and $0.4 million for fiscal year 2007, and none thereafter.

Stock Compensation — Stock compensation expenses were $2.0 million and $2.1 million in the three-month periods ended July 29, 2005 and July 30, 2004, respectively. The net decrease in deferred compensation expense year over year reflected deferred compensation expenses amortization from WebManage and the deferred salary compensation program recorded in the first quarter of fiscal 2005 that were fully amortized by the first quarter of fiscal 2006 partially offset by higher stock compensation relating to newly issued restricted stock awards and assumed options from the Alacritus acquisition in the first quarter of fiscal 2006. Based on deferred stock compensation recorded at July 29, 2005, estimated future deferred stock compensation amortization expenses are $6.0 million in the remainder of fiscal 2006, $6.5 million in fiscal 2007, $4.4 million in fiscal 2008 and $0.7 million in fiscal 2009 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 workforce and consolidations of facilities. As of July 29, 2005, we have no outstanding balance in our restructuring liability for the first restructuring. The second restructuring related to the closure of an engineering facility and consolidation of resources to the Sunnyvale headquarters. As a result of this restructuring, we incurred 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 29, 2005, $0.6 million was included in other accrued liabilities and the remaining $2.6 million was classified as long-term obligations, all relating to the facility charge for the second restructuring.

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

The following analysis sets forth the changes in the restructuring reserve for the three months ended July 29, 2005 (in thousands):


	Facility
	Accrual

Reserve balance at April 30, 2004	$	5,208
Cash payments		(705	)

Reserve balance at April 30, 2005		4,503
Cash payments		(90	)
Adjustments		(1,256	)

Reserve balance at July 29, 2005	$	3,157

Interest Income — Interest income was $9.0 million and $4.1 million for the first quarters of fiscal 2006 and 2005, 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 2006 as a result of rising average interest rates and higher cash and invested balances in a higher interest-rate portfolio environment.

Other Income (Expense), Net — Other Income (Expense), Net, included net exchange losses from foreign currency transactions of $0.3 million and $0.9 million in the three-month periods ended July 29, 2005 and July 30, 2004, respectively. We believe that period-to-period changes in foreign exchange gain or losses will continue to be impacted by hedging costs associated with our forward and option activities and forecast variance.

Provision for Income Taxes — For the three-month period ended July 29, 2005, we applied an annual tax rate of 16.9% to pretax income versus 18.0% for the comparable period in the prior year. These rates reflect a favorable foreign tax ruling for our principal European subsidiary. 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.

Liquidity and Capital Resources

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


	*Balance Sheet and Other Cash Flows*

As of July 29, 2005, as compared to April 30, 2005, our cash, cash equivalents, and short-term investments increased by $44.8 million to $1,214.7 million. We derive our liquidity and capital resources primarily from our cash flow from operations and from working capital. Working capital increased by $10.8 million to $1,066.5 million as of July 29, 2005, compared to $1,055.7 million as of April 30, 2005.

During the three-month period ended July 29, 2005, we generated cash flows from operating activities of $139.0 million as compared with $76.7 million in the same period in fiscal 2005. The largest driver of this increase was the first quarter fiscal 2006 net income of $60.1 million as compared to $46.9 million in the same period in fiscal 2005. In addition to higher net income and noncash adjustments in the first quarter of fiscal 2006, the primary factors that impacted the period-to-period change in cash flows relating to operating activities included the following:


	•	An increase in deferred revenues from higher software subscription and service billings attributable to our continuing shift toward larger enterprise customers, as well as renewals of existing maintenance agreements;

	•	Increased income taxes payable, primarily reflecting higher profitability in the three-month period ended July 29, 2005 as compared to the same period in the prior year and lower tax payments compared to the same period in the prior year; and

	•	Decreased accounts receivable balances due primarily to more linear shipments in the first quarter of fiscal 2006.

The above factors were partially offset by the effects of:


	•	Decreased accrued compensation and related benefits due to payout of higher commission and higher performance-based payroll expenses accrued in fiscal 2005 and paid in the first quarter of fiscal 2006 as compared the same period a year ago;

	•	An increase in inventories due primarily to ramping up of purchased components in anticipation of revenue growth.

We expect that cash provided by operating activities may fluctuate in future periods as a result of a number of factors, including fluctuations in our operating results, shipment linearity, accounts receivable collections, inventory management, and the timing of tax and other payments.

Capital expenditures for the three-month period ended July 29, 2005 were $33.5 million as compared to $32.3 million in the same period a year ago. We used net proceeds of $8.8 million and $9.6 million in the three-month periods ended July 29, 2005 and July 30, 2004, respectively, for net purchases/redemptions of short-term investments. Investing activities in the three-month period ended July 29, 2005 also included new investments in privately held companies of $0.3 million. In the first quarter of fiscal 2006, we acquired Alacritus for a purchase price of approximately $13.7 million, including assumed options, cash payments of $11.0 million and related transaction costs.

We received $45.2 million and $24.5 million in the three-month periods ended July 29, 2005 and July 30, 2004, respectively, from net financing activities, which included sales of common stock related to employee stock transactions net of common stock repurchases. We repurchased 3.3 million and 2.5 million shares of common stock at a total of $95.5 million and $47.7 million during three-month periods ended July 29, 2005 and July 30, 2004, respectively. Other financing activities provided $50.8 million and $23.2 million in the three-month periods ended July 29, 2005 and July 30, 2004, respectively, which related to sales of common stock related to employee stock transactions. During the three-month period ended July 29, 2005, we withheld $0.4 million from certain employees’ exercised shares of their restricted stock to reimburse for federal, state, and local withholding taxes obligations.

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.


	*Other Sources and Uses of Cash and Tax Opportunities*

The American Jobs Creation Act of 2004 (“the Jobs Act”) created a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by providing an 85% dividend-received deduction for certain dividends from certain non-U.S. subsidiaries. The deduction is subject to a number of limitations, and we are currently considering recently issued Treasury and IRS guidance on the application of the deduction. We are not yet in a position to decide whether, and to what extent, foreign earnings that have not yet been remitted to the U.S. might be repatriated. Based on the analysis to date, however, it is reasonably possible that as much as $355.0 million might be repatriated, with a respective tax liability of up to $15.0 million. We expect to be in a position to finalize our analysis during our third quarter of fiscal 2006.

For the three-month periods ended July 29, 2005 and July 30, 2004, we recorded tax benefits, in the form of reduced payments, of $16.3 million and $5.7 million, respectively, associated with disqualifying dispositions of employee stock options. If stock option exercise patterns change, we may receive less cash from stock option exercises and may not receive the same level of tax benefits in the future, which could cause our cash payments for income taxes to increase.


	*Contractual Cash Obligations and Other Commercial Commitments*

The following summarizes our contractual cash obligations and commercial commitments at July 29, 2005, and the effect such obligations are expected to have on our liquidity and cash flow in future periods, (in thousands):


Contractual Obligations:	2006		2007		2008		2009		2010		Thereafter		Total

Rent operating lease payments(1)	$	11,480	$	12,367	$	12,399	$	12,149	$	9,691	$	30,075	$	88,161
Equipment operating lease payments		3,778		3,628		2,674		1,291		10		—		11,381
Venture capital funding commitments(2)		389		519		507		494		482		508		2,899
Purchase commitments and other(3)		552		605		5		2		—		—		1,164
Capital Expenditures(4)		14,291		319		—		—		—		—		14,610
Communications & Maintenance(5)		4,383		1,716		675		67		29		—		6,870
Restructuring Charges(6)		424		565		579		604		637		348		3,157

Total Contractual Cash Obligations	$	35,297	$	19,719	$	16,839	$	14,607	$	10,849	$	30,931	$	128,242

For purposes of the above table, contractual obligations for the purchase of goods and services are defined as agreements that are enforceable, legally binding on us, and subject us to penalties if we cancel the agreement. Some of the figures we include in this table are based on management’s estimates and assumptions about these obligations, including their duration, the possibility of renewal or termination, anticipated actions by third parties, and other factors. Because these estimates and assumptions are necessarily subjective, the enforceable and legally binding obligations we will actually pay in future periods may vary from those reflected in the table.


Other Commercial Commitments:	2006		2007		2008		2009		2010		Thereafter		Total

Lines of Credit(7)	$	450	$	—	$	—	$	—	$	—	$	337	$	787
Restricted Cash(8)		1,674		532		642		455		42		2,224		5,569

Total Commercial Commitments	$	2,124	$	532	$	642	$	455	$	42	$	2,561	$	6,356


(1)	We enter into operating leases in the normal course of business. We lease sales offices, research and development facilities, and other property and equipment under operating leases throughout the U.S. and internationally, which expire through fiscal 2015. Substantially all lease agreements have fixed payment terms based on the passage of time and contain escalation clauses. Some lease agreements provide us with the option to renew the lease or to terminate the lease. Our future operating lease obligations would change if we were to exercise these options and if we were to enter into additional operating lease agreements. Sublease income of $0.1 million 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 subparagraph (6) 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 and other represent agreements to purchase component inventory from our suppliers and/or contract manufacturers that are enforceable and legally binding against us. Other examples include minimum cash commitments related to facilities and utilities. Purchase commitments and other excludes (a) purchases of goods and services we expect to consume in the ordinary course of business in the next 12 months; (b) open purchase orders that represent an authorization to purchase

rather than a binding agreement; (c) agreements that are cancelable without penalty and costs that are not reasonably estimable at this time.

(4) Capital expenditures include worldwide contractual commitments to purchase equipment and to construct building and leasehold improvements, which will be recorded as Property and Equipment.

(5) Under certain communication contracts with major telecommunication companies as well as maintenance contracts with multiple vendors, we are required to pay based on a minimum volume. Such obligations expire in April 2010.

(6) These amounts are included on our Consolidated Balance Sheets under Long-term Obligations and Other Accrued Liabilities, which is comprised of committed lease payments and 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.

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

(8) 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.


	*Capital Expenditure Requirements*

We expect capital expenditures to increase in the future consistent with the growth in our business, as we continue to invest in people, land, buildings, capital equipment and enhancements to our worldwide infrastructure. We expect that our existing facilities and those being developed in Sunnyvale, California, Research Triangle Park (“RTP”), North Carolina and worldwide are adequate for our requirements over at least the next two years and that additional space will be available as needed. We expect to finance all our construction projects, including our contractual commitments, operating leases, and any required capital expenditures over the next few years through cash from operations and existing cash and investments.


	*Off-Balance Sheet Arrangements*

As of July 29, 2005, our financial guarantees of $1.7 million that were not recorded on our balance sheet consisted of standby letters of credit related to workers’ compensation, a customs guarantee, a corporate credit card program, and a foreign lease.

As of July 29, 2005, our notional fair values of foreign exchange forward and foreign currency option contracts totaled $224.2 million. We do not believe that these derivatives present significant credit risks, because the counterparties to the derivatives consist of major financial institutions, and we manage the notional amount of contracts entered into with any one counterparty. We do not enter into derivative financial instruments for speculative or trading purposes. Other than the risk associated with the financial condition of the counterparties, our maximum exposure related to foreign currency forward and option contracts is limited to the premiums paid.

We offer both recourse and nonrecourse 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 initially defer 100% of the recourse lease receivable and recognize revenue over the term of the lease as the lease payments become due. As of July 29, 2005, and April 30, 2005, the maximum recourse exposure under such leases totaled approximately $8.3 million and $7.0 million, respectively. Under the terms of the nonrecourse leases we do not have any continuing obligations or liabilities. To date, we have not experienced significant losses under this lease financing program.

We have entered into indemnification agreements with third parties in the ordinary course of business. Generally, these indemnification agreements require us to reimburse losses suffered by the third party due to various events, such as lawsuits arising from patent or copyright infringement. These indemnification

obligations are considered off-balance sheet arrangements in accordance with FASB, Interpretation 45, of FIN 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.”

As of July 29, 2005, except for operating leases and other contractual obligations outlined under the “Contractual Cash Obligations” table, we do not have any off-balance sheet financing arrangements or liabilities, retained or contingent interests in transferred assets, or any obligation arising out of a material variable interest in an unconsolidated entity. We also do not have any majority-owned subsidiaries that are not included in the consolidated financial statements. Additionally, we do not have any interest in or relationship with, any special purpose entities.


	*Liquidity and Capital Resource Requirements*

Key factors affecting our cash flows include our ability to effectively manage our working capital, in particular, accounts receivable and inventories and future demand for our products and related pricing. We expect to incur higher capital expenditures in the near future to expand our operations. We will from time to time acquire products and businesses complementary to our business. In the future, we may continue to repurchase our common stock, which would reduce cash, cash equivalents, and/or short-term investments available to fund future operations and meet other liquidity requirements. Based on past performance and current expectations, we believe that our cash and cash equivalents, short-term investments, and cash generated from operations will satisfy our working capital needs, capital expenditures, stock repurchases, contractual obligations, and other liquidity requirements associated with our operations through at least the next 12 months.

Critical Accounting Estimates and Policies

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 April 30, 2005.

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 and reserves;

	•	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, 2005.

New Accounting Standards

See Note 12 of the Consolidated Condensed Financial Statements for a full description of recent accounting pronouncements including the respective expected dates of adoption and effects on results of operations and financial condition.

Risk Factors

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.


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

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

	•	A shift in federal government spending pattern

	•	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

	•	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.

The majority of revenue in any given quarter is derived from orders booked in the same quarter. Bookings typically follow intra-quarter seasonality patterns weighted towards the back-end of the quarter. If bookings in the latter part of a quarter are not achieved, there is a potential impact to revenue.

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.


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

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

In the storage market, our primary and nearline storage system products and our associated storage software portfolio competes primarily with storage system products and data management software from EMC Corporation, Hitachi Data Systems, Hewlett-Packard Company, IBM Corporation, and Sun Microsystems, Inc. We also see Dell, Inc. as an emerging competitor in the storage marketplace, primarily due to a business partnership that has been established between Dell and EMC, allowing Dell to resell EMC storage hardware and software products. We have also historically encountered less-frequent competition from companies including Engenio Information Technologies, Inc. (formerly the Storage Systems Group of LSI Logic Corp.), StorageTek Technology Corporation, Dot Hill Systems Corporation, and Xiotech Corporation. In the nearline storage market, which includes the disk-to-disk backup and regulated data storage segments, our NearStore appliances compete primarily against products from EMC and 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. 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 affect on our business, financial condition, and results of operations.

Increased competition could also result in price reductions, reduced gross margins, and loss of market share, any of which could materially 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, and any disruption or termination of these supply arrangements could delay shipment of our products and could materially and adversely affect our operating results.

We rely on a limited number of suppliers of several key components utilized in the assembly of our products. We purchase 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

	•	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 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.


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

We currently rely on several contract manufacturers to manufacture most of our products. Our reliance on our third-party contract manufacturers reduces our control over the manufacturing process, exposing us to risks, including reduced control over quality assurance, production costs, and product supply. If we should fail to effectively manage our relationships with our contract manufacturers, or if our contract manufacturers experience delays, disruptions, capacity constraints, or quality control problems in their manufacturing operations, our ability to ship products to our customers could be impaired and our competitive position and reputation could be harmed. Qualifying a new contract manufacturer and commencing volume production are expensive and time-consuming. If we are required to change contract manufacturers or assume internal

manufacturing operations, we may lose revenue and damage our customer relationships. If we inaccurately forecast demand for our products, we may have excess or inadequate inventory or incur cancellation charges or penalties, which could adversely impact our operating results. As of April 30, 2005, we have no purchase commitment under these agreements.

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


	Our future financial performance depends on growth in the 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.

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 will result in decreased revenues and lower revenue growth rates. The network storage and content delivery market growth declined significantly beginning in the third quarter of fiscal 2001, 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.


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

Our future growth depends upon the successful development and introduction of new hardware and software products. Due to the complexity of storage subsystems and 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. 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 occurs, 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 gross margins may vary based on the configuration of our product and service solutions, and such variation may make it more difficult to forecast our earnings.*

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

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


	•	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

	•	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.


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

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

Acquisitions of companies entail numerous risks, and we may not be able to successfully integrate acquired operations and products or realize anticipated synergies, economies of scale, or other value. Integration risks and issues may include, but not limited to, key personnel retention and assimilation, management distraction, technical development, and unexpected costs and liabilities, including goodwill impairment charges. In addition, we may 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 operation.

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.

Our ability to increase our revenues depends on expanding our direct sales operations and reseller distribution channels and continuing to provide excellent global service and support. If we are unable to effectively develop, retain, and expand our global sales and service workforce or to establish and cultivate relationships with our indirect reseller and distribution channels, our ability to grow and increase revenue could be harmed.

In an effort to gain market share and support our global customers, we will need to expand our worldwide direct sales operations and global service and support infrastructure to support new and existing enterprise customers. Expansion of our direct sales operations, reseller/distribution channels, and global service and support operations may not be successfully implemented, and the cost of any expansion may exceed the revenues generated.

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. Additionally, if we do not manage distribution of our products and services and support effectively, or if our resellers’ financial conditions or operations weaken, our revenues and gross margins could be adversely affected.


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

We conduct business internationally. For the first quarter of fiscal year 2006, 40.5% 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 utilize forward and option contracts to hedge our foreign 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.

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

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.


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

An element of our strategy to increase revenue is to strategically partner with major third-party software and hardware vendors that integrate our products into their products and also comarket our products with these vendors. 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.


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

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


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

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


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

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


	•	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, and channel and strategic partners

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

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.


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

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


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

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


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

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

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

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


	Our business is subject to changing laws and regulations and public disclosure that has increased both our costs and the risk of noncompliance. Failure to comply with these new regulations could have an adverse effect on our business and stock price.

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

We have recently completed our evaluation of our internal controls over financial reporting as required by Section 404 of the Sarbanes-Oxley Act of 2002. Although our assessment, testing, and evaluation resulted in our conclusion that as of April 30, 2005, our internal controls over financial reporting were effective, we cannot predict the outcome of our testing in future periods. If our internal controls are ineffective in future periods, our business and reputation could be harmed. We may incur additional expenses and commitment of management’s time in connection with further evaluations, either of which could materially increase our operating expenses and accordingly reduce our net income.

We also face increasing complexity in our product design and procurement operations as we adjust to new and upcoming requirements relating to the materials composition of many of our products. The European Union (“EU”) has adopted two directives to facilitate the recycling of electrical and electronic equipment sold in the EU. The first of these is the Waste Electrical and Electronic Equipment (WEEE) directive, which directs EU member states to enact laws, regulations, and administrative provisions to ensure that producers of electrical and electronic equipment are financially responsible for specified collection, recycling, treatment, and environmentally sound disposal of products placed on the market after August 13, 2005, and from products in use prior to that date that are being replaced. The EU has also adopted the Restriction on the Use of Certain Hazardous Substances in Electrical and Electronic Equipment (“RoHS”) directive. The RoHS directive restricts the use of lead, mercury, and certain other substances in electrical and electronic products placed on the market in the European Union after July 1, 2006.

Similar laws and regulations have been or may be enacted in other regions, including in the United States, China, and Japan. Other environmental regulations may require us to reengineer our products to utilize components that are more environmentally compatible, and such reengineering and component substitution may result in additional costs to us. Although we do not anticipate any material adverse effects based on the nature of our operations and the effect of such laws, there is no assurance that such existing laws or future laws will not have a material adverse effect on our business.


	*Changes in financial accounting standards or practices may cause adverse unexpected fluctuations and affect our reported business and financial results.*

In December 2004 the FASB issued SFAS No. 123R (revised 2004), which will require us, beginning in the first quarter of fiscal 2007, to expense employee stock options for financial reporting purposes. Adoption of SFAS No. 123R will result in lower reported earnings per share, which could negatively impact our future stock price. In addition, this could also impact our ability or future practice of utilizing broad-based employee stock plans to attract, reward, and retain employees, which could also adversely impact our operations.

In addition, the FASB requires certain valuation models to estimate the fair value of employee stock options. These models, including the Black-Scholes option-pricing model, use varying methods, inputs, and assumptions selected across companies. If another party asserts that the fair value of our employee stock options is misstated, securities class action litigation could be brought against us, or the market price of our common stock could decline, or both could occur. As a result of these changes, we could incur losses, and our operating results and gross margins may be below our expectations and those of investors and stock market analysts.


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

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


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

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 derivative financial instruments for speculative or trading purposes. All financial instruments are used in accordance with management-approved policies.

Market Interest and Interest Income Risk

Interest and Investment Income — As of July 29, 2005, we had short-term investments of $983.2 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, and auction-rate securities, are subject to interest rate and interest income risk and will decrease in value if market interest rates increase. A hypothetical 10 percent increase in market interest rates from levels at July 29, 2005 would cause the fair value of these short-term investments to decline by approximately $2.9 million. Because we have the ability to hold these investments until maturity we would not expect any significant decline in value of our investments caused by market interest rate changes. Declines in interest rates over time will, however, reduce our interest income. We do not use derivative financial instruments in our investment portfolio.

Foreign Currency Exchange Rate Risk

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 outstanding at July 29, 2005, the gains or losses were included in other comprehensive income.

We do not enter into foreign exchange contracts for speculative or trading purposes. In entering into forward and option foreign exchange contracts, we have assumed the risk that might arise from the possible inability of counterparties to meet the terms of their contracts. We attempt to limit our exposure to credit risk by executing foreign exchange contracts with creditworthy multinational commercial banks. All contracts have a maturity of less than one year.

The following table provides information about our foreign exchange forward and option contracts outstanding on July 29, 2005 (in thousands):


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

Forward contracts:
	CAD		Sell		7,784	$	6,358	$	6,359
	ILS		Sell		10,648	$	2,354	$	2,354
	EUR		Sell		115,360	$	140,179	$	139,985
	GBP		Sell		19,333	$	33,991	$	33,912
	ZAR		Sell		20,021	$	3,030	$	3,030
	AUD		Buy		12,578	$	9,504	$	9,504
	CHF		Buy		585	$	455	$	455
	DKK		Buy		11,963	$	1,949	$	1,949
	EUR		Buy		9,316	$	11,272	$	11,304
	GBP		Buy		2,282	$	3,992	$	4,003
	SEK		Buy		10,558	$	1,364	$	1,364
Option contracts:
	EUR		Sell		6,000	$	7,276	$	7,344
	GBP		Sell		1,500	$	2,633	$	2,657


Item 4.	*Controls and Procedures*

Disclosure controls are controls and 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 and procedures 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 July 29, 2005, the end of the fiscal period covered by this quarterly 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.

PART II. OTHER INFORMATION


Item 1.	*Legal Proceedings*

None


Item 2.	*Unregistered Sales of Equity Securities and Use of Proceeds*

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


					Total Number of		Approximate Dollar
					Shares Purchased		Value of Shares
			Average		as Part of the		That May yet be
	Shares		Price Paid		Repurchase		Purchased Under the
Period	Purchased		per Share		Program(1)		Repurchase Program(2)

May 1, 2005 — May 31, 2005		—	$	—		14,566,101	$	320,925,379
June 1, 2005 — June 30, 2005		3,261,950	$	29.29		17,828,051	$	225,382,165
July 1, 2005 — July 29, 2005		—	$	—		17,828,051	$	225,382,165

Total		3,261,950	$	29.29		17,828,051	$	225,382,165


(1)	This amount represented total number of shares purchased under our publicly announced repurchase programs since inception.

(2)	On May 24, 2005, our Board approved a new, incremental stock repurchase program in which up to $300.0 million of additional shares of our outstanding common stock may be purchased. The stock repurchase program may be suspended or discontinued at any time.


Item 3.	*Defaults Upon Senior Securities*

None


Item 4.	*Submission of Matters to a Vote of Security Holders*

None


Item 5.	*Other Information*

The information required by this item is incorporated by reference from our Proxy Statement for the 2005 Annual Meeting of Stockholders.


Item 6.	*Exhibits*


2	.1(3)	Agreement and Plan of Merger, dated as of November 3, 2003, by and among Network Appliance, Inc., Nagano Sub, Inc., and Spinnaker Networks, Inc.

2	.2(3)	Amendment to Merger Agreement, dated as of February 9, 2004, by and among Network Appliance, Inc., Nagano Sub, Inc., and Spinnaker Networks, Inc.

2	.3	Agreement and Plan of Merger and Reorganization, dated as of June 15, 2005, by and among Network Appliance, Inc., Dolphin Acquisition Corp., and Decru, Inc.

3	.1(1)	Certificate of Incorporation of the Company.

3	.2(1)	Bylaws of the Company.

3	.3(6)	Certificate of Amendment to the Bylaws of the Company.

4	.1(1)	Reference is made to Exhibits 3.1 and 3.2.

4	.2(4)	Spinnaker Networks, Inc. 2000 Stock Plan.

4	.3(7)	Form of Stock Option Grant Notice and Option Agreement under the Decru, Inc. Amended and Restated 2001 Equity Incentive Plan.



4	.4(7)	Form of Stock Option Grant Notice and Option Agreement under the Decru, Inc. 2001 Equity Incentive Plan

4	.5(7)	Form of Early Exercise Stock Purchase Agreement under the Decru, Inc. 2001 Equity Incentive Plan.

4	.6(7)	Form of Restricted Stock Bonus Grant Notice and Agreement under the Decru, Inc. 2001 Equity Incentive Plan.

10	.1(2)	Asset Purchase Agreement dated June 20, 2003, by and between Auspex Systems, Inc. and the Company.

10	.2(5)	Purchase and Sale Agreement dated July 27, 2004 by and between Cisco Systems, Inc. and the Company.

31	.1	Certification of Chief Executive Officer pursuant to Securities Exchange Act Rules 13a-15(e) and 15d-15(e) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated September 2, 2005.

31	.2	Certification of Chief Financial Officer pursuant to Securities Exchange Act Rules 13a-15(e) and 15d-15(e) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated September 2, 2005.

32	.1	Certification of Chief Executive Officer pursuant to 18 U .S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated September 2, 2005.

32	.2	Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated September 2, 2005.


(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 Quarterly Report on Form 10-Q dated August 31, 2004.

(6)	Previously filed as an exhibit with the Company’s Current Report on Form 8-K dated May 4, 2005.

(7)	Previously filed as an exhibit with the Company’s Form S-8 registration statement dated September 2, 2005.

SIGNATURE

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
	Executive Vice President of Finance and
	Chief Financial Officer

Date: September 2, 2005

EXHIBIT INDEX


2	.1(3)	Agreement and Plan of Merger, dated as of November 3, 2003, by and among Network Appliance, Inc., Nagano Sub, Inc., and Spinnaker Networks, Inc.

2	.2(3)	Amendment to Merger Agreement, dated as of February 9, 2004, by and among Network Appliance, Inc., Nagano Sub, Inc., and Spinnaker Networks, Inc.

2	.3	Agreement and Plan of Merger and Reorganization, dated as of June 15, 2005, by and among Network Appliance, Inc., Dolphin Acquisition Corp., and Decru, Inc.

3	.1(1)	Certificate of Incorporation of the Company.

3	.2(1)	Bylaws of the Company.

3	.3(6)	Certificate of Amendment to the Bylaws of the Company.

4	.1(1)	Reference is made to Exhibits 3.1 and 3.2.

4	.2(4)	Spinnaker Networks, Inc. 2000 Stock Plan.

4	.3(7)	Form of Stock Option Grant Notice and Option Agreement under the Decru, Inc. Amended and Restated 2001 Equity Incentive Plan.

4	.4(7)	Form of Stock Option Grant Notice and Option Agreement under the Decru, Inc. 2001 Equity Incentive Plan.

4	.5(7)	Form of Early Exercise Stock Purchase Agreement under the Decru, Inc. 2001 Equity Incentive Plan.

4	.6(7)	Form of Restricted Stock Bonus Grant Notice and Agreement under the Decru, Inc. 2001 Equity Incentive Plan.

10	.1(2)	Asset Purchase Agreement dated June 20, 2003, by and between Auspex Systems, Inc. and the Company.

10	.2(5)	Purchase and Sale Agreement dated July 27, 2004 by and between Cisco Systems, Inc. and the Company.

31	.1	Certification of Chief Executive Officer pursuant to Securities Exchange Act Rules 13a-15(e) and 15d-15(e) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated September 2, 2005.

31	.2	Certification of Chief Financial Officer pursuant to Securities Exchange Act Rules 13a-15(e) and 15d-15(e) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, dated September 2, 2005.

32	.1	Certification of Chief Executive Officer pursuant to 18 U .S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated September 2, 2005.

32	.2	Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated September 2, 2005.


(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 Quarterly Report on Form 10-Q dated August 31, 2004.

(6)	Previously filed as an exhibit with the Company’s Current Report on Form 8-K dated May 4, 2005.

(7)	Previously filed as an exhibit with the Company’s Form S-8 registration statement dated September 2, 2005.


	rather than a binding agreement; (c) agreements that are cancelable without penalty and costs that are not reasonably estimable at this time.

(4)	Capital expenditures include worldwide contractual commitments to purchase equipment and to construct building and leasehold improvements, which will be recorded as Property and Equipment.

(5)	Under certain communication contracts with major telecommunication companies as well as maintenance contracts with multiple vendors, we are required to pay based on a minimum volume. Such obligations expire in April 2010.

(6)	These amounts are included on our Consolidated Balance Sheets under Long-term Obligations and Other Accrued Liabilities, which is comprised of committed lease payments and 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.

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

(8)	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.