1 ================================================================================ SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 --------------- FORM 10-Q --------------- (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JULY 30, 1999 OR [ ] 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) CALIFORNIA 77-0307520 (STATE OR OTHER JURISDICTION OF (IRS EMPLOYER IDENTIFICATION NO.) INCORPORATION OR ORGANIZATION) 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 [X] No [ ] Number of shares outstanding of the registrant's class of common stock, as of the latest practicable date. OUTSTANDING AT CLASS JULY 30, 1999 ----- -------------- Common Stock....................... 73,571,159 ================================================================================
2 TABLE OF CONTENTS <TABLE> <CAPTION> PAGE NO. -------- <S> <C> PART I -- FINANCIAL INFORMATION Item 1. Condensed Consolidated Financial Statements (Unaudited) Condensed Consolidated Balance Sheets as of July 30, 1999 and April 30, 1999 2 Condensed Consolidated Statements of Income for the three-month periods ended July 30, 1999 and July 31, 1998 3 Condensed Consolidated Statements of Cash Flows for the three-month periods ended July 30, 1999 and July 31, 1998 4 Notes to Condensed Consolidated Financial Statements 5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 8 Item 3. Quantitative and Qualitative Disclosures About Market Risk 14 PART II -- OTHER INFORMATION Item 1. Legal Proceedings 15 Item 2. Changes in Securities 15 Item 3. Defaults Upon Senior Securities 15 Item 4. Submission of Matters to Vote of Securityholders 15 Item 5. Other Information 15 Item 6. Exhibits and Reports on Form 8-K 16 SIGNATURE 17 </TABLE> 1
3 PART I. FINANCIAL INFORMATION ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS NETWORK APPLIANCE, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) <TABLE> <CAPTION> July 30, April 30, 1999 1999 --------- --------- (UNAUDITED) <S> <C> <C> ASSETS CURRENT ASSETS: Cash and cash equivalents $ 230,025 $ 221,284 Short-term investments 15,869 5,800 Accounts receivable, net 68,910 57,163 Inventories 15,019 13,581 Prepaid expenses and other assets 4,689 7,384 Deferred taxes 13,534 10,134 --------- --------- Total current assets 348,046 315,346 PROPERTY AND EQUIPMENT, NET 25,016 19,271 DEPOSITS 4,500 7,000 OTHER ASSETS 4,772 4,730 --------- --------- $ 382,334 $ 346,347 ========= ========= LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 22,405 $ 15,126 Income taxes payable 3,928 1,108 Accrued compensation and related benefits 10,213 15,189 Other accrued liabilities 8,890 7,633 Deferred revenue 12,959 11,474 --------- --------- Total current liabilities 58,395 50,530 LONG-TERM OBLIGATIONS 68 93 --------- --------- 58,463 50,623 --------- --------- SHAREHOLDERS' EQUITY: Common stock 254,508 240,093 Retained earnings 69,422 55,954 Cumulative other comprehensive loss (59) (323) --------- --------- Total shareholders' equity 323,871 295,724 --------- --------- $ 382,334 $ 346,347 ========= ========= </TABLE> See accompanying notes to condensed consolidated financial statements. 2
4 NETWORK APPLIANCE, INC. CONDENSED CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED) <TABLE> <CAPTION> THREE MONTHS ENDED ------------------------ JULY 30, JULY 31, 1999 1998 -------- -------- <S> <C> <C> NET SALES $103,279 $ 57,375 COST OF SALES 42,539 23,239 -------- -------- Gross Margin 60,740 34,136 -------- -------- OPERATING EXPENSES: Sales and marketing 26,884 14,935 Research and development 11,220 6,081 General and administrative 3,818 1,885 -------- -------- Total operating expenses 41,922 22,901 -------- -------- INCOME FROM OPERATIONS 18,818 11,235 OTHER INCOME, NET 2,063 121 -------- -------- INCOME BEFORE INCOME TAXES 20,881 11,356 PROVISION FOR INCOME TAXES 7,413 4,259 -------- -------- NET INCOME $ 13,468 $ 7,097 ======== ======== NET INCOME PER SHARE: Basic $ 0.18 $ 0.11 ======== ======== Diluted $ 0.16 $ 0.10 ======== ======== SHARES USED IN PER SHARE CALCULATIONS: Basic 73,094 67,096 ======== ======== Diluted 83,399 74,542 ======== ======== </TABLE> See accompanying notes to condensed consolidated financial statements. 3
5 NETWORK APPLIANCE, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED) <TABLE> <CAPTION> THREE MONTHS ENDED ------------------------- JULY 30, JULY 31, 1999 1998 --------- --------- <S> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 13,468 $ 7,097 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 2,837 2,122 Provision for doubtful accounts 304 100 Deferred income taxes (3,400) (217) Deferred rent (25) (6) Changes in assets and liabilities: Accounts receivable (12,005) (1,734) Inventories (1,219) (1,021) Prepaid expenses and other assets 2,595 716 Accounts payable 7,279 (2,500) Income taxes payable 9,720 3,937 Accrued compensation and related benefits (4,976) (3,226) Other accrued liabilities 1,257 126 Deferred revenue 1,485 989 --------- --------- Net cash provided by operating activities 17,320 6,383 --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of short-term investments (12,419) (7,080) Redemptions of short-term investments 2,350 2,950 Purchases of property and equipment (8,306) (2,340) Payment/refund of deposits, net 2,500 (9,500) --------- --------- Net cash used in investing activities (15,875) (15,970) --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Repayments of long-term obligations -- (3) Proceeds from sale of common stock, net 7,296 3,751 --------- --------- Net cash provided by financing activities 7,296 3,748 --------- --------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 8,741 (5,839) CASH AND CASH EQUIVALENTS: Beginning of period 221,284 37,315 --------- --------- End of period $ 230,025 $ 31,476 ========= ========= NONCASH INVESTING AND FINANCING ACTIVITIES: Income tax benefit from employee stock transactions $ 6,900 $ 2,234 SUPPLEMENTAL CASH FLOW INFORMATION: Income taxes paid $ 34 $ 453 </TABLE> See accompanying notes to condensed consolidated financial statements. 4
6 NETWORK APPLIANCE, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS The accompanying condensed consolidated financial statements have been prepared by Network Appliance, Inc. without audit and reflect all adjustments, which are, in the opinion of management, necessary for a fair presentation of our financial position and results of operations for the interim periods. The statements have been prepared in accordance with the regulations of the Securities and Exchange Commission (SEC). Accordingly, they do not include all information and footnotes required by generally accepted accounting principles. The results of operations for the three-month period ended July 30, 1999 are not necessarily indicative of the operating results to be expected for the full fiscal year or future operating periods. The information included in this report should be read in conjunction with the audited consolidated financial statements and notes thereto for the fiscal year ended April 30, 1999 and the risk factors as set forth in our Annual Report on Form 10-K, including, without limitation, risks relating to fluctuating operating results, customer and market acceptance of new products, dependence on new products, rapid technological change, litigation, dependence on growth in the network file server market, expansion of international operations, product concentration, changing product mix, competition, management of expanding operations, dependence on high-quality components, dependence on proprietary technology, intellectual property rights, dependence on key personnel, volatility of stock price, shares eligible for future sale, effect of certain anti-takeover provisions, dilution and the Year 2000 Issue. Any party interested in reviewing these publicly available documents should contact the SEC or our Chief Financial Officer. 2. SIGNIFICANT ACCOUNTING POLICIES Fiscal Periods - We operate on a 52-week or 53-week year ending on the last Friday in April. Fiscal 2000 is a 52-week year. Fiscal 1999 was a 53-week year. The quarter ended July 30, 1999 includes 13 weeks of operating activity, compared to 14 weeks of activity for the corresponding period of the prior fiscal year. Foreign Currency Translation - In the first quarter of fiscal 2000, we determined that the functional currencies of certain of our foreign subsidiaries had changed from the local currencies to the Euro. Accordingly, assets and liabilities of our foreign subsidiaries are translated into Euro at the exchange rates in effect as of the balance sheet date, and results of operations for each subsidiary are translated using average rates in effect for the period presented. Translation adjustments have been included within shareholders' equity as a cumulative other comprehensive loss. The effect of the change in functional currencies did not have a material impact on our consolidated financial position, results of operations or cash flows. 3. INVENTORIES Inventories consist of the following: <TABLE> <CAPTION> JULY 30, APRIL 30, 1999 1999 ------- ------- (IN THOUSANDS) <S> <C> <C> Purchased components $ 3,552 $ 5,316 Work in process 2,186 1,727 Finished goods 9,281 6,538 ------- ------- $15,019 $13,581 ======= ======= </TABLE> 5
7 NETWORK APPLIANCE, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 4. COMMON STOCK AND NET INCOME PER SHARE The following is a reconciliation of the numerators and denominators of the basic and diluted net income per share computations for the periods presented: <TABLE> <CAPTION> THREE MONTHS ENDED ----------------------- JULY 30, JULY 31, 1999 1998 -------- -------- <S> <C> <C> (In thousands, except per share amounts) NET INCOME (NUMERATOR): Net income, basic and diluted $ 13,468 $ 7,097 ======== ======== SHARES (DENOMINATOR): Weighted average common shares outstanding 73,155 67,582 Weighted average common shares outstanding subject to repurchase (61) (486) -------- -------- Shares used in basic computation 73,094 67,096 Weighted average common shares outstanding subject to repurchase 61 486 Common shares issuable upon exercise of stock options 10,244 6,960 -------- -------- Shares used in diluted computation 83,399 74,542 ======== ======== NET INCOME PER SHARE: Basic $ 0.18 $ 0.11 ======== ======== Diluted $ 0.16 $ 0.10 ======== ======== </TABLE> 6
8 NETWORK APPLIANCE, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 5. COMPREHENSIVE INCOME The components of comprehensive income, net of tax, are as follows: <TABLE> <CAPTION> THREE MONTHS ENDED -------------------- JULY 30, JULY 31, 1999 1998 ------- ------- (IN THOUSANDS) <S> <C> <C> Net income $13,468 $ 7,097 Change in cumulative translation adjustment 264 17 ------- ------- Comprehensive income $13,732 $ 7,114 ======= ======= </TABLE> 6. NEW ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities," which defines derivatives, requires that all derivatives be carried at fair value, and provides for hedging accounting when certain conditions are met. This statement is effective for all fiscal quarters of fiscal years beginning after June 15, 2000. On a forward-looking basis, although we have not fully assessed the implications of this new statement, we do not believe adoption of this statement will have a material impact on our consolidated financial position, results of operations or cash flows. 7
9 This Form 10-Q contains forward-looking statements about future results, which are subject to risks and uncertainties, including those discussed below. Our actual results may differ significantly from the results discussed in the forward-looking statements. We are subject to a variety of other additional risk factors, more fully described in our Annual Report on Form 10-K filed with the Securities and Exchange Commission. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS The following table sets forth certain consolidated statements of income data as a percentage of net sales for the periods indicated: <TABLE> <CAPTION> THREE MONTHS ENDED ----------------------- JULY 30, JULY 31, 1999 1998 -------- -------- <S> <C> <C> Net sales 100.0% 100.0% Cost of sales 41.2 40.5 ------ ------ Gross margin 58.8 59.5 ------ ------ Operating expenses: Sales and marketing 26.0 26.0 Research and development 10.9 10.6 General and administrative 3.7 3.3 ------ ------ Total operating expenses 40.6 39.9 ------ ------ Income from operations 18.2 19.6 Other income, net 2.0 0.2 ------ ------ Income before income taxes 20.2 19.8 Provision for income taxes 7.2 7.4 ------ ------ Net income 13.0% 12.4% ====== ====== </TABLE> Net Sales -- Net sales increased by 80.0% to $103.3 million for the three months ended July 30, 1999, from $57.4 million for the three months ended July 31, 1998. This increase was primarily attributable to a higher volume of units shipped, as compared to the corresponding period of the prior fiscal year. Factors impacting unit growth include: o growth in the network attached storage market, increased market acceptance of the appliance concept and the growing enterprise market driven by the need for reliable internet infrastructure; o acceleration in deployment of our products among Internet and enterprise related customers, particularly for E-business and new E-commerce applications; o strong demand for our F700 filer product family utilizing primarily fibre-channel connectivity; o increased worldwide shipment of NetApp(R) Cluster Failover; o increased worldwide demand for our NetCache(TM) solutions; o additional filer demand created by SnapMirror(TM) to store the remote replicated data for disaster recovery; o expansion of our direct sales force and o initial sales to our two new OEM partners. 8
10 Net sales growth was also positively impacted by: o a higher average selling price of our F700 filer product family due primarily to the increase in storage content; o the introduction of new software features with SnapMirror, SnapRestore(TM) and Cluster Failover and; o increased add on software licenses from multi-protocol, software subscription and service revenues due to a growing installed base. Factors which partially offset overall net sales growth include declining unit sales of our older product family and decreases in base prices of our current product line due to competitive forces from the recent disk repricing. International net sales (including United States exports) grew by 124.0% for the three-month period ended July 30, 1999, as compared to the comparable period of the prior fiscal year. International net sales were $28.4 million, or 27.5% of total net sales, for the three-month period ended July 30, 1999. The increase in international sales for the three-month period ended July 30, 1999, was primarily a result of European sales growth, due to increased headcount in the direct sales force, increased indirect channel sales through resellers, increased shipments of filers, Cluster Failover solutions, NetCache appliances and increased sales of add-on software licenses. Asia Pacific net sales growth for the three-month period ended July 30, 1999, was also driven by increased headcount in the direct sales force, increased shipments of filers, NetCache appliances and increased sales of add-on software licenses, as compared to the corresponding period of the prior fiscal year. We cannot assure you that our net sales will continue to increase in absolute dollars or at the rate at which they have grown in recent fiscal periods. Gross Margin -- Gross margin decreased slightly to 58.8% for the three months July 30, 1999 from 59.5% for the three months ended July 31, 1998. Primary factors negatively impacting gross margin were: o the increase in the sales volume of the F700 product family carrying additional costs associated with greater disk drive and memory content; o recent price reductions on disk drives due to competitive pricing pressure from other storage vendors. Factors negatively impacting gross margin were partially offset by: o the increase in product volume; o lower costs of key components and o increased manufacturing efficiencies. Gross margin was also favorably impacted by the licensing of add on software from multi-protocol, Cluster Failover, SnapMirror and SnapRestore and support contracts, and by growth in software subscription and service revenues due to a larger installed base. Our gross margin has been and will continue to be affected by a variety of factors, including: o competition; o product configuration; o direct versus indirect sales; o the mix and average selling prices of products, including software licensing; o new product introductions and enhancements; and o the cost of components and manufacturing labor. 9
11 Our gross margin may also vary based upon the configuration of systems that are sold and whether they are sold directly or through indirect channels. Highly configured systems have historically generated lower overall gross margin percentages due to greater disk drive and memory content. Sales and Marketing -- Sales and marketing expenses consist primarily of salaries, commissions, advertising and certain promotional expenses and customer service and support costs. Sales and marketing expenses increased 80.0% to $26.9 million for the three months ended July 30, 1999 from $14.9 million for the three months ended July 31, 1998. These expenses were 26.0% of net sales for both the three months ended July 30, 1999 and July 31, 1998, respectively. The increase in absolute dollars was primarily related to the continued expansion of our sales and marketing organization, including growth in the domestic and international direct sales forces and increased commission expenses. We expect to continue to increase our sales and marketing expenses 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 believe that our continued growth and profitability is dependent in part on the successful expansion of our international operations, and therefore, have committed significant resources to increase international sales. Research and Development -- Research and development expenses consist primarily of salaries and benefits, prototype expenses, and fees paid to outside consultants. Research and development expenses increased 84.5% to $11.2 million for the three months ended July 30, 1999 from $6.1 million for the three months ended July 31, 1998. These expenses represented 10.9% and 10.6% of net sales, respectively, for the three months ended July 30, 1999 and July 31, 1998. Research and development expenses increased in absolute dollars, primarily as a result of increased headcount, ongoing support of current and future product development and enhancement efforts and prototyping expenses associated with the development of new products. These new products included the F700 series filers, the Cluster Failover solutions, the C700 family and Netcache software release, as well as new enterprise software offerings and data management tools with SnapMirror, SnapRestore and SecureAdmin(TM). 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 intend to continuously expand our existing product offerings and to introduce new products and expect that such expenditures will continue to increase in absolute dollars. For the three months ended July 30, 1999 and July 31, 1998, no software development costs were capitalized. General and Administrative -- General and administrative expenses were $3.8 million for the three months ended July 30, 1999, as compared to $1.9 million for the three months ended July 31, 1998. These expenses represented 3.7% and 3.3% of net sales for the three months ended for such periods. Increases in absolute dollars were primarily due to increased headcount, expenses associated with initiatives to implement enterprise-wide management information systems, increases to the allowance for doubtful accounts and outside service fees. We believe that our general and administrative expenses will increase in absolute dollars as we continue to build our infrastructure. Other Income, net -- Other income, net, was $2.1 million and $0.1 million for the three months ended July 30, 1999 and July 31, 1998, respectively. The increase was due primarily to interest income earned on the net proceeds from the March 1999 follow-on public offering, cash generated from operations and net proceeds from stock option exercises. The first quarter of fiscal 1999 included losses from foreign currency transactions compared to minimal foreign currency losses recorded in the current quarter, primarily the result of the implementation of our new hedging program. Provision for Income Taxes -- Our effective tax rate was 35.5% for the three-months period ended July 30, 1999 compared to 37.5% for the three-months period ended July 31, 1998. The effective tax rates differed from the U.S. statutory rate of 35% primarily due to state taxes partially offset by earnings of foreign subsidiaries being taxed at lower rates. 10
12 CERTAIN RISK FACTORS Although we have experienced significant revenue growth in recent periods, this growth may not be indicative of our future operating results. As a result, we believe that period-to-period comparisons of our results of operation 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 the following: the level of competition in our target product markets; the size and timing and cancellation of significant orders; product configuration and mix; market acceptance of new products and product enhancements; new product announcements or introductions by us or our competitors; deferrals of customer orders in anticipation of new products or product enhancements; changes in pricing by us or our competitors; our ability to timely develop, introduce and market new products and enhancements; supply constraints; technological changes in our target product markets; the levels of expenditure on research and development and expansion of our sales and marketing programs; seasonality; and general economic trends. In addition, sales for any future quarter may vary and accordingly be inconsistent with our plans. We generally operate with limited order backlog because our products are typically shipped shortly after orders are received. As a result, product sales in any quarter are generally dependent on orders booked and shipped in that quarter. Product sales are difficult to forecast because the network file server market is rapidly evolving and our sales cycle varies substantially from customer to customer. We conduct business internationally. For the three months ended July 30, 1999, approximately 27.5% of our net sales were to international customers (including United States 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 and government spending patterns. Our international sales are denominated in U.S. dollars and in foreign currencies. An increase in the value of the U.S. dollar relative to foreign currencies could make our products more expensive and, therefore, potentially less competitive in foreign markets. For international sales and expenditures denominated in foreign currencies, we are subject to risks associated with currency fluctuations. We hedge risks associated with foreign currency transactions in order to minimize the impact of changes in foreign currency exchange rates on earnings. We utilize forward contracts to hedge trade and intercompany receivables and payables. All hedge contracts are marked to market through earnings every period. We believe that these forward contracts do not subject us to undue risk due to foreign exchange movements because gains and losses on these contracts are offset by losses and gains on the underlying assets and liabilities. 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. We cannot assure you that such factors will not materially adversely affect our future international sales and, consequently, our operating results. Although operating results have not been materially and adversely affected by seasonality in the past, because of the significant seasonal effects experienced within the industry, particularly in Europe, we cannot assure you that our future operating results will not be adversely affected by seasonality. We believe that continued growth and profitability will require successful expansion of our international operations and sales and therefore we have committed significant resources to such expansion. In order to successfully expand international sales in fiscal 2000 and subsequent periods, we must strengthen foreign operations, hire additional personnel and recruit additional international distributors and resellers. This will require significant management attention and financial resources and could materially adversely affect our operating results. To the extent that we are unable to effect these additions in a timely manner, our growth, if any, in international sales will be limited, and our operating results could be materially adversely affected. In addition, we cannot assure you that we will be able to maintain or increase international market demand for our products. 11
13 LIQUIDITY AND CAPITAL RESOURCES As of July 30, 1999, as compared to the April 30, 1999 balances, our cash, cash equivalents and short-term investments increased by $18.8 million to $245.9 million. Working capital increased by $24.8 million to $289.7 million. We generated cash from operating activities totaling $17.3 million and $6.4 million for the three-month periods ended July 30, 1999 and July 31, 1998, respectively. Net cash provided by operating activities for the three-month period ended July 30, 1999 principally related to net income of $13.5 million, increases in accounts payable, income taxes payable, deferred revenue and other accrued liabilities and decreases in prepaid expenses and other assets, coupled with depreciation and amortization which are non-cash expenses, partially offset by increases in accounts receivable, inventories, deferred income taxes and decreases in accrued compensation and related benefits. We used $8.3 million and $2.3 million of cash during the three-month periods ended July 30, 1999 and July 31, 1998, respectively, to purchase property and equipment. The increases were primarily attributed to our relocation in June 1999 to the Sunnyvale headquarters facility. During the current quarter, we received back our $2.5 million deposit in connection with the $36.0 million operating lease. We have used $10.1 million and $4.1 million during the three-month periods ended July 30, 1999 and July 31, 1998, respectively, for net short-term investment purchases. Financing activities provided $7.3 million and $3.7 million during the three-month periods ended July 30, 1999 and July 31, 1998, respectively. The increase in cash provided by financing activities for the three months ended July 30, 1999, compared to the corresponding period of the prior fiscal year, was due to an increased quantity of stock options exercised at a higher average exercise price and a greater number of employees participating in the employee stock purchase plan. In fiscal 1999, we executed agreements to acquire approximately 18 acres of land in Sunnyvale, California and to develop 393,000 square feet of buildings. We subsequently assigned our rights and obligations under all the agreements for the Sunnyvale facilities to a third-party entity and entered into three operating leases. The leases require monthly payments which vary based on the London Interbank Offered Rate (LIBOR) plus a spread (6.7% at July 30, 1999). The aggregate annual minimum rent commitments under the $44.0 million lease is approximately $2.9 million which began in August 1999. The lease payments under the $48.0 million and $36.0 million operating leases are expected to commence in June 2000 and will also vary based on LIBOR plus a spread. The operating leases mentioned above require us to maintain specified financial covenants with which we were in compliance as of July 30, 1999. Excluding the commitments related to the aforementioned properties, which we have assigned to third parties and accounted for as operating leases, we currently have no significant commitments other than commitments under operating leases. We believe that our existing liquidity and capital resources, including the available amounts under the $5.0 million line of credit, are sufficient to fund our operations for at least the next twelve months. YEAR 2000 The Year 2000 issue refers to computer programs which use two digits rather than four to define a given year and which therefore might read a date using "00" as the year 1900 rather than the year 2000. As a result, many companies' systems and software may need to be upgraded or replaced in order to function correctly after December 31, 1999. We are currently conducting a general software upgrade and replacement program to enhance our computer systems and applications, in particular those systems and applications related to our manufacturing, distribution and financial operations. As part of this larger program we are addressing the critical areas of our internal computer systems, products and relationships with external organizations for Year 2000 compliance. We are addressing Year 2000 compliance for both our IT and non-IT systems, which typically include embedded technology such as microcontrollers. 12
14 As part of our general systems upgrade we have evaluated and selected various significant computer software applications which are represented by vendors as Year 2000 compliant. We have substantially completed installation of such software in our domestic operations by the end of the first quarter of fiscal 2000 which will be followed by installation in our international operations throughout fiscal 2000. Most of our existing business applications are already supported by Year 2000 compliant software. With the system changes implemented to date and other planned changes, we anticipate that our internal computer software applications will be Year 2000 compliant prior to December 31, 1999. We believe that our current products are Year 2000 compliant, and our new products are being designed to be Year 2000 compliant. We rely on numerous third party vendors for certain products and services. We are communicating with our principal service providers and suppliers to assess their Year 2000 readiness. Responses indicate that our significant service providers currently have compliant versions of their systems available or are well into the renovation and testing phases with completion scheduled prior to December 31, 1999. We are still assessing the effect Year 2000 issues will have on our service providers and suppliers, however, our principal service providers and suppliers have represented to us that they are Year 2000 compliant. We can give you no guarantee that the systems and products of these service providers and suppliers on which we rely are, or will be, Year 2000 compliant. Our contingency planning for Year 2000 issues relates primarily to the efforts of our third-party vendors. In the event of any Year 2000 disruptions related to third-party software, we expect to follow the individual vendor's contingency directives. With respect to suppliers, we will consider alternative sources as a contingency plan, if necessary. Contingency planning will continue throughout 1999 and our plans will be modified based upon the progress of our remediation efforts, system updates and installations and based upon our communications with selected suppliers. We have determined that our "worst case" scenario relates to Year 2000 compliance problems of our third party vendors and suppliers and other external organizations which if not remedied could materially adversely affect our operating results. The costs we expect to incur in connection with our overall general systems upgrade program, including both internal and third party costs, are primarily external costs for software licenses, and implementation and consulting services. These systems and applications were selected primarily for features and functionality in addition to Year 2000 compliance. Accordingly, we do not itemize costs of Year 2000 compliance separately. Our expectations regarding the impact of Year 2000 issues are forward looking statements and actual results could vary due to the factors discussed in this section. While we believe that the estimated cost of becoming Year 2000 compliant will not be significant to our operating results, failure to complete all the work in a timely manner could materially adversely affect our operating results. While we expect all planned work to be completed, we can not guarantee that all systems will be in compliance by the Year 2000, the systems of suppliers and other companies and government agencies on which we rely will be Year 2000 compliant, or that our contingency planning will be able to fully address all potential interruptions. Therefore, Year 2000 issues could cause delays in our ability to produce or ship our products, process transactions or otherwise conduct business in any of our markets. Year 2000 issues could lower demand for our products while increasing our costs. The occurrence of one or more of these factors could materially adversely affect our operating results. NEW ACCOUNTING STANDARDS In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which defines derivatives, requires that all derivatives be carried at fair value, and provides for hedging accounting when certain conditions are met. This statement is effective for all fiscal quarters of fiscal years beginning after June 15, 2000. On a forward-looking basis, although we have not fully assessed the implications of this new statement, we do not believe adoption of this statement will have a material impact on our consolidated financial position, results of operations or cash flows. 13
15 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to market risk related to fluctuations in interest rates and in 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 Risk Short-term Investments - As of July 30, 1999, we had short-term investments of $15.9 million. These short-term investments consist of highly liquid investments with original maturities at the date of purchase between three and twelve months. These investments are subject to interest rate risk and will decrease in value if market interest rates increase. A hypothetical 10 percent increase in market interest rates from levels at July 30, 1999, would cause the fair value of these short-term investments to decline by an immaterial amount. 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. Operating Lease Commitments - As of July 30, 1999, we have outstanding lease commitments to a third-party entity under operating lease agreements, which vary based on a monthly LIBOR rate plus a spread. However, a hypothetical 10 percent decrease in interest rates would not have a material impact on us. Increases in interest rates could, however, increase our rent expenses associated with future lease payments. We do not currently hedge against interest rate increases. The hypothetical changes and assumptions discussed above will be different from what actually occurs in the future. Furthermore, such computations do not anticipate actions that may be taken by management, should the hypothetical market changes actually occur over time. As a result, the effect on actual earnings in the future will differ from those described above. 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 contracts to hedge against the short-term impact of foreign currency fluctuations on certain assets and liabilities denominated in foreign currencies. All hedge instruments are marked to market through earnings every period. We believe that these forward contracts do not subject us to undue risk due to foreign exchange movements because gains and losses on these contracts are offset by losses and gains on the underlying assets and liabilities. All contracts have a maturity of less than one year and we do not defer any gains and losses, as they are all accounted for through earnings every period. The following table provides information about our foreign exchange forward contracts outstanding on July 30, 1999, (in thousands): <TABLE> <CAPTION> BUY/ FOREIGN CONTRACT VALUE FAIR VALUE CURRENCY SELL CURRENCY AMOUNT USD IN USD - -------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> EUR Buy 5,026 5,256 5,391 EUR Sell 16,273 16,548 17,455 GBP Buy 1,000 1,639 1,619 GBP Sell 3,752 6,162 6,073 CHF Sell 1,891 1,265 1,271 </TABLE> 14
16 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS None ITEM 2. CHANGES IN SECURITIES None ITEM 3. DEFAULTS UPON SENIOR SECURITIES None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None ITEM 5. OTHER INFORMATION None 15
17 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBITS <TABLE> <S> <C> 10.27 Construction Management Agreement (Phase II - Improvements), dated May 3, 1999, by and between BNP Leasing Corporation and the Registrant 10.28 Lease Agreement (Phase II - Improvements), dated May 3, 1999, by and between BNP Leasing Corporation and the Registrant 10.29 Lease Agreement (Phase II - Land), dated May 3, 1999, by and between BNP Leasing Corporation and the Registrant 10.30 Pledge Agreement (Phase II - Land), dated May 3, 1999, by and between BNP Leasing Corporation and the Registrant 10.31 Pledge Agreement (Phase II - Improvements), dated May 3, 1999, by and between BNP Leasing Corporation and the Registrant 10.32 Purchase Agreement (Phase II - Land), dated May 3, 1999, by and between BNP Leasing Corporation and the Registrant 10.33 Purchase Agreement (Phase II - Improvements), dated May 3, 1999, by and between BNP Leasing Corporation and the Registrant 10.34 Construction Management Agreement (Phase III - Improvements), dated June 16, 1999, by and between BNP Leasing Corporation and the Registrant 10.35 Lease Agreement (Phase III - Improvements), dated June 16, 1999, by and between BNP Leasing Corporation and the Registrant 10.36 Lease Agreement (Phase III - Land), dated June 16, 1999, by and between BNP Leasing Corporation and the Registrant 10.37 Pledge Agreement (Phase III - Land), dated June 16, 1999, by and between BNP Leasing Corporation and the Registrant 10.38 Pledge Agreement (Phase III - Improvements), dated June 16, 1999, by and between BNP Leasing Corporation and the Registrant 10.39 Purchase Agreement (Phase III - Land), dated June 16, 1999, by and between BNP Leasing Corporation and the Registrant 10.40 Purchase Agreement (Phase III - Improvements), dated June 16, 1999, by and between BNP Leasing Corporation and the Registrant 27.1 Financial Data Schedule </TABLE> (b) REPORTS ON FORM 8-K None 16
18 SIGNATURE Pursuant to the requirements of the Securities and Exchange Act of 1934, as amended, the registrant duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. NETWORK APPLIANCE, INC. (Registrant) /s/ JEFFRY R. ALLEN ---------------------------------------- Jeffry R. Allen Senior Vice President Finance and Operations, Chief Financial Officer and Secretary Date: August 31, 1999 17
19 EXHIBIT INDEX <TABLE> <CAPTION> EXHIBIT NUMBER DESCRIPTION - ------- ----------- <S> <C> 10.27 Construction Management Agreement (Phase II - Improvements), dated May 3, 1999, by and between BNP Leasing Corporation and the Registrant 10.28 Lease Agreement (Phase II - Improvements), dated May 3, 1999, by and between BNP Leasing Corporation and the Registrant 10.29 Lease Agreement (Phase II - Land), dated May 3, 1999, by and between BNP Leasing Corporation and the Registrant 10.30 Pledge Agreement (Phase II - Land), dated May 3, 1999, by and between BNP Leasing Corporation and the Registrant 10.31 Pledge Agreement (Phase II - Improvements), dated May 3, 1999, by and between BNP Leasing Corporation and the Registrant 10.32 Purchase Agreement (Phase II - Land), dated May 3, 1999, by and between BNP Leasing Corporation and the Registrant 10.33 Purchase Agreement (Phase II - Improvements), dated May 3, 1999, by and between BNP Leasing Corporation and the Registrant 10.34 Construction Management Agreement (Phase III - Improvements), dated June 16, 1999, by and between BNP Leasing Corporation and the Registrant 10.35 Lease Agreement (Phase III - Improvements), dated June 16, 1999, by and between BNP Leasing Corporation and the Registrant 10.36 Lease Agreement (Phase III - Land), dated June 16, 1999, by and between BNP Leasing Corporation and the Registrant 10.37 Pledge Agreement (Phase III - Land), dated June 16, 1999, by and between BNP Leasing Corporation and the Registrant 10.38 Pledge Agreement (Phase III - Improvements), dated June 16, 1999, by and between BNP Leasing Corporation and the Registrant 10.39 Purchase Agreement (Phase III - Land), dated June 16, 1999, by and between BNP Leasing Corporation and the Registrant 10.40 Purchase Agreement (Phase III - Improvements), dated June 16, 1999, by and between BNP Leasing Corporation and the Registrant 27.1 Financial Data Schedule </TABLE> 18