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March 23, 1999

TMF Interview With
Network Appliance CEO
Dan Warmenhoven

Part 3

Dale: What are the things you worry about as a manager and an allocator of shareholder capital?

Warmenhoven: In our case, it is primarily execution. Let me tell you the how I view, you know, the "tops-down," what to worry about questions. The first one you have to worry about is there a market, is it growing, right? And my answer to you is "I've got big ones." It's $9 billion, it's growing enormously, and it's got a preference for appliances. I'm not market-challenged.

The second one is, "Do I have a competitive position where I'd have to worry?" And my feeling is we have a very very strong product line. We've distanced ourselves dramatically from the competitors, and while we have a healthy paranoia for those competitors, we also have the strength of product and strength of organization to win.

So the third set of issues is more internally focused, and that's really the things I worry about -- execution. Growing at this rate puts a tremendous strain on systems, people, management structures, and a variety of other things. Couple that fast growth with a high flux rate in our product line -- you know every year we replace the entire product line at least once a year, if not more. We'll replace the disk storage systems, and probably twice a year we release new software -- so it's just a very high rate of change. So you've got enormous growth going along with enormous change, and the risk of something going wrong is actually pretty high. You know, we break systems internally all the time. Just at the end of January we converted to our third customer call management system, we shifted over to product call management -- it's our third one in basically five years because we've outgrown the other two.

Dale: Do you ever worry about your extraordinary growth attracting lots of competition?

Warmenhoven: No, I'm really not that worried. I should be, but I'm not. We've seen a number of start-ups come and most of them try to come in rather than take us head on. [They] try to come in underneath our price points, and that's a very difficult market segment to try to make a viable business in because the ASPs [Average Selling Prices] are low, the margins are low -- you need a ton of volume to get a profit. And let's say probably half a dozen of them die right there. In fact we refer to it in executive staff as the "coral coast" -- they just kind of hit the reef and die.

You know, I'm not worried about them, and I'm not worried about the big computer companies either. Guys like Sun are actually pulling back from this kind of technology. I think they're going to be more specialized around their core severs and so forth.

Dale: Well, I think a lot of people in looking at a company like yours or looking at a company like Cisco, they think you're these hardware companies, where a lot of your value-added comes from software.

Warmenhoven: That's actually right. In fact, we refer to it as "tin-wrap software." We couldn't quite figure out a way to shrink-wrap it, but it's a tin-wrap box. If you look at our gross margins on our filer product without the disks, it looks a lot like Cisco's. It is almost the same as Cisco -- it's upper 60s low 70s and the disks that we sell -- we sell pretty close to a straight price. We don't try to command a premium on those, and so the margins are much lower. So if you look at just the filer business, where the software is, it looks just like Cisco.

We don't break it out in terms of the pricing, but I'll give you one example of an obsolete product, just a product we no longer ship -- we discontinued doing it this last fall. We were shipping a 90 MHz Pentium in a chassis, the system you couldn't even buy at a local computer store -- this was really just last summer-- and the price of that unit was $20,000 and it sold very well. And I guess the question is, you tell me, what's the value-added of the software? It's a lot, and that's actually been the key to business. Most of our engineers are software engineers. 80% of our engineering staff is software engineering.

Dale: I've known EMC since 1994, and a lot of people... get hung up and think it's a disk-drive company when they're actually adding value to the disks. They're just not in the disk-drive business. They actually like it when the price of disks goes down.

Warmenhoven: So do I. We're quick to try to pass on that cost reduction to our customers.

Dale: Does it hurt you at all when disk drive prices don't go down, or does it worry you that telecom bandwidth is continually getting cheaper? Does that hurt your product proposition?

Warmenhoven: No, not in the case of disk drives. I was just contemplating disk drive prices not going down.

Dale: They're pretty much always going down.

Warmenhoven: Yeah, they're pretty much always going down. In fact, I've got a card that I carry around that's got the cost per gig over time and it's just enormous. I mean it just plummets. Basically, I mean Seagate's got a pricing strategy of every time they bring out a new generation of drives they double capacity, and they bring it out at exactly the same price as the prior generation at its intro. Then they have a curve that they just plot over the next nine months where the price is going to go.

Dale: Nine months. That's actually faster than Moore's Law.

Warmenhoven: Yeah, well, call it 9-12 months. It's in that range. So they drop the price over this curve -- actually you get to the bottom in nine months when it flattens off and then they bring in the next generation, which is again twice as expensive but twice the capacity. But it happens to be at exactly the same price you got the last generation. So I don't worry because I buy the drives at the same prices as EMC, or Sun, or Compaq or any of my other competitors. So we're all going to get the same basic pricing structure from our suppliers. So I'm not concerned about drive prices either plummeting or staying stable.

Dale: On the second question -- you know, you read people like George Gilder and he's the kind of guy who talks about bandwidth becoming as cheap as air. And that's not an immediate thing, but longer term, does that concern you?

Warmenhoven: No, not particularly. I remember 20 years ago, I was at IBM at the time and I was in a meeting with a bunch of guys from AT&T and we were working on some standards -- this was, of course, when the dial modem of 134 1/2 bits per second was considered pretty good -- and the raging debate at the time was, should you worry about data compression techniques and transmission efficiency because bandwidth was going to become so plentiful and cheap. OK? You get the big picture, right? So it's the same debate 20 years later -- this has been going on for 20 years -- the volume of communication expands to fill the available bandwidth and stretch it to its limits.

It's like software -- code always expands to fill whatever available resource. And I see the same thing in communications -- when the bandwidth gets cheap, people bring in new data types... You bring on RealMedia, RealNetworks, RealAudio. You know, you do Victoria's Secret over the Web or you watch the shuttle launch. And you get more graphics and you get more animation -- I just don't see it ending. Bandwidth is an enabler to new data forms, and I think that's all great.

I know of people who talk about putting in systems for distributing movies and they're doing full feature length movies over the Web. Ever think about how Titanic got into 10,000 theaters on day one? That's a hell of a logistics problem. Think about if you could mail that through the Web. Think about how big a package that is. Do you think that will fill the bandwidth? I think so.

Dale: You take the bandwidth stuff out of the way or you make it cheaper, then it really unleashes people's creativity.

Warmenhoven: Exactly. I think that people [who] say bandwidth will be infinite and so cheap that's it going to never get utilized, I think they're lacking in imagination.

Dale: I think people can be very creative as to why things are going to fail.

Warmenhoven: Yeah, I have to agree. I'll tell you, I don't see it. I am bullish on technology having a great future.

Dale: I run a value portfolio here at the Fool and the largest holding is Cisco, and lots of value investors would stay away from that.

Warmenhoven: Yeah, the P/Es are too high, right?

Dale: Yeah.

Warmenhoven: In fact, that's an issue for us.... one of the big issues for investors interested in getting into this area will say, "Gee, you multiples are too high." And I'll say, "Compare us to some of the other companies and I'm not so sure. Plus look at how the stock has performed over the last two or three years. The multiple's always been too high."

In fact, I had a meeting with a major portfolio manager and we had met with him a year prior and he took out his notes from a year ago and he said, yeah you did this, you did that exact change with the product line, introduced this feature, you did this deal, etc. And he takes out his calculator and starts punching some numbers all of a sudden. Our CFO looks at him and says, "What are you doing, calculating the money you didn't make by not buying a year ago." And he said, "Yeah, absolutely." It turns out they're now are a big investor.

The question is not "Is the multiple at the moment high?" It's a question of "Do you think the stock has appreciation potential?" I think we're a high growth company. I personally believe we have the opportunity to be the next Cisco. I think we can create a market segment called data storage appliances, and I think we can be a leader in it. I think we can dominate that segment.

Dale: One of the biggest hang-ups I have is so-called value investors out there who like Bethlehem Steel at 12 times earnings where the target market is growing at 2-3% per year, but they don't like markets where something is selling at 80 times earnings and growing 30 times faster. It's exponential growth that people have trouble with.

One last question. Microsoft has got a grand mission of a PC on every desktop, does Network Appliance have a grand mission?

Warmenhoven: Yeah, I want to hold all of your data.

Dale: Ok. That makes sense.

Warmenhoven: I want to hold it regardless of where it is. Whether it's in your server room, whether it's in the Internet, whether it's the email you haven't picked up yet, I want to hold it. I'd just like to have all of your data in some nice safe places based on Network Appliance.

Related links:
-- Network Appliance website
-- Network Appliance message board
-- Interview with NTAP Founder Dave Hitz, 9/23/98

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