- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

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 OCTOBER 30, 1998

[ ] 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 INCORPORATION (IRS EMPLOYER IDENTIFICATION NO.)
OR ORGANIZATION)

2770 SAN TOMAS EXPRESSWAY, 95051
SANTA CLARA, CALIFORNIA (ZIP CODE)
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)

REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (408) 367-3000

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 [ ]

Indicate the number of shares outstanding of the issuer's class of common
stock, as of the latest practicable date.

OUTSTANDING AT
CLASS OCTOBER 30, 1998
----- ----------------

Common Stock.......................................... 34,172,541

- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
2

TABLE OF CONTENTS

PAGE
----

PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements................. 3
Condensed Consolidated Balance Sheets as of October 30, 1998
and April 30, 1998........................................ 3
Condensed Consolidated Statements of Income for the three
and six-month periods ended October 30, 1998 and October
24, 1997.................................................. 4-5
Condensed Consolidated Statements of Cash Flows for the
six-month periods ended October 30, 1998 and October 24,
1997...................................................... 6
Notes to Condensed Consolidated Financial Statements........ 7
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 11
Item 3. Quantitative and Qualitative Disclosures About Market
Risk...................................................... 15

PART II. OTHER INFORMATION
Item 1. Legal Proceedings........................................... 16
Item 2. Changes in Securities....................................... 16
Item 3. Defaults Upon Senior Securities............................. 16
Item 4. Submission of Matters to a Vote of Securityholders.......... 16
Item 5. Other Information........................................... 16
Item 6. Exhibits and Reports on Form 8-K............................ 16
SIGNATURE............................................................. 17

2
3

PART I. FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NETWORK APPLIANCE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)

ASSETS

OCTOBER 30, APRIL 30,
1998 1998
----------- ---------
(UNAUDITED)

CURRENT ASSETS:
Cash and cash equivalents................................. $ 48,355 $ 37,315
Short-term investments.................................... 8,750 10,800
Accounts receivable, net.................................. 44,928 34,313
Inventories............................................... 10,722 8,707
Prepaid expenses and other................................ 2,067 2,524
Deferred taxes............................................ 6,743 5,280
-------- --------
Total current assets.............................. 121,565 98,939
-------- --------
Property and Equipment, net................................. 14,060 12,217
Deposits.................................................... 10,500 --
Other Assets................................................ 4,423 4,580
-------- --------
$150,548 $115,736
======== ========

LIABILITIES AND SHAREHOLDERS' EQUITY

CURRENT LIABILITIES:
Accounts payable.......................................... $ 12,385 $ 10,041
Income taxes payable...................................... 3,975 1,782
Accrued compensation and related benefits................. 9,652 8,485
Other accrued liabilities................................. 5,890 4,201
Deferred revenue.......................................... 7,248 4,799
-------- --------
Total current liabilities......................... 39,150 29,308
-------- --------
Long-Term Obligations....................................... 134 163
-------- --------
SHAREHOLDERS' EQUITY:
Common stock.............................................. 75,468 65,924
Retained earnings......................................... 35,814 20,341
Cumulative translation adjustment......................... (18) --
-------- --------
Total shareholders' equity........................ 111,264 86,265
-------- --------
$150,548 $115,736
======== ========

See accompanying notes to condensed consolidated financial statements.

3
4

NETWORK APPLIANCE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

THREE MONTHS ENDED
--------------------------
OCTOBER 30, OCTOBER 24,
1998 1997
----------- -----------

Net Sales................................................... $65,625 $38,401
Cost of Sales............................................... 26,881 15,746
------- -------
Gross margin.............................................. 38,744 22,655
------- -------
OPERATING EXPENSES:
Sales and marketing....................................... 17,064 9,672
Research and development.................................. 6,722 3,903
General and administrative................................ 2,552 1,493
------- -------
Total operating expenses.......................... 26,338 15,068
------- -------
Income from Operations...................................... 12,406 7,587
Other Income, net........................................... 995 229
------- -------
Income before Income Taxes.................................. 13,401 7,816
Provision for Income Taxes.................................. 5,025 2,931
------- -------
Net Income.................................................. $ 8,376 $ 4,885
======= =======
NET INCOME PER SHARE:
Basic..................................................... $ 0.25 $ 0.15
======= =======
Diluted................................................... $ 0.22 $ 0.14
======= =======
Pro Forma -- Basic (Note 8)............................... $ 0.12 $ 0.08
======= =======
Pro Forma -- Diluted (Note 8)............................. $ 0.11 $ 0.07
======= =======
SHARES USED IN PER SHARE CALCULATION:
Basic..................................................... 33,939 32,306
======= =======
Diluted................................................... 38,056 36,076
======= =======
Pro Forma -- Basic (Note 8)............................... 67,878 64,612
======= =======
Pro Forma -- Diluted (Note 8)............................. 76,112 72,152
======= =======

See accompanying notes to condensed consolidated financial statements.

4
5

NETWORK APPLIANCE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

SIX MONTHS ENDED
--------------------------
OCTOBER 30, OCTOBER 24,
1998 1997
----------- -----------

Net Sales................................................... $123,000 $71,821
Cost of Sales............................................... 50,120 29,316
-------- -------
Gross margin................................................ 72,880 42,505
-------- -------
OPERATING EXPENSES:
Sales and marketing....................................... 31,999 18,165
Research and development.................................. 12,803 7,318
General and administrative................................ 4,437 2,849
-------- -------
Total operating expenses............................. 49,239 28,332
-------- -------
Income from Operations...................................... 23,641 14,173
Other Income, net........................................... 1,116 397
-------- -------
Income before Income Taxes.................................. 24,757 14,570
Provision for Income Taxes.................................. 9,284 5,464
-------- -------
Net Income.................................................. $ 15,473 $ 9,106
======== =======
NET INCOME PER SHARE:
Basic..................................................... $ 0.46 $ 0.28
======== =======
Diluted................................................... $ 0.41 $ 0.26
======== =======
Pro Forma -- Basic (Note 8)............................... $ 0.23 $ 0.14
======== =======
Pro Forma -- Diluted (Note 8)............................. $ 0.20 $ 0.13
======== =======
SHARES USED IN PER SHARE CALCULATION:
Basic..................................................... 33,734 32,131
======== =======
Diluted................................................... 37,772 35,674
======== =======
Pro Forma -- Basic (Note 8)............................... 67,468 64,262
======== =======
Pro Forma -- Diluted (Note 8)............................. 75,544 71,348
======== =======

See accompanying notes to condensed consolidated financial statements.

5
6

NETWORK APPLIANCE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)

SIX MONTHS ENDED
--------------------------
OCTOBER 30, OCTOBER 24,
1998 1997
----------- -----------

CASH FLOWS FROM OPERATING ACTIVITIES:
Net income................................................ $ 15,473 $ 9,106
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation and amortization........................ 4,792 2,426
Provision for doubtful accounts...................... 700 91
Deferred income taxes................................ (1,463) (39)
Deferred rent........................................ (29) (21)
Changes in assets and liabilities:
Accounts receivable............................... (11,329) (9,293)
Inventories....................................... (2,019) (1,798)
Prepaid expenses and other........................ 472 (433)
Accounts payable.................................. 2,361 1,009
Income taxes payable.............................. 5,904 2,468
Accrued compensation and related benefits......... 1,167 498
Other accrued liabilities......................... 1,689 644
Deferred revenue.................................. 2,449 1,159
-------- -------
Net cash provided by operating activities....... 20,167 5,817
-------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of short-term investments....................... (12,880) (5,250)
Redemptions of short-term investments..................... 14,930 6,916
Purchases of property and equipment....................... (6,183) (3,262)
Payment of deposits....................................... (10,500) --
-------- -------
Net cash used in investing activities............. (14,633) (1,596)
-------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayments of long-term obligations....................... (17) (10)
Proceeds from sale of common stock, net................... 5,523 2,789
-------- -------
Net cash provided by financing activities......... 5,506 2,779
-------- -------
Net Increase in Cash and Cash Equivalents................... 11,040 7,000
CASH AND CASH EQUIVALENTS:
Beginning of period....................................... 37,315 21,520
-------- -------
End of period............................................. $ 48,355 $28,520
======== =======

See accompanying notes to condensed consolidated financial statements.
6
7

NETWORK APPLIANCE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(DOLLAR AND SHARE AMOUNTS IN THOUSANDS, EXCEPT PER-SHARE DATA)
(UNAUDITED)

1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The accompanying condensed consolidated financial statements have been
prepared by Network Appliance, Inc. (the Company) without audit and reflect all
adjustments which are, in the opinion of management, necessary for a fair
presentation of the financial position and the results of operations of the
Company 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 and six-month periods ended October 30, 1998 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, 1998 and the risk factors as set
forth in the Company's Annual Report on Form 10-K, including, without
limitation, risks relating to history of operating losses, fluctuating operating
results, dependence on new products, rapid technological change, 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, the
effect of certain anti-takeover provisions and the Year 2000 Issue. Any party
interested in reviewing these publicly available documents should contact the
SEC or the Chief Financial Officer of the Company.

2. FISCAL PERIODS

The Company operates on a 52-week or 53-week year ending on the last Friday
in April. Fiscal 1999 is a 53-week year. Fiscal 1998 was a 52-week year. The
quarter ended October 30, 1998 includes 13 weeks of operating activity, compared
to 13 weeks of activity for the corresponding period of the prior fiscal year.
The six months ended October 30, 1998 includes 27 weeks of activity, compared to
26 weeks of activity for the corresponding period of the prior fiscal year.

3. INVENTORIES

Inventories consist of the following:

OCTOBER 30, APRIL 30,
1998 1998
----------- ---------

Purchased components.................................... $ 4,106 $4,494
Work in process......................................... 2,547 1,889
Finished goods.......................................... 4,069 2,324
------- ------
$10,722 $8,707
======= ======

4. COMMITMENTS

In June 1998, the Company executed an agreement to acquire 5.9 acres of
land in Sunnyvale, California and the accompanying 127,000 square foot building.
Under terms of the agreement, the Company paid $5,000 of the $33,750 purchase
price as a nonrefundable deposit. The agreement allows the Company to assign its
rights and obligations to a third-party entity should the Company decide to
enter into an operating lease. It is the Company's intent to assign its rights
and obligations to a third-party entity and enter into an operating lease,
provided the Company can obtain satisfactory leasing terms.

7
8
NETWORK APPLIANCE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLAR AND SHARE AMOUNTS IN THOUSANDS, EXCEPT PER-SHARE DATA)
(UNAUDITED)

In June 1998, the Company signed a 25-year operating lease requiring annual
lease payments of $3,084, commencing in October 1999, for a 6.2-acre plot in
Sunnyvale, California. In connection with executing the operating lease
agreement, the Company also signed an option agreement to purchase the 6.2 acres
of land. Under terms of the option agreement, the Company paid a $4,500
nonrefundable deposit. The option allows the Company to purchase the land,
within a 90-day period, commencing in December 1999 at a purchase price of
$23,745 and its rights and obligations under this agreement may be assigned to
third parties. It is the Company's intent to assign its purchase option to a
third-party entity and to enter into an operating lease with the third-party
entity, provided the Company can obtain satisfactory leasing terms.

5. LINE OF CREDIT

In July 1998, the Company negotiated a $5,000 unsecured revolving credit
facility with a domestic commercial bank. Under terms of the credit facility,
which expires in July 1999, the Company must maintain various financial
covenants. Any borrowings under this agreement bear interest at either LIBOR
plus 1% or at the Lender's "prime" lending rate, such rate determined at the
discretion of the Company. As of October 30, 1998, there were no borrowings
under the credit facility and the line was available for draw. In December 1998,
the Company drew a $2.5 million letter of credit against its line of credit to
facilitate requirements associated with the acquisition of land in Sunnyvale,
California and the accompanying 79,000 square foot building.

6. COMMON STOCK AND NET INCOME PER SHARE

The Company has adopted the provisions of Statement of Financial Accounting
Standards No. 128, "Earnings Per Share" (SFAS 128), effective in the third
quarter of fiscal 1998. SFAS 128 requires the presentation of basic and diluted
net income 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 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 and common shares issuable upon exercise of stock options. Net income
per share data for the three and six-month periods ended October 24, 1997 has
been restated to conform to SFAS 128.

8
9
NETWORK APPLIANCE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLAR AND SHARE AMOUNTS IN THOUSANDS, EXCEPT PER-SHARE DATA)
(UNAUDITED)

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 SIX MONTHS ENDED
------------------------- -------------------------
OCTOBER 30, OCTOBER 24, OCTOBER 30, OCTOBER 24,
1998 1997 1998 1997
----------- ----------- ----------- -----------

NET INCOME (NUMERATOR):
Net income, basic and diluted............. $ 8,376 $ 4,885 $15,473 $ 9,106
======= ======= ======= =======
SHARES (DENOMINATOR):
Weighted average common shares
outstanding............................ 34,026 33,086 33,898 32,999
Weighted average common shares outstanding
subject to repurchase.................. (87) (780) (164) (868)
------- ------- ------- -------
Shares used in basic computation.......... 33,939 32,306 33,734 32,131
Weighted average common shares outstanding
subject to repurchase.................. 87 780 164 868
Common shares issuable upon exercise of
stock options.......................... 4,030 2,990 3,874 2,675
------- ------- ------- -------
Shares used in diluted computation........ 38,056 36,076 37,772 35,674
======= ======= ======= =======
NET INCOME PER SHARE:
Basic..................................... $ 0.25 $ 0.15 $ 0.46 $ 0.28
======= ======= ======= =======
Diluted................................... $ 0.22 $ 0.14 $ 0.41 $ 0.26
======= ======= ======= =======

7. COMPREHENSIVE INCOME

The Company has adopted Statement of Financial Accounting Standards (SFAS)
No. 130, "Reporting Comprehensive Income," as of the first quarter of fiscal
1999. SFAS No. 130 establishes new rules for the reporting and display of
comprehensive income and its components; however, it has no impact on the
Company's net income or shareholders' equity.

The components of comprehensive income, net of tax, are as follows:

THREE MONTHS ENDED SIX MONTHS ENDED
-------------------------- --------------------------
OCTOBER 30, OCTOBER 24, OCTOBER 30, OCTOBER 24,
1998 1997 1998 1997
----------- ----------- ----------- -----------

Net income............................ $8,376 $4,885 $15,473 $9,106
Change in cumulative translation
adjustment.......................... (35) -- (18) --
------ ------ ------- ------
Comprehensive income.................. $8,341 $4,885 $15,455 $9,106
====== ====== ======= ======

8. SUBSEQUENT EVENTS

On November 6, 1998, the Company entered into an Original Equipment
Manufacturer (OEM) Product agreement with Fujitsu Limited concerning certain
hardware and software products. Under the terms of the agreement, Fujitsu
Limited (Fujitsu) will purchase hardware and software products from Network
Appliance, Inc. (NetApp) for resale and provide visibility of the use of NetApp
technology in Fujitsu filer products, press releases and on NetApp software.
Fujitsu may use its own name, trade names, trademarks, symbol, logo, brand and
serial numbers with regard to the use or sale of NetApp products or Fujitsu
products containing or consisting of NetApp products. The agreement continues
for an initial period of three years and thereafter is renewable for successive
one year periods unless either party gives at least six months notice prior to
the end of any such period of its intention not to renew.

9
10
NETWORK APPLIANCE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLAR AND SHARE AMOUNTS IN THOUSANDS, EXCEPT PER-SHARE DATA)
(UNAUDITED)

On November 17, 1998, the Board of Directors approved a two-for-one stock
split of the Company's common stock to be distributed on or about December 21,
1998 to holders of record on December 11, 1998. Pro forma share and per-share
amounts have been presented within the Condensed Consolidated Statements of
Income.

9. NEW ACCOUNTING PRONOUNCEMENT

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, 1999. On a
forward-looking basis, although the Company has not fully assessed the
implications of this new statement, the Company does not believe adoption of
this statement will have a material impact on the Company's financial position
or results of operations.

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:

Net Sales............................. 100.0% 100.0% 100.0% 100.0%
Cost of Sales......................... 41.0 41.0 40.8 40.8
----- ----- ----- -----
Gross margin................ 59.0 59.0 59.2 59.2
----- ----- ----- -----
Operating Expenses:
Sales and marketing................. 26.0 25.2 26.0 25.3
Research and development............ 10.2 10.2 10.4 10.2
General and administrative.......... 3.9 3.9 3.6 4.0
----- ----- ----- -----
Total operating expenses.... 40.1 39.3 40.0 39.5
----- ----- ----- -----
Income from operations................ 18.9 19.7 19.2 19.7
Other income, net..................... 1.5 0.6 0.9 0.6
----- ----- ----- -----
Income before income taxes............ 20.4 20.3 20.1 20.3
Provision for income taxes............ 7.6 7.6 7.5 7.6
----- ----- ----- -----
Net Income.................. 12.8% 12.7% 12.6% 12.7%
===== ===== ===== =====

10
11

Net Sales -- Net sales increased by 70.9% to $65.6 million for the three
months ended October 30, 1998, from $38.4 million for the three months ended
October 24, 1997. 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 expansion of the Company's direct sales
force; increased unit shipments principally due to the successful launching of
the Company's F700 Filer product family during the second quarter of fiscal
1999, and the continued growth in sales of the NetApp(TM) F630; the shipment of
NetCache(TM) appliances; increases in software subscription and service revenues
due to a growing installed base; and increased sales of multi-protocol systems.
Net sales growth was also positively impacted by a higher average selling price
of the newly introduced F700 Filer product family due primarily to the increase
in storage content, and an increase in the average selling price of the NetApp
F630 primarily facilitated by the incorporation of fibre-channel disk drives
which increase system capacity. Factors which partially offset overall net sales
growth include declining unit sales of the Company's older product family and
decreases in base prices of the Company's older product line due to competitive
forces.

Net sales increased by 71.3% to $123.0 million for the six months ended
October 30, 1998, from $71.8 million for the six months ended October 24, 1997.
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 expansion of the Company's direct sales force; increased
unit shipments principally due to the successful launching of the Company's F700
Filer product family during the second quarter of fiscal 1999, and the continued
growth in sales of the NetApp F630 and NetApp F520; the shipment of NetCache
appliances; increases in software subscription and service revenues due to a
growing installed base; and increased sales of multi-protocol systems. Net sales
growth was also positively impacted by a higher average selling price of the
newly introduced F700 Filer product family due primarily to the increase in
storage content, and an increase in the average selling price of the NetApp F630
primarily facilitated by the incorporation of fibre-channel disk drives which
increase system capacity. Factors which partially offset overall net sales
growth include declining unit sales of the Company's older product family and
decreases in base prices of the Company's older product line due to competitive
forces.

International net sales (including U.S. exports) grew by 95.9% and 84.2%,
for the three and six-month periods ended October 30, 1998, respectively, as
compared to comparable periods of the prior fiscal year. International net sales
were $16.9 million, or 25.8% of total net sales, and $29.6 million, or 24.1% of
total net sales, for the three and six months ended October 30, 1998,
respectively. The increase in international sales for the three and six-month
periods ended October 30, 1998, was primarily a result of European sales growth,
due to increased headcount in the direct sales force, increased shipments of
filers and the sale of NetCache appliances. Asia Pacific net sales growth for
the three and six-month periods ended October 30, 1998, was also due to
increased headcount in the direct sales force, increased shipments of filers and
the sale of NetCache appliances, as compared to the corresponding periods of the
prior fiscal year.

There can be no assurance that the Company's 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 remained constant at 59.0% and 59.2% for the
three and six-month periods ended October 30, 1998, as compared to the
corresponding periods of the prior fiscal year. The consistency in the gross
margin for the three and six months ended October 30, 1998, as compared to the
corresponding periods of the prior fiscal year, was primarily attributable to
the increase in product volume, lower costs of key components, increased
manufacturing efficiencies, and by increased market acceptance of the Company's
product line with the continuance of the cost-reduced designs introduced in June
and July 1997 and the introduction of the F700 Filer product family during the
second quarter of fiscal 1999. Gross margin was also favorably impacted by the
licensing of multi-protocol software and by growth in software subscription and
service revenues due to a larger installed base. Factors contributing to gross
margin growth were partially offset by the increase in the sales volume of the
F700 product family maintaining incremental costs associated with the
manufacture of filers with larger storage content and the effect of base system
price reductions across the full range of filers.

11
12

The Company's gross margin has been and will continue to be affected by a
variety of factors, including: competition; product configuration; direct versus
indirect sales; the mix and average selling prices of products, including
software licensing; new product introductions and enhancements and the cost of
components and manufacturing labor. The Company's 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 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 76.4% to $17.1
million for the three months ended October 30, 1998 from $9.7 million for the
three months ended October 24, 1997. For the six months ended October 30, 1998,
sales and marketing expenses of $32.0 million reflect an increase of 76.2% over
the comparable period of fiscal 1998. These expenses were 26.0% and 25.2% of net
sales for the three months ended October 30, 1998 and October 24, 1997,
respectively, and were 26.0% and 25.3%, respectively, of net sales for the six
months then ended. The increase in absolute dollars was primarily related to the
continued expansion of the Company's sales and marketing organization, including
growth in the domestic and international direct sales forces and increased
commission expenses. The Company expects to continue to increase its 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. The Company believes that its continued
growth and profitability is dependent in part on the successful expansion of its
international operations, and therefore, has committed significant resources to
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 72.2% to $6.7 million
for the three months ended October 30, 1998 from $3.9 million for the three
months ended October 24, 1997. These expenses represented 10.2% of net sales for
the three months ended October 30, 1998 and October 24, 1997. For the six-month
periods, research and development expenses increased 75.0% to $12.8 million in
fiscal 1999 from $7.3 in fiscal 1998, and represented 10.4% and 10.2% of net
sales, respectively, for those periods. 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, including the NetApp F700 series filers. The Company believes that
significant investments in research and development will be required to remain
competitive and expects that such expenditures will continue to increase in
absolute dollars. For the three and six months ended October 30, 1998 and
October 24, 1997, no software development costs were capitalized, as amounts
that qualified for capitalization were immaterial.

General and Administrative -- General and administrative expenses were $2.6
million for the three months ended October 30, 1998, as compared to $1.5 million
for the three months ended October 24, 1997. These expenses represented 3.9% of
net sales for such periods. For the six-month periods, general and
administrative expenses increased 55.7% to $4.4 million in fiscal 1999 from $2.8
million in fiscal 1998 and represented 3.6% and 4.0% of net sales, respectively,
for those periods. Increases in absolute dollars were primarily as a result of
increased headcount, and increases to the allowance for doubtful accounts and
outside service fees. The Company believes that its general and administrative
expenses will increase in absolute dollars as the Company continues to build its
infrastructure.

Other Income, net -- Other income, net, was $1.0 million and $0.2 million
for the three months ended October 30, 1998 and October 24, 1997, respectively.
During the six months ended October 30, 1998, other income was $1.1 million, as
compared to $.4 million in the corresponding period of the prior year. The
increase was due primarily to foreign currency exchange gains recorded in the
second quarter of fiscal 1999.

Provision for Income Taxes -- The Company's effective tax rate was 37.5%
for both the three and six-month periods ended October 30, 1998 and October 24,
1997.

12
13

The Company's quarterly operating results have varied in the past and may
vary significantly in the future, depending on a number of factors, including:
the level of competition; the size and timing of significant orders; product
configuration and mix; market acceptance of new products and product
enhancements; new product announcements or introductions by the Company or its
competitors; deferrals of customer orders in anticipation of new products or
product enhancements; changes in pricing by the Company or its competitors; the
ability of the Company to develop, introduce and market new products and product
enhancements on a timely basis; hardware component costs; supply constraints;
the Company's success in expanding its sales and marketing programs;
technological changes in the network file server market; the mix of sales among
the Company's sales channels; levels of expenditure on research and development;
changes in Company strategy; personnel changes; the Company's ability to
successfully expand international operations; general economic trends and other
factors.

The Company conducts business internationally. Accordingly, the Company's
future operating results could be materially and adversely affected by a variety
of uncontrollable and changing factors including foreign currency exchange
rates, regulatory, political or economic conditions in a specific country or
region, trade protection measures and other regulatory requirements and
government spending patterns, among other factors. 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 Europe, there can be no assurance that the Company's future
operating results will not be adversely affected by seasonality.

Sales for any future quarter are not predictable with any significant
degree of certainty. The Company generally operates with limited order backlog,
because its products typically are 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 also difficult to forecast,
because the network file server market is rapidly evolving and the Company's
sales cycle varies substantially from customer to customer. A significant
portion of the Company's revenues in any quarter may be derived from sales to a
limited number of customers. Any significant deferral of these sales could have
a material adverse effect on the Company's results of operations in any
particular quarter; and to the extent that significant sales occur earlier than
expected, operating results for subsequent quarters may be adversely affected.
The Company's expense levels are based, in part, on its expectations as to
future sales. As a result, if sales levels are below expectations, net income
may be disproportionately affected. Although the Company has experienced
significant revenue growth in recent periods, such growth may not be indicative
of future operating results. Period-to-period comparisons of its results of
operations are not necessarily meaningful and should not be relied upon as an
indicator of future performance. Due to all of the foregoing factors, it is
possible that in some future quarter the Company's operating results may be
below the expectations of public market analysts and investors. In such event,
the price of the Company's common stock would likely be materially and adversely
affected.

This Form 10-Q contains forward-looking statements about future results,
which are subject to risks and uncertainties. Network Appliance's actual results
may differ significantly from the results discussed in the forward-looking
statements. The Company is subject to a variety of other additional risk
factors, more fully described in the Company's Annual Report on Form 10-K filed
with the Securities and Exchange Commission.

LIQUIDITY AND CAPITAL RESOURCES

As of October 30, 1998, as compared to the April 30, 1998 balances, the
Company's cash, cash equivalents and short-term investments increased by $9.0
million to $57.1 million. Working capital increased by $12.8 million to $82.4
million, impacted primarily by increases in cash and cash equivalents, accounts
receivable and inventories, partially offset by increases in deferred revenue,
accounts payable, income taxes payable and other accrued liabilities, and a
decrease in short-term investments. The Company generated cash from operating
activities totaling $20.2 million and $5.8 million for the six-month periods
ended October 30, 1998 and October 24, 1997, respectively. Net cash provided by
operating activities for the six-month period ended October 30, 1998 principally
related to net income of $15.5 million, increases in income taxes payable,
deferred revenue, accounts payable and other accrued liabilities, coupled with
depreciation and amortization which are non-cash expenses, partially offset by
increases in accounts receivable and inventories.
13
14

The Company used $6.2 million and $3.3 million of cash during the six-month
periods ended October 30, 1998 and October 24, 1997, respectively, to purchase
property and equipment. The Company provided for $2.1 million and $1.7 million
during the six-month periods ended October 30, 1998 and October 24, 1997,
respectively, for net short-term investment redemptions. Financing activities
provided $5.5 million and $2.8 million during the six-month periods ended
October 30, 1998 and October 24, 1997, respectively. The increase in cash
provided by financing activities for the six months ended October 30, 1998,
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 June 1998, the Company executed an agreement to acquire 5.9 acres of
land in Sunnyvale, California and the accompanying 127,000 square foot building.
Under terms of the agreement, the Company paid $5.0 million of the $33.8 million
purchase price as a nonrefundable deposit. The agreement allows the Company to
assign its rights and obligations to a third-party entity should the Company
decide to enter into an operating lease. It is the Company's intent to assign
its rights and obligations to a third-party entity and enter into an operating
lease, provided the Company can obtain satisfactory leasing terms.

In June 1998, the Company signed a 25-year operating lease requiring annual
lease payments of $3.1 million, commencing in October 1999, for a 6.2-acre plot
in Sunnyvale, California. In connection with executing the operating lease
agreement, the Company also signed an option agreement to purchase the 6.2 acres
of land. Under terms of the option agreement, the Company paid a $4.5 million
nonrefundable deposit. The option allows the Company to purchase the land,
within a 90-day period, commencing in December 1999 at a purchase price of $23.7
million and its rights and obligations under this agreement may be assigned to
third parties. It is the Company's intent to assign its purchase option to a
third-party entity and to enter into an operating lease with the third-party
entity, provided the Company can obtain satisfactory leasing terms.

In July 1998, the Company negotiated a $5.0 million unsecured revolving
credit facility with a domestic commercial bank. Under terms of the credit
facility, which expires in July 1999, the Company must maintain various
financial covenants. Any borrowings under this agreement bear interest at either
LIBOR plus 1% or at the Lender's "prime" lending rate, such rate determined at
the discretion of the Company. As of October 30, 1998, there were no borrowings
under the credit facility and the line was available for draw. In December 1998,
the Company drew a $2.5 million letter of credit against its line of credit to
facilitate requirements associated with the acquisition of land in Sunnyvale,
California and the accompanying 79,000 square foot building, described below.

In August 1998, the Company entered into an agreement to acquire land in
Sunnyvale, California and the accompanying 79,000 square foot building. Under
terms of the agreement, the Company paid $2.0 million of the $16.8 million
purchase price as a deposit, of which $1.0 million was paid subsequent to
October 30, 1998. Upon satisfaction of certain conditions under the agreement,
subsequent to October 30, 1998, the Company paid a supplemental deposit of $0.5
million. The deposits are nonrefundable with limited exceptions. The agreement
allows the Company to assign its rights and obligations to a third-party entity
should the Company decide to enter into an operating lease. It is the Company's
intent to assign its rights and obligations to a third-party entity and enter
into an operating lease, provided the Company can obtain satisfactory leasing
terms. Excluding the commitments related to the aforementioned properties, which
the Company intends to assign to a third party and then establish operating
leases, the Company currently has no significant commitments other than
commitments under operating leases. The Company believes that its existing
liquidity and capital resources, including the $5.0 million line of credit, are
sufficient to fund its operations for at least the next twelve months.

14
15

YEAR 2000 ISSUE

The Year 2000 (Y2K) 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. The critical areas being
addressed by the Company are its internal computer systems, products made by the
company and relationships with external organizations. The Company is addressing
both information technology ("IT") and non-IT systems, which typically include
embedded technology, such as microcontrollers.

Although the Company is currently assessing the impact the Year 2000 Issue
will have on its internal information systems, it has evaluated and selected
significant computer software applications for compatibility with the year 2000,
which are represented by their vendors as Y2K compliant. Most of the Company's
existing business applications are already supported by Y2K compliant software.
The Company has selected software, which is also represented by their vendor as
Y2K compliant, to support the other business applications, in particular, the
manufacturing, distribution and financial operations of the business.
Expectations by the Company are to have completed installation of such software
in the domestic operations by the close of the fiscal year ended April 30, 1999,
followed by the early part of fiscal year 2000 for the international operations.
There are no known non-IT issues that will adversely impact the Company's
information systems capabilities. With the system changes implemented to date
and other planned changes, the Company anticipates that its internal computer
software applications will be compatible with the year 2000. In the event of any
Y2K disruptions, the Company will follow the software vendors' contingency
directives. The Company does not anticipate that addressing the Year 2000 Issue
for its internal information systems will have a material adverse impact on its
operations, financial results or cash flows. However, there can be no assurance
that these costs will not be greater than anticipated, or corrective actions
undertaken will be completed before any Year 2000 problems could occur.

The Company believes that its current products are Year 2000 compliant and
that new products are being designed to be Year 2000 compliant. The Company will
continue performing ongoing testing. The Company has addressed non-IT issues
with respect to their manufacturing facilities and determined there are no known
non-IT issues that will adversely impact the Company's operations. The Company
does not anticipate that addressing the Year 2000 Issue for its current and
future products will have a material adverse impact on its operations, financial
results or cash flows. However, there can be no assurance that these costs will
not be greater than anticipated, or corrective actions undertaken will be
completed before any Year 2000 problems could occur. The Year 2000 Issue could
lower demand for the Company's products while increasing the Company's costs.
These combining factors, while not quantified, could have a material adverse
impact on the Company's business, operating results, financial condition and
cash flows.

The Company is dependent on numerous vendors and customers, which may incur
disruptions as a result of year 2000 software issues. Accordingly, no assurance
can be given that the Company's operations will not be impacted by this
worldwide issue. The Company has determined that its "worst case" scenario is
with respect to Y2K issues with external organizations. The Company is
continually addressing the Y2K issues with external organizations. This involves
customers, suppliers and service providers. Although the initial review does not
indicate any significant risk, this will be an ongoing effort. The Company's
initial survey of its suppliers and service providers for Y2K readiness has
resulted in a majority of the responses being favorable in relationship to Y2K
compliance. Of the relationships with certain key suppliers, all appear to be
Y2K compliant. If key suppliers fail to adequately address the Year 2000 Issue
for the products they provide the Company, this could have a material adverse
impact on the Company's business, operating results, financial condition or cash
flows. The Company is still assessing the effect the Year 2000 Issue will have
on its suppliers and, at this time cannot determine the impact it will have. The
Company will consider alternative vendors as a contingency plan, if deemed
necessary.

With the actions that have been taken and the other planned activities, the
Company is not anticipating any significant disruption of business.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not Applicable

15
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

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) EXHIBITS

10.20 OEM Distribution and License Agreement, dated October 27, 1998, by
and between Dell Products L.P. and the Registrant.

27.1 Financial Data Schedule.

(b) REPORTS ON FORM 8-K

None

16
17

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
Vice President Finance and
Operations, Chief Financial Officer
(Principal Financial Officer)

Date: December 11, 1998

17
18

EXHIBIT INDEX

EXHIBIT
NUMBER DESCRIPTION
- ------- -----------

10.20* OEM Distribution and License Agreement, dated October 27,
1998, by and between Dell Products L.P. and the Registrant.
27.1 Financial Data Schedule

- ------------------

*Specified portions of this agreement have been omitted and have been filed
separately with the Commission pursuant to a request for confidential
treatment.