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Aruba Networks (NASDAQ:ARUN)

Q1 2013 Earnings Call

November 15, 2012 4:30 pm ET

Executives

Maria Riley - Director

Dominic P. Orr - Chairman, Chief Executive Officer and President

Michael M. Galvin - Chief Financial Officer and Principal Accounting Officer

Hitesh Sheth - Former Chief Operating Officer

Keerti Melkote - Co-Founder, Chief Technology Officer and Director

Analysts

Jason Ader - William Blair & Company L.L.C., Research Division

Mark Sue - RBC Capital Markets, LLC, Research Division

Ehud A. Gelblum - Morgan Stanley, Research Division

Trevor Bacon - Lazard Capital Markets LLC, Research Division

Jeffrey T. Kvaal - Barclays Capital, Research Division

Kent Schofield - Goldman Sachs Group Inc., Research Division

Jess L. Lubert - Wells Fargo Securities, LLC, Research Division

Jonathan B. Ruykhaver - Stephens Inc., Research Division

William H. Choi - Janney Montgomery Scott LLC, Research Division

Rohit N. Chopra - Wedbush Securities Inc., Research Division

Amitabh Passi - UBS Investment Bank, Research Division

Josh Beck - Pacific Crest Securities, Inc., Research Division

George C. Notter - Jefferies & Company, Inc., Research Division

Sanjiv R. Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Aruba Networks First Quarter 2000 (sic) Earnings Conference Call. [Operator Instructions] Today's conference is being recorded, November 15, 2012. I would now like to turn the conference over to Maria Riley, Investor Relations. Please go ahead.

Maria Riley

Good afternoon, and thank you for joining us on today's conference call to discuss Aruba Networks' fiscal first quarter 2013 results. This call is also being broadcast live over the Web and can be accessed in the Investor Relations section of Aruba Networks' website at www.arubanetworks.com.

With me on today's call are Dominic Orr, Aruba's President and Chief Executive Officer; Michael Galvin, Aruba's Chief Financial Officer; and Keerti Melkote, Aruba's Co-Founder and Chief Technology Officer.

After the market closed today, Aruba issued a press release announcing the results for its fiscal first quarter ended October 31, 2012. If you would like a copy of the release, you can access it online at the company's website, or you can call The Blueshirt Group at (415) 217-7722, and we will send you a copy.

We would like to remind you that during the course of this conference call, Aruba Networks' management will make forward-looking statements, including statements regarding the company's expectations regarding growth drivers, including the rapid proliferation of mobile devices, BYOD and IT spend; customer adoption and penetration of our MOVE architecture, Mobility Access Switches and software solutions; the company's ability to penetrate larger accounts; the company's future economic performance, pipeline, financial condition, tax rate and results of operations; the company's ability to expand its business and grow its market share in its core market segments as well as new segments such as managed service providers and mid-tier customers; and the company's expectation that it will grow revenues faster than expenses as a general trend.

These forward-looking statements involve a number of risks and uncertainties, some of which are beyond our control, which could cause actual results to differ materially from those anticipated by these statements. These forward-looking statements apply as of today, and you should not rely on them as representing our views in the future. And we undertake no obligation to update these statements after this call.

For a more detailed description of these risks and uncertainties, please refer to our Annual Report on Form 10-K filed with the SEC on October 11, 2012, as well as our earnings release posted a few minutes ago on our website. Copies of these documents may be obtained from the SEC or by visiting the Investor Relations section on our website.

Also, please note that unless otherwise specifically noted, all financial measures we use on this call are expressed on a non-GAAP basis and have been adjusted to exclude certain charges. We have provided reconciliations of these non-GAAP financial measures to GAAP financial measures in the Investor Relations section of our website located at www.arubanetworks.com and in our earnings press release.

Now I'd like to introduce Dominic Orr, President and Chief Executive Officer of Aruba Networks. Dominic?

Dominic P. Orr

Thank you. Good afternoon, and thank you for taking the time to attend our fiscal first quarter 2013 conference call.

We delivered a strong first quarter, achieving our 14th consecutive quarter of record revenues. We believe that the proliferation of mobile devices, the BYOD trend and new applications such as unified communications collaboration, also -- or UCC, are top priorities for CIOs and are powering continued demand for Aruba's mobility-centric access network solutions.

In the first quarter, we grew revenue to $144.5 million, up 21% year-over-year and 4% sequentially. We delivered 21% operating margin, EPS of $0.18 and generated $36.9 million in cash from operations. Our linearity in the quarter was better than a typical Q1, and we were pleased with our continued momentum in the market. Bookings were strong in the quarter with good growth in the U.S., Asia-Pacific/Japan and developing markets, while Europe continued to be impacted by some macro weaknesses.

During the quarter, we added a record number of new customers, and demand was strong across our product portfolio. Customer adoption is increasing for our recently introduced ClearPass and Aruba Instant Enterprise solutions. We have had a number of recent key wins that showcase our momentum across our expanding addressable market. Major customers that selected both ClearPass and our core wireless LAN products included one of the largest U.S.-based retail banks, a prominent Canadian financial services company, a leading computer software developer and one of the U.S. Government's largest civilian agencies. Key customers that selected Aruba to upgrade their 8O2.11n network to support multimedia and UCC applications included one of the largest global software companies and the leading U.S. online streaming media provider. Customers that selected Aruba Instant Enterprise for employee and guest access included a large U.S. retailer and a network of assisted living facilities. And key wins for Aruba's Mobility Access Switchers included a large U.S. school district and a domestic luxury retail chain. In many of these wins, we are displacing our largest competitor.

Security-focused enterprises, governments and campuses are expanding and upgrading their wireless networks to accommodate more users, more devices and more applications. We are strategically positioned in this segment of the market where our differentiated mobility-centric value proposition resonates. And we continue to deliver solid growth.

Our ClearPass pipeline continues to grow and is expanding our presence among Fortune 500 customers, creating new sales opportunities for our core wireless LAN products. In our core wireless LAN market, we compete against Cisco. And we continue to win through the differentiation of our security, scalability and application Aware QOS [ph]. These are all areas where Aruba is the technology leader.

Additionally, with Aruba Instant Enterprise, we are starting to grow our presence with managed services providers and mid-tier customers. With this product, we have combined enterprise-class performance with simplified deployment and a competitive price point, which resonates with customers in this market segment.

In summary, we had a solid Q1, and we are entering the second quarter with strong momentum. We are pleased with our solid execution of the strategy we laid out at our Analyst Day in March this year. Our results this quarter further demonstrate our clear technology differentiation and leadership position.

I would now like to turn the call over to Mike for a detailed financial review of the quarter.

Michael M. Galvin

Thank you, Dom. In Q1 2013, total revenue was $144.5 million, growing 4% sequentially and 21% year-over-year. Product revenue of $119.2 million grew 2% sequentially and 18% year-over-year. Professional services and support revenue of $25.3 million grew 14% sequentially and 39% year-over-year. U.S. revenue grew 15% year-over-year, representing 64% of total Q1 revenue. EMEA revenue grew 19% year-over-year, representing 15% of total revenue for Q1. And Asia-Pacific/Japan grew 40% year-over-year, representing 17% of total revenue. On a sequential basis, the U.S. was the primary driver of Q1 growth.

Total non-GAAP gross margin in Q1 was 73%, an increase from 71.6% in Q1 '12 and a decrease from 73.6% in Q4 '12. Q1 non-GAAP product gross margin was 71.6%, an increase of 70.1% -- or from 70.1% in Q1 '12 and a decrease from 72.9% in Q4 '12. Our product gross margin continues to perform at the higher end of our historical range, one of the highest in our history, and is driven by the product and geographic mix variables in each quarter.

Q1 non-GAAP services gross margin was 79.7% compared with 77.4% in the prior quarter and 80.3% in the same period a year ago. Our services gross margin is driven by headcount and infrastructure investments on the cost side and the amount and timing of support contracts on the revenue side. Our guidance for total non-GAAP gross margin remains at the high end of our near-term range of 70% to 72%.

Non-GAAP research and development expense was $22.5 million. As a percentage of revenue, R&D was 15.6% compared with 14.7% in Q4 '12. Our R&D spending levels are affected by the timing of headcount additions and programmatic spend related to our product road map. We will continue to invest in R&D for further product innovation and differentiation.

Non-GAAP sales and marketing expense was $44.6 million in Q1. As a percentage of revenue, Q1 sales and marketing was 30.9% compared to 31.7% in Q4 '12.

Non-GAAP G&A expense increased to $7.9 million in Q1 from $7.6 million in Q4 '12. As a percentage of revenue, G&A expense in Q1 was 5.5%, consistent with Q4 '12. Total headcount at the end of Q1 was 1,293, an increase of 70 from the prior quarter.

In total, Q1 non-GAAP operating expenses were $75.1 million, or 52% of revenue, compared to $72.3 million or 51.9% of revenue in Q4 '12. While we will continue to make investments in the business, we expect to grow revenue faster than expenses as a general trend.

Our non-GAAP operating profit in Q1 was $30.4 million, or 21% of revenue, compared to 19.5% in Q1 '12 and 21.7% in Q4 '12.

Our non-GAAP tax rate was 28%, equal to our guidance. As we have previously discussed, our overall tax rate is subject to change, including from the projected geographic mix of the company's revenue as well as changes resulting from any new U.S. or international regulations or interpretations. We continue to expect our full year 2013 non-GAAP tax rate to be approximately 28%.

Non-GAAP net income for the quarter was $22.1 million or $0.18 per diluted share. This compares to $22.1 million, or $0.18 per diluted share, in Q4 '12 and $16.7 million or $0.14 per share in Q1 '12. The weighted average shares outstanding were 122.4 million shares on a diluted basis in Q1.

On a GAAP basis, net loss was $0.8 million, or $0.01 per diluted share, compared with a Q4 '12 net loss of $3 million, or $0.03 per diluted share, and a Q1 '12 net loss of $0.5 million or $0.00 on a per-diluted share basis. A full reconciliation of GAAP and non-GAAP information is contained in our financial results press release issued this afternoon.

Turning to the balance sheet, we finished Q1 with cash and short-term investments of $377.5 million, an increase of $31.3 million over the prior quarter. Cash flow from operations in Q1 was a strong $36.9 million.

Under our share repurchase program, in Q1, we repurchased approximately 590,000 shares of common stock at an average price of $19.52 per share or an aggregate purchase of approximately $11.5 million. This adds to the 1.4 million shares we repurchased in Q4 '12. The weighted average shares outstanding impact of the 2 quarters of buyback on Q1's diluted share count was approximately 1.6 million shares.

We ended Q1 with $73 million of accounts receivable, a decrease from the Q4 '12 balance of $80.2 million. Days sales outstanding improved to 46 days, a decrease from 52 days in Q4 '12 and 51 days in Q1 '12. Our target range for DSO remains 50 to 55 days.

Total deferred revenue of $113.9 million increased 25% year-over-year and $10.9 million, or 11%, from Q4 '12. Short-term deferred revenue of $88.2 million increased 16% year-over-year and increased 9% sequentially. The primary changes in our deferred revenue balances are due to new support contracts with our customers and the inventory stocking orders of our value-added distributors.

Aruba's inventory total $28.2 million at the end of Q1, an increase of $6 million from the end of Q4.

Let me now turn to our second quarter guidance. Before reviewing the guidance, let me remind you that guidance consists of forward-looking statements, and please keep in mind our earlier comments regarding such statements. Looking forward, while the macroeconomic environment remains mixed and Europe remains challenged, we continued to see strong demand for mobility products across our platform driven by strong secular trends and our product differentiation. We are encouraged by the solid Q1 we delivered. As such, we expect Q2 '13 revenue to be in the range of $150 million to $153 million, an increase of 19% to 21% year-over-year and 4% to 6% sequential. We expect non-GAAP EPS to be approximately $0.19 per share using 125 million shares on a diluted basis.

With that, let me turn the call over to the operator to take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from the line of Jason Ader with William Blair.

Jason Ader - William Blair & Company L.L.C., Research Division

Yes, I had just real 2 quick ones. Number one, on services. Mike, maybe you can talk to the growth in services or what drove that. It seemed like it was above normal. And then, Dominic, on ClearPass, can you just talk about when you think it will be material, multimillions of dollars kind of impact to the P&L?

Michael M. Galvin

Yes, with regards to services, it was a good quarter for services. The bulk of that revenue number is made up of our support contracts with our customers. And basically, the timing of the renewal of those contracts and the size, obviously, can affect the revenue in any given quarter. In this quarter, we had a good quarter. Both the timing of the contract renewals and the size of some of them was favorable. So we felt good about that.

Dominic P. Orr

And Jason, as regarding ClearPass, we are continuously in the pipeline of projects and pilots' build-up. And even in the quarter just passed, there has been a revenue conversion now and we're expecting from this quarter onward there will be increasing trend of revenue conversions. So it's starting to kick in. I would say we'd not be able to break out for you by product line about the exact magnitude.

Operator

Our next question comes from the line of Mark Sue with RBC Capital Markets.

Mark Sue - RBC Capital Markets, LLC, Research Division

Mike, it's -- gentlemen, the guidance is healthy. But if I look at the percentage growth, it seems to be below that of your largest competitor, which is growing a little bit faster. Can you discuss maybe some market share dynamics, maybe some color on regions and verticals where you might be gaining some share, where you might be ceding some share and kind of just your thought on the -- your ability to grow faster than the market?

Dominic P. Orr

Sure, Mark. There really -- we can roughly look at this market as the large enterprise, large campus and the key work which we have for the last 10 years been done with. And in this market, we are building up the Layer 1 through 7 stack to get more and more value, not only market share but profit share, I would say. And we feel very good in this area. We continue to increase our win rate and bidding competition. And then there is the service provider space where we participate through the managed service metric, going back to the previous large enterprise, using them as a channel. That portion of the market is good. We also have experimented with much lower-margin service provider hotspot business, particularly in certain geography. That is growing very rapidly. We found that, that is not aligned with our business model. We exited that market. And my understanding is several of our competitors have decided to move in and pick up some of the business that we left behind. The third area is if you look at the numbers that you quoted for one of our -- the largest competitor, they're talking about outdoor network, and that is part of the service provider offering as well and we just simply are not in that marketplace. The marketplace that everybody has a piece in -- and I think the last competitor through the brand and channel has the significant presence -- and is starting to heat up quite a bit is the mid-tier market, where, like I say, everybody is in that market. And that is the market that traditionally, Aruba had not participate in. But since last quarter when we introduced Aruba Instant Enterprise, we were starting to get into the market, and the next 2 quarters, I expect that this will get traction and be incremental growth opportunity.

Mark Sue - RBC Capital Markets, LLC, Research Division

Okay, that's helpful. And Dom, maybe if you can help us understand. What are your customers saying about the importance of wireless? It seems you're bucking the trend of a weak macro environment wireless is doing quite well. What is that replacing in terms of the rank order of importance of IT spending? And are you also seeing any changes in deal sizes because of the macro?

Dominic P. Orr

Actually, the -- let's talk about deal size first. If you look into our worldwide deal sizes or international deal size, I would say, average, stays the same. I see some increase in Asia-Pacific/Japan. I see some -- a little bit of a shrinkage in Europe. But domestic deal size actually has trended up a bit noticeably. And that is, I think, due to the fact that with the explosion of all these mobility devices, that the density for coverage needs to be higher. So regarding the budget and budget priority, we -- actually, the -- just humbly follow the tablets and the smartphones. And it seems like that, that they, independent of how much people gripe about the budget, they continue to be able to come out with new devices on their network. And since this device do not have an Ethernet port, it really christens up the needs of wireless infrastructure. Now wireless infrastructure is one thing. But associated with these new devices and the mobility of the workforce, we are dealing with secure access policy, policy management, guest access system, BYOD management. And that is totally related to the mobility infrastructure on top of the wireless. And I think a lot of our competitors are focusing on getting market share purely of what I call Layer 2 WiFi, and missing out a lot of the Layer 4-7 richness in the market. And I think over time, that is where the profit share will gravitate as we have learned very well in the Ethernet switching market there's Layer 2 market, Layer 3, Ethernet market and Layer 4-7 Ethernet market. And over time, anybody who just compete on market share on Layer 2 Ethernet market do not come out with a very, very good business model. And it is exactly the same thing is happening now: Layer 2 WiFi for shared connectivity, hotspot; Layer 3 WiFi for much large -- larger, scalable network; and Layer 1-7 WiFi for all of these security, mobility-centric, multimedia unified communication support systems. And that is where Aruba is single-mindedly focused on. We want to absolutely dominate the profit share in this market.

Operator

Our next question comes from the line of the Ehud Gelblum with Morgan Stanley.

Ehud A. Gelblum - Morgan Stanley, Research Division

A couple of questions. First of all, maybe for Mike on gross margin. You said strength came out of the U.S. this quarter, and yet gross margins on the product side went down a little bit. If you can just comment on that and maybe just kind of give us a walk on gross margin as you're looking out into the future but kind of understands just the moving pieces there. And can you -- Dom, can you quantify for us ClearPass and Instant? Are they large enough to quantify and get a sense as to what's happening to the core wireless LAN business on a sequential year-over-year basis versus the growth in Instant and ClearPass as they come on?

Michael M. Galvin

Yes, Ehud. So on the gross margin, yes, we did feel real good about the results this quarter. It was one of our highest results in our history and definitely at the high end of the guidance range even from a products perspective. In any given quarter, product and geographic mix definitely impact the margin, obviously. Americas was a good mix this quarter, but it's not the only variable. And we've got -- we kind of have 3 tiers of gross margin around the world. I kind of call it an upper class, a middle class and lower class. And definitely, in any given quarter, you get a mix of those geographically. And then you also get a mix of product, right, where you've got our switches are on the lower end of our margin profile and, obviously, software up at the top. So you get a mix of all these things, and they play and do -- every quarter, you see some of that variability just as you go back in our history. But we feel very good about the performance. On a competitive front, we definitely did not see any gross margin degradation from any pricing pressure or competitive pressure. It was a -- we continue to win in that area on differentiation. And it really just comes down to geographic mix and product mix with any given quarter.

Dominic P. Orr

And regarding product mix, Ehud, well, first of all, historically, the company do not break out revenue by product line. Having said that, on top of the reported results on revenue, I'd like to further comment that I'm extremely delighted about our booking momentum for the quarter. And from a booking perspective, ClearPass and Aruba Instant, which both have been just introduced a little bit over 1 quarter, has turned out to be neck-to-neck the 2 fastest-growing booking -- from a booking perspective, fastest-growing product line ever introduced by Aruba in our 10.5-year company history. So that's -- I'll leave it at that.

Ehud A. Gelblum - Morgan Stanley, Research Division

Great. Can you -- one more thing. Can you -- when you go into this -- you said the hottest area right now is the SMB and the mid-tier where you're attacking it with Aruba Instant. What's the key differentiator between Aruba Instant and the guys who are coming up attacking that business from a different angle? Is security less of an issue? Or do you still have all your security software and pieces in your Aruba Instant product as well?

Dominic P. Orr

So the Aruba Instant Enterprise -- so traditionally, we have Aruba Instant. A year -- a quarter ago, we introduced Aruba Instant Enterprise edition. And in that edition, we have basically the basic security, basic access management and network management function all bundled in. The major differentiation of that product line is the absolute zero-touch deployment. I think a lot of our competition emphasize on ease to install versus one touch to install. This is actually totally cloud-based, so zero-touch activated product. And that is probably singularly the biggest feature that has been well received by the channel community in terms of almost 0 cost of installation. And that would -- that turned into, obviously, profitability in the channel.

Operator

Our next question comes from the line of Ryan Hutchinson with Lazard Capital Markets.

Trevor Bacon - Lazard Capital Markets LLC, Research Division

This is Trevor Bacon in for Ryan. Just a follow-up on ClearPass. Can you talk about the conversion rate with respect to the pilots and any internal targets you want to hit? And then regarding the pricing dynamics, have you made any progress on the subscription service model?

Dominic P. Orr

Can you repeat the second question? What? Subscription model?

Michael M. Galvin

Well, subscription pricing for ClearPass.

Trevor Bacon - Lazard Capital Markets LLC, Research Division

Pricing for ClearPass?

Dominic P. Orr

Yes, okay. So let me answer the second question first. The subscription model. Actually, we have introduced recently, besides the permanent license agreement, also a new license agreement based on number of devices and number of functions you turn on, and that has been very well received. Regarding the conversion, at this moment, I would say the -- I'm very, very happy with the conversion rate. The only thing that is disappointing for us is our customer conversion rate is really limited by Aruba and Aruba's partners' professional service bandwidth to help them turn on the new different -- so workflow processes associated with this whole BYOD mentioned processes. And so one of our biggest focus in the next 6 months is training effort and assisting our partners to turn on the professional services. That factor is the only thing that is preventing a lot -- a higher rate of conversion on this one.

Operator

Our next question comes from the line of Jeff Kvaal with Barclays.

Jeffrey T. Kvaal - Barclays Capital, Research Division

You folks had been at the high end of your gross margin range for a few quarters here. And also now, your operating margin range is in the midpoint. To what extent might you consider raising either of those ranges, particularly as ClearPass in particular becomes a bigger of sales?

Michael M. Galvin

Yes, the margins have obviously been performing well. We laid out at the last Analyst Day this near-term guidance, which really carries us through FY '13. We continue to feel good about the ranges, as you can see, and actually the high end of the ranges. We have variability in every quarter, and we got a lot of product in geo mix issues. So we still feel out of that Analyst Day and through this next fiscal year that, that's the prudent range to guide to. And we'll keep executing to that and hopefully keep over-executing to that.

Jeffrey T. Kvaal - Barclays Capital, Research Division

Excellent. And then also, similarly, of all the companies that we track, your percentage of stock-based compensation tends to be amongst the highest and, in some cases, by a wide margin. Do you folks have plans to bring that down as a percentage of your overall earnings?

Michael M. Galvin

Yes, Jeff, we look at that very closely. We do -- you obviously try to -- we're in a competitive environment when it comes to hiring, et cetera, and our acquisition activity, et cetera. So we look at that, and we are managing that number and absolutely, like other lines on our P&L, have the objectives to improve that line over time. One thing you do see is that it doesn't happen in a stair step function just because of the nature of the accountant. So you can be putting things into place at any given time. And it takes a little bit for the accounting to kick in and start to show some healthy improvements there. But it is something we watch very closely and manage to and is a focus for us go forward.

Operator

[Operator Instructions] And our next question comes from the line of Kent Schofield with Goldman Sachs.

Kent Schofield - Goldman Sachs Group Inc., Research Division

Can you give us an update on the Mobility Access Switches and just how you're, I guess, resourcing those with sales headcount at this point, I guess, relative to some of the opportunities like a ClearPass?

Dominic P. Orr

So I think -- that's a good question -- the Mobility Access Switch now, from a domestic sales point of view, has become a standard -- part of the standard toolkits now for our sales. So it does playing -- quite widespread, we don't track it as new product anymore. For the international market, we still are waiting for a couple of models to complete the suite to more -- to fit more in the market. From a momentum point of view, the -- continue to be the markets that are pioneers to adopt Aruba's wireless LAN first, which is basically the education market and the high-tech market. They also are the markets that first adopt our MOVE architecture, complete architecture viewpoint. And so those are the markets that the mobility switches have the most traction.

Kent Schofield - Goldman Sachs Group Inc., Research Division

Got you. And then as we look at Europe, obviously it's tough in that region. Are you expecting any sort of improvement there anytime soon? Or more of the same going forward?

Dominic P. Orr

At least in the planning horizon that we have set guidance for you, we have taken a pretty conservative view that we do not expect it to improve, this whole big thing.

Operator

Our next question comes from the line of Jess Lubert with Wells Fargo Securities.

Jess L. Lubert - Wells Fargo Securities, LLC, Research Division

Two questions, actually. First, I was hoping you could talk a little bit about the pull-through opportunities you're seeing with ClearPass. Thus far, particularly in accounts that weren't previously Aruba customers, what percent are looking at other products? And how big do you believe the multiplier might be for every dollar of ClearPass?

Dominic P. Orr

So right now, the -- ClearPass is still in the 3 situations. One is the -- our existing installed base upgrading on that software. The second is for an environment where people already have installed our competitors' infrastructure and is considering ClearPass because of its multi-vendor -- unique multi-vendor capability. The -- in those situations, obviously, it's the software only. And then the third category is bringing ClearPass and Aruba wireless infrastructure and wire infrastructure together. And then the -- our third category, the pull-through ratio was roughly 1:3. $1 of ClearPass pull-through, roughly $2.50 to $3 of other Aruba gear.

Jess L. Lubert - Wells Fargo Securities, LLC, Research Division

And are you seeing any evidence that in those non-Aruba customers, that ClearPass is serving as that Trojan Horse to maybe pull through some of your other products in the future? Can you maybe just talk about those conversations?

Dominic P. Orr

Yes, absolutely. But at this current moment, we are very, very focused on just doing a good job being a multi-vendor access policy partner for our customers and get our credibility in those major accounts. So -- but all indication is they are open -- there's definitely open opportunity there, and we are seeing already some early indications that, that will happen.

Jess L. Lubert - Wells Fargo Securities, LLC, Research Division

And then last one for me. Can you talk about what you saw in the federal vertical this quarter? And when I look at your guidance for next quarter, what are your assumptions with respect to federal spending next quarter?

Dominic P. Orr

Last quarter, federal was very good. I'm very, very happy with it. And this quarter, we expect that it will moderate down more to the regular run rate, and it is baked in into our guidance.

Michael M. Galvin

And I think key for our fed business, too, was the expansion of the types of agencies that were starting -- we've had a very strong history in the defense areas, et cetera, but the national and civilian agencies are absolutely getting onto the mobility bandwagon, if you will, and the growth there is good.

Dominic P. Orr

And I think one of the highlights for last quarter for federal business is not only the volume but the number of new design wins is very encouraging.

Operator

Our next question comes from the line Jonathan Ruykhaver with Stephens.

Jonathan B. Ruykhaver - Stephens Inc., Research Division

I just have one question, also on ClearPass. But I'm kind of curious. How successful have you been in driving recognition for the need for ClearPass as a supplement to a more strategic MOVE initiative? And is there any way you could quantify that success through possibly some kind of attach rate for ClearPass to MOVE initiatives?

Dominic P. Orr

Are you saying that do we have any kind of market education or market development program to raise awareness of the need for a solution like ClearPass? Is that the question?

Jonathan B. Ruykhaver - Stephens Inc., Research Division

Yes. And how's -- whether or not you're seeing ClearPass viewed as a supplement to a strategic MOVE initiative on the part of a customer?

Michael M. Galvin

I see, okay. So you want...

Hitesh Sheth

Yes, I can answer that. So, I mean, from our perspective, ClearPass actually is an integral part of mobile picture. We've always messaged the notion of role-based access control across wired and wireless with MOVE. And what ClearPass brings to the table is the policy definition component of [indiscernible]. So it's been, I guess, from an architecture perspective a part of it. So in terms of expansion and positioning, it just plays straight into the architecture play there. It's not a distinct sort of initiative the way we think of it.

Jonathan B. Ruykhaver - Stephens Inc., Research Division

Right. So it's safe to assume that the attach rate for ClearPass to MOVE is high and should grow over time?

Hitesh Sheth

I think you have the MOVE architecture through ClearPass. Obviously, we'll run it for you. The good thing is because it is multi-vendor, it lets a customer start on any vendor and migrate to -- the infrastructure to Aruba. And in that perspective, yes, exactly what you said, that's right. MOVE is the umbrella, but ClearPass is one of the components that goes into it.

Operator

Our next question comes from the line of Bill Choi with Janney Montgomery Scott.

William H. Choi - Janney Montgomery Scott LLC, Research Division

Two questions for me. On ClearPass, this resource constraint, can you talk about how long it will be in a backlog situation and how we can really improve that? What are the key elements that need to improve? And how long does it take to implement this? And lastly on the ClearPass part, what would you say -- of the pilot today, how -- what percentage is interested in the subscription model versus the normal license model? And then the follow-up would be on Mark's question about how do we capture this high growth rate in the service provider WiFi? Obviously, you exited that due to low margins. But both talking with Cisco about their margins there, which they say is actually quite good, and looking at Ruckus doing mid-60s type of gross margin, it looks quite attractive. What can you do to participate in some of the growth and take some of those profit that seems better than expected?

Dominic P. Orr

Okay, so this is 3 in 1, right? Okay, so let's take the second one. It is too early to tell where people are favoring the terminal license or the takeaway because we really introduced it like 30-plus days. So maybe if we can defer it 1 or 2 quarter to answer that question. In terms of the take rate, there are 4 or 5 different modules in ClearPass. Some of them can be installed within 2 hours and some of them need workflow reengineering and reconfiguration of a customer environment. It has nothing to do with our products. It has something to do with you turning the customer organization from an IT-driven operations to a user-driven operation, and that is the biggest value of ClearPass. It decouple the requirement of IT, helpdesk and operations headcount from the explosion of guest and mobile devices in your network. And so a lot of the professionals are not related to doing anything with our product but configuring the whole environment, and there is a lot of partners who are interested in picking up this hot area. So the -- all I can say is there will be quarter after quarter of market and development and training in this area. I really cannot tell you when we'd be done, so to speak. But obviously, we are not paying attention to this. And the fact that we -- some of the projects are still being deployed doesn't mean that the customer already bought it. We just want to have it bought -- used more widely and, therefore, you increase the user and the device count and so on that becomes annuity. Regarding the certify business, actually the -- if you look into it, there is the smarter offload business and the more not-so-smart offload business. And just looking at the reference customers cited by the Ruckus IPO, I think they're pretty sure in picking up the higher-value, high-margin service provider project. I'm not so sure other vendors are -- maybe let's say they may be less discriminate. I know for a fact there are projects out there that some of our competitors want that is close to 0 gross margin. But if you had something to hide behind, you're probably can pick that. But if you're a pure play, you would not.

Operator

Our next question comes from the line of Rohit Chopra with Wedbush.

Rohit N. Chopra - Wedbush Securities Inc., Research Division

Couple of questions. One, I just want to get a sense, Mike, on inventory. It seems like it moved a lot sequentially, a little atypical. And then maybe the other question is for Keerti. Cisco does talk about their strength in the enterprise, and they mentioned their upgradeable access points. So I just wanted to -- maybe you could maybe explain why you don't have one, why you don't need one. Or if you'll just maybe go through the upgradable access point economics, if you don't mind, just to get a sense?

Michael M. Galvin

Yes. On the inventory, we did have a I guess you call it a inventory build quarter, and you're always trying to manage the balance between your working capital management and good availability of your products. So we built the inventory this quarter. If you look at our history, we're very comfortable at those levels. And we're very comfortable in a turns environment of 5 to 6 go forward, which has kind of been our long-term target. So we did build up. We had gotten -- frankly, we had gotten somewhat low on some key products the last couple of quarters and so proactively went to get that more in the range. And when you do a build like that during the quarter, obviously your turns will take a little bit of a hit. But we balance that every quarter and feel very -- we're very comfortable with the position there.

Dominic P. Orr

And on the upgradable access points story, this is not new news for Cisco. This is take 2 in fact. They had a similar story for abg, the 11n with the AP-1252, I believe, when they announced it. And finally, customers didn't adopt it because if you're making a purchasing decision today, you can actually make a very economical 11n in your purchasing decision and then do a real AC upgrade decision at a subsequent point in time because there's no real driving need for AC today. There's no clients out there that are looking for AC support. So if you're just -- and more importantly, from a labor cost perspective, you have to take 2 trips to the ceiling anyway. You have to deploy one access point and then you had to either plug in the module or plug in a new access point. So the labor costs, while I think is going to be material. So we just believe in mainstream access point, 11n access point, today that is plugged into the network, delivering the high performance and the purpose-built AC access point. Not 11n access point that can have an AC module but something that is built from the ground up to deliver the high performance, delivers both on the pricing piece, but, more importantly also, on the functionality and performance piece to what enterprises need, which is why we're taking the pure-play approach rather than the upgradeability approach.

Keerti Melkote

I think in general, Keerti here, it was 2 kind. So let me just start there. In fact, it's not that the labor costs, were changing their access point and changing a module and access points, both of them in fact, all the customers I talked to said that it is much higher cost for you to send somebody to know what they're doing, to go up the ceiling, open up an access point, remove something or insert something in the little slot there to make sure it's slotted correctly and so on compared to changing an access point, number one. Number 2 is whenever a new set of radios and a technology has come up, particularly of different speed, there's normally an ecosystem of chips in terms of processor and memory and I/O and so on that are made to make that system effective. If you are just putting a slot there using the existing 11n ecosystem chips, that you guarantee your customer that when that faster radio module come out, you will have a suboptimal ecosystem chipset to support it. So it's guaranteed bad performance. Number 3, I strongly suggest that you go to Cisco and ask them if they are willing to release their records for you of what percentage of their customer who bought the 1252 model, where they sell 11 abg access point with a slot for their 11n radio, what percentage of those customer actually came back and plugged in that module. Please ask them. Do me a favor. Thank you, okay. And see [indiscernible], I can also something more, so - -which is the feature set also of the AC module will not be compatible with the rest of the feature set because of different chipset that we know of. So -- and the clients have looked at it and said they're going to just wait for the full thing.

Operator

Our next question comes from the line of Amitabh Passi with UBS.

Amitabh Passi - UBS Investment Bank, Research Division

And Dom, I was curious if you have a sense of what your win rate is today against your largest competitor. And would you say your win rate is improving, stayed the same or even deteriorated, if at all? And then as a follow-up, Keerti, I was just wondering if you had any update on 802.11n AC just your updated or latest thoughts on the adoption curve there.

Keerti Melkote

For the last quarter, our win rate against our biggest competitor was improving steadily every month. I can see that. So we are very, very bullish, and I think this trend will continue, so, in our targeted space.

Dominic P. Orr

And in regards to AC adoption, we expect clients to come to market around the back-to-school season next summer. So that's when the demand curve for AC will start to pick up as well.

Operator

Our next question comes from the line of Josh Beck with Pacific Crest Securities.

Josh Beck - Pacific Crest Securities, Inc., Research Division

I noticed that you commented on better linearity kind of in your normal Q1. We've seen a couple of other hardware reports this week where they had solid results but it was a little bit more back-end loaded. So I'm just wondering if there were certain verticals that drove that or just trying to kind of reconcile why your linearity was maybe a little bit better than some of the other hardware peers that we've seen this week.

Dominic P. Orr

Well, we see linearity in the quarter being good both in revenue and in booking. And there is no obvious driver for any particular vertical.

Michael M. Galvin

Yes, it was just -- it was pretty broad based. And just the flow of the orders through the quarter was solid on any measure. But again, definitely into Q1, so it was a good linear quarter.

Josh Beck - Pacific Crest Securities, Inc., Research Division

Did you have larger deals earlier in the quarter that helped that? Or again, was it just pretty broad based against all...

Dominic P. Orr

It is pretty broad based, yes. So it was all like that, a couple of big deals come in and we got the first half done or something like that, so.

Josh Beck - Pacific Crest Securities, Inc., Research Division

Okay. And then just last one on the product gross margins. I know this has been asked a couple of times, but it sounds like Americas was strong and that should be favorable. I'm just wondering if the #1 driver for the sequential downtick, even though it was small, was more mixed towards switching and hardware, maybe away from software. Or is there nothing really that concrete that really drove the slight sequential decrease?

Michael M. Galvin

Yes, you definitely can get slight mix differences on the products. A little bit more towards APs [ph]. And then I would say really, though, overall, just kind of geographic mix, some of the developing areas. You get certain size deals in those areas. Then the level and pricing of those deals is very consistent. It's just a matter of timing of when you get them. So it's a little bit of both.

Operator

Our next question comes from the line of George Notter with Jefferies.

George C. Notter - Jefferies & Company, Inc., Research Division

I guess I'm wondering. If I look at Cisco, for example, and their wireless business, I think they're approaching now $500 million a quarter. And if you look at that as your largest customer, how do you think their business kind of shakes out between high end and other segments of the market? I think that you gave us a sense on service provider, but I guess I'm wondering if you guys feel like you're sales force limited in the high end of the market or channel limited at the high end of the market. Are there other kind of obvious things that you can do to keep growing there?

Dominic P. Orr

So like -- we clearly see that for the whole, the mid-tier channel business, Cisco has a very strong, entrenched run rate because just a complete product portfolio will carry the wireless as a component. I think some of the large, international, global accounts, they have a, well, very good strategic relationship. So is the projects in between -- those are the large building, large campuses in the verticals -- that we have traditionally excelled. Now with ClearPass, we are getting very good success in penetrating the larger global account. And with Aruba Instant, we are starting an assault into the mid-tier. So -- and service provider, we already have touched on. We will continue to work on the service provider business through the managed service angle. We would not actively participate in the off flow and outdoor mesh [ph], that kind of projects.

George C. Notter - Jefferies & Company, Inc., Research Division

I guess my question is in those segments of the marketplace, do you still think you're still seeing every deal? Or do you think there's a lot of opportunity that kind of go by you without getting a shot on goal for the...

Dominic P. Orr

Absolutely, we're not seeing every deal. We're winning almost every deal we see. But definitely, the -- we can expand. Obviously, we have our EPS constraint like every -- all investors expectations. And -- but we are a go-to-market constraint at this moment.

Operator

Our next question comes from the line of Sanjiv Wadhwani with Stifel, Nicolaus.

Sanjiv R. Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Question for Mike and then for Dom. Mike, can you just talk about the -- which verticals did well during the quarter? I know you mentioned the government vertical, but any other color in other verticals? And then for Dom, I just wanted to get a picture on ClearPass. You mentioned that when ClearPass was pulling in other Aruba products, it's sort of a 1:3 or dollar relationship. What happens in the other situation where a customer has already installed Aruba hardware and then you start putting in ClearPass? What's the opportunity for ClearPass in those instances?

Dominic P. Orr

I think in the later case, most of the situation relate to the customer already have Aruba wireless. But after installing ClearPass, even though ClearPass is a multi-vendor platform, if you have Aruba Wi infrastructure and you have Aruba remote access infrastructure, it gives you a lot more granular control. So that opened up opportunity for us.

Sanjiv R. Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Is there any way to quantify? Let's say if you've got $100 worth of Aruba wireless in there, what's the opportunity within that customer for ClearPass?

Dominic P. Orr

No, I think because ClearPass is very much device and user driven in terms -- so we have 5-digit ClearPass to use, 6-digit ClearPass to use, 7-digit ClearPass, too. And then it is very hard to just map it out. At least we don't have enough quantitatively significant metrics to give you at this moment.

Michael M. Galvin

Hey Sanjiv, on the vertical or industry question, yes, so we did talk about fed earlier. Probably the other 2 that I would say probably stand out in the quarter, financial services, we mentioned a couple of deals in Dom's introductory comments and the general enterprise. Those verticals probably stood out in the quarter.

Operator

Our next question comes from the line of Subus Subramania [ph] with the Judda Group [ph].

Unknown Analyst

My question is on core wireless LAN infrastructure growth rate versus if you take Aruba Instant, ClearPass and wire. So if you look at it on a year-over-year level, can you talk about kind of what -- how much incremental of that 20% growth is coming from these newer products versus what the core market is growing for you?

Dominic P. Orr

I think the predominant growth is from our core wireless LAN infrastructure because both ClearPass and Aruba Instant Enterprise are really relatively new, the products that we're seeing some good booking momentum but really is not significantly reflected in revenue yet.

Unknown Analyst

And is that true, Dom, you had Aruba Instant also into it, not just Aruba Instant Enterprise?

Dominic P. Orr

Yes, I think Aruba Instant and Aruba Instant Enterprise together. I can say that.

Unknown Analyst

And then 802.11 AC, how do you see that transition? I know it's not till maybe the latter half of next year, but do you expect to see a pause in front of that as we get to kind of mid next year? And what was the experience with 11n? And are there parallels that can be drawn?

Keerti Melkote

I think with 11n, the adoption was pretty rapid, as we have said in the past, mainly because I think with 11n, there were some unique dynamics where 2008 was a recession year. There were some pushback in the wireless LAN market. And 11n really hit mainstream in 2009. So the adoption was, I think, pretty accelerated with 11n. Also, the performance benefit was pretty significant as well. It's almost like a 10x gain over abg. In comparison, the AC benefit over n is about a 4x gain from a mainstream perspective. Plus, the clients, more importantly, are, I think, going to hit the market more slowly. So my -- our expectation is that AC will be definitely well received. We have not seen any pause in the market waiting for AC because 11n, especially the 3 SIM 11n delivers on the performance requirements of today. So -- but when AC does come to market, there'll be a price premium to it. So there'll be a moderate, I would say, opportunity to upgrade the networks and increasingly -- increasing over the years. Now also, AC is going to come in 2 flavors. The initial AC is just simply a speed bump, the 4x. The more interesting version of AC will be the multiuser MIMO, which will come out 2 or 3 years afterwards. And that's where we expect a significant architectural shift to happen as well.

Operator

[Operator Instructions] Ladies and gentlemen, that's all the time we have for questions today. I would now like to turn the conference back to Mr. Orr for final remarks.

Dominic P. Orr

Before I close this call, I'd like to sincerely thank all the Aruba employees who are on the call, in fact the whole company, for your very touching effort and behavior exhibited during the last several weeks regarding the Hurricane Sandy, the kind of effort that you have gone out to take care of one another on the East Coast and the kind of money that you have raised for -- to support the Red Cross effort, the volunteer work that you have done and the equipment, Keerti, you donated to supply the wireless infrastructure for a lot of the FEMA, shelters and some of the fire stations that lost communication. Your behavior is highly touching and highly appreciated. I want to take this opportunity to thank all of you. You really make me very proud.

After that, I want to thank everybody for taking the call and all our channel partners and our customer for their support. And thank you for listening. We look forward to updating you in progress in the coming months.

Operator

Ladies and gentlemen, this concludes our conference for today. Thank you for your participation. You may now disconnect.

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