Brocade Communications Systems's CEO Discusses F4Q 2012 Results - Earnings Call Transcript

Nov.19.12 | About: Brocade Communications (BRCD)

Brocade Communications Systems (NASDAQ:BRCD)

Q4 2012 Earnings Call

November 19, 2012 5:30 pm ET

Executives

Robert Eggers

Michael A. Klayko - Former Chief Executive Officer, Director and Chairman Of Corporate Development Committee

Daniel W. Fairfax - Chief Financial Officer, Principal Accounting Officer and Vice President of Finance

David B. Stevens - Former Chief Technology Officer

Ken K. Cheng - Vice President of Routing, Application Delivery and Software Networking Group

Jason Nolet - Vice President of Data Center Networking Group

Analysts

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

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

Paul H. Mansky - Cantor Fitzgerald & Co., Research Division

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

Amitabh Passi - UBS Investment Bank, Research Division

Keith F. Bachman - BMO Capital Markets U.S.

Mark Sue - RBC Capital Markets, LLC, Research Division

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Matthew S. Robison - Wunderlich Securities Inc., Research Division

Brian Marshall - ISI Group Inc., Research Division

Erik Suppiger - JMP Securities LLC, Research Division

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

Scott Schmitz - Morgan Stanley, Research Division

Operator

Good day, and welcome to the Brocade Communications Systems, Inc. Fourth Quarter 2012 Earnings Conference Call. [Operator Instructions] Today's conference is being recorded. At this time, I would like to turn the conference over to Rob Eggers, Vice President of Investor Relations with Brocade. Please go ahead.

Robert Eggers

Thank you, Siobhan. Good afternoon, and welcome to Brocade's Q4 and Fiscal Year 2012 Earnings Call. By now, you should've seen our press release and prepared comments which are available on our website, brcd.com. The press release is also distributed by Marketwire and furnished to the SEC.

Before we take your questions, investors should note our comments today may include forward-looking statements regarding Brocade's financial results, plans, market opportunities and business outlook, which are only predictions, and involve risks and uncertainties such that actual results may vary significantly. These and other risks are set forth in more detail in our Form 10-K for the fiscal year ended October 29, 2011, and in our Form 10-Q for the quarter ended July 28, 2012.

These forward-looking statements reflect beliefs, assumptions, outlook, estimates and predictions as of today, and Brocade expressly assumes no obligation to update any such forward-looking statements. In addition, this presentation may include various third-party estimates regarding the total available market for SAN and IP Networking, as well as other measures, which do not necessarily reflect the view of Brocade. Further, Brocade does not guarantee the accuracy or reliability of any such information or forecast.

This presentation includes non-GAAP financial measures. The most directly comparable GAAP information and a reconciliation between the non-GAAP and GAAP figures are provided in our Q4 2012 press release, which has been furnished to the SEC on Form 8-K and in our slide presentation and prepared comments on our website, brcd.com.

Here to take your questions are Mike Klayko, Brocade's CEO; Dan Fairfax, CFO; and Dave Stevens, CTO and VP of Corporate Developments; Jason Nolet, VP Data Center Networking; and Ken Cheng, VP of Routing Application Delivery and Software Networking. I will now turn the call over to CEO, Mike Klayko. Mike?

Michael A. Klayko

Thank you, Rob. Good afternoon, everyone, and thank you for joining us today. Before we take your questions, Dan and I wanted to make a few comments about the quarter and fiscal 2012.

Q4 is another great quarter for Brocade and a very strong ending for our fiscal year 2012. And we broke a number of company records, including revenue, net income and operating cash flow. Fueled by a highly innovative product portfolio, strong customer traction and continued solid execution, we exceeded both our revenue and profitability guidance for the quarter. And we achieved record revenue of $578 million, an increase of 5% from prior year, driven by the growth in our SAN and Ethernet switch products, led by our award-winning Ethernet fabric portfolio.

Further, both our non-GAAP gross margin and operating margin increased again in the fourth quarter, allowing us to outperform our target model. As such, we're very pleased to report non-GAAP earnings per share in the quarter of $0.17, an increase of $0.01 from the prior year and representing our fifth consecutive quarter of year-over-year EPS growth.

For the year, we achieved record revenue of more than $2.2 billion, with non-GAAP earnings per share of $0.66, which is a 33% increase year-over-year. We saw significant improvements in both gross margin and operating margin while achieving record net income in the year, again, exceeding our target model.

Turning to the balance sheet. We made significant improvements as well with our record operating cash flow of $591 million during the year. We eliminated the remaining balance of our term debt, repurchased more than $130 million of common stock and increased our cash balance by more than 70%, and Brocade exited 2012 in a net positive cash position a full year ahead of our earlier expectations.

Before I make additional comments on Q4 2012, let me comment on next quarter. For the first quarter, we continue to see healthy demand across our product portfolio and remain highly focused on our strategy in driving shareholder value. While Dan will give you more specific details on our guidance in a moment, I can tell you that we're projecting that first quarter revenues to be between $565 million to $585 million, and our non-GAAP EPS will be $0.15 to $0.16.

Now our strong business model has also enabled us to make strategic investments on our core businesses as well as emerging technologies. For example, our continued investment in data center fabrics has positioned us as a leader in the industry with a competitively innovative and differentiated product portfolio of both SAN and Ethernet fabric solutions.

This year, we launched additional products as part of our first-to-market 16-gig SAN portfolio, and we're seeing a rapid adoption of this technology with 16-gig products now making up nearly 35% of our SAN director and switch sales.

In Ethernet fabrics, we introduced the Brocade VDX 8770 modular switch this quarter, which further enhances our portfolio of Brocade VCX fabric-enabled products and reinforces our technology leadership and redefining data center architectures. We now have more than 800 Brocade VDX customers worldwide, giving us a considerable lead with customer adoption in this emerging market category.

In routing and application delivery, our investments in technology innovation resulted in strong Service Provider revenues in FY '12. During Q4, we announced the 24-port 10-gigabit Ethernet module for the Brocade MLXe routers, enabling our customers to build the industry's highest-density core router in a single platform.

In FY '12, we also announced our comprehensive vision and strategy for software-defined networking that sets the stage for continued groundbreaking technology and product innovation. We are already leading the industry in key areas of SDN, including support of OpenFlow on our high-end router family. As we look to the future of networking, we see SDN as a disruptive force, reflecting the needs for networks to be much more flexible and elastic. We believe the network of tomorrow will be much more open, not closed, and it will include software and hardware components for multiple suppliers working together. Most importantly, we believe this transition represents significant new business opportunities for Brocade in working with service providers and enterprises to deliver services faster and to provide new value-added services for their customers.

Brocade intends to lead in this category to complement its Ethernet fabric and cloud-routing solutions. We have outlined a comprehensive SDN strategy that includes a 4-pronged approach: innovation through internal R&D, strategic industry partnerships, advanced technology acquisition and talent recruitment of industry leaders. The recent acquisition of Vyatta is a key part of this strategy, and we believe this will help us address the virtual routing, security and VPN opportunities in the software networking segment.

Moving to the campus LAN space. We delivered a significant refresh of our campus portfolio this year, introducing true innovation in a market that has been in need of architectural transformation for more than a decade. We're seeing great results in the sale of our Brocade ICX switches to our channel partners. Customer and partner feedback on the innovative Brocade HyperEdge technology has been very positive as well.

In total, we are exiting FY '12 with a full portfolio of world-class products and an innovative technology roadmap in the strategically important areas, driving network transformation across all customer segments, including the data center, public and private clouds, including campus networking.

With our product portfolio being as strong as it has ever been, the customer traction we have ever seen and the financial performance we have demonstrated this past year, we believe Brocade is well positioned for the future.

I'll now turn the call over to Dan for a brief summary of our fourth quarter results and guidance for the fourth -- for the first quarter. Dan?

Daniel W. Fairfax

Yes, thanks, Mike. As you have seen in our prepared remarks, we had a great quarter with revenue of $578 million. Our overall non-GAAP gross margin was 64.8% in the quarter, and the resulting non-GAAP operating margin was 22.5%. We generated cash flow from operations of $210 million, repaid $30 million of our term loan and repurchased $60 million of stock during the quarter. We are pleased that we're able to pay down the remaining term loan balance this quarter and be net cash positive as we exited fiscal '12.

We provided Q1 guidance in our prepared remarks, and I'd like to take a minute now to just to give a little more color around our assumptions. We considered a number of factors, including the following, in setting our outlook for the first quarter. The current macroeconomic environment continues to show uncertainty, especially in Europe and in the U.S., as a result of the impending federal fiscal cliff. We continue to see encouraging demand trends for our SAN products, and we expect SAN revenue in Q1 to grow by 3% to 6% sequentially. We expect our IP networking revenue in Q1 to be lower quarter-over-quarter, as Federal revenue will be down, which is typical for our January business. We expect non-GAAP operating expenses to be approximately $250 million in Q1, which includes expenses related to the Vyatta acquisition. For Q1, we are expecting total revenue between $565 million and $585 million and non-GAAP EPS of $0.15 to $0.16.

From a tax rate perspective, we assume a structural non-GAAP rate of 29% to 31% for fiscal year '13. Discrete events can impact our tax rate from time to time, but we do not include those around in our assumptions around our structural rate. With the passage of California State Proposition 39, the "Single Sales Factor" tax initiative in California earlier this month, we anticipate taking a onetime, non-cash charge in Q1 of up to $78 million to reduce our California deferred tax assets. This won't impact our GAAP earnings in Q1, but our non-GAAP tax rate should still be 29% to 31% for the quarter. For California State, cash tax will not be affected by the change in law. Based on our Q1 outlook, we expect to manage the business to the target model given at our Analyst Day in September 2012. And finally, we have purchased an additional 25 million of our shares since the beginning of the first quarter.

Now with that, I will turn the call back over to the operator to begin the question-and-answer session. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] And we'll take our first question from Jess Lubert with Wells Fargo Securities.

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

Maybe just to start, I've got a couple but could you provide us with an update on where you are in the search for a new CEO, how the process is going, and when we should be thinking about an announcement there?

Michael A. Klayko

Yes, Jeff, this is Mike. I will tell you that the board is being very diligent. And I will also tell you that a lot of progress has been made to the point that this will probably be my last earnings call with you.

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

Okay. And then I had a question on the Enterprise Ethernet business. It appeared to decline sequentially, following a strong July period. As a result, I was hoping you could discuss what you saw from a linearity perspective in that business, what was most responsible for the sequential decline. Is it the fiscal cliff, macro concerns in Europe? And if you could help us understand how you're thinking about that Enterprise Ethernet component heading into the January quarter, that would be helpful.

Daniel W. Fairfax

Jeff, this is Dan. Let me start with that and then maybe Dave Stevens will have a couple of comments as well. So in terms of the federal fiscal cliff, I would say we had a very good Federal quarter. And so from the standpoint of Federal, that was quite strong. We think more general to our Enterprise business certainly over the last number of quarters. We've been winning a significant number of larger deals. And the mix in our fourth quarter of larger transactions versus our base level of business wasn't as strong as it had been in the third quarter. So Dave, maybe anything else you want to add on top?

David B. Stevens

Yes, I would just reiterate what Dan said that there -- that tends to be a bit little lumpy. And we didn't see those in Q4, where we did see them in Q3. I would say, overall, we've seen a very good growth and a lot of strength in the ICX products. There's been very good reception to the whole HyperEdge messaging, combined with the routing products in that space. So that continues to resonate very, very well. We're continuing to see strength and improvement in the channel programs and partners and the sales force efficiency. And so I would really just attribute it to what Dan said with the lumpiness.

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

And just the last one for me, in your presentation, you mentioned that the IP router revenue was impacted by the delay of several large router projects. Can you provide us with a sense of how much business slipped out of the period, how many deals were involved and when you expect this business to close?

Ken K. Cheng

This is Ken, Jeff. And so as you probably know that the routers are sold into both Enterprise and Service Provider markets, and we have seen very healthy revenue growth on the Service Provider market but softness in Enterprise. And it's typically because of the timing of purchases and delay of big deals.

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

So was that Enterprise Ethernet weakness a function of router sales?

David B. Stevens

Well, I think that -- this is Dave again. They tend to go hand in hand. So we'll send -- it's not directly related to router sales. But when we go into a larger Enterprise network, for example, we'll use routing products in the core in the aggregation layer of those networks. And we'll tend to use stackable products like the ICX up in the closet. So while they’re not directly tied together in larger Enterprise environments, they tend to get sold at the same time into those environments. So softness in one tends to come hand in hand with the other one.

Operator

Our next question is from Jason Ader with William Blair.

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

I was wondering, Mike, could you comment on why you think you're doing so well and -- given the weak backdrop for storage? I mean, if you look across the big storage array vendors, it was pretty brutal last quarter. So do you think it's just all 16-gig share gains or what else could be going on?

Michael A. Klayko

I think there's a lot of things going on, Jason. First off, I think great products actually can trump some of the headwinds and market conditions, whether they be just storage related or macro. And so we have some great products right now, so we're taking advantage of that product lead. Second is there's a customer refreshes that are going on. There's a huge opportunity that Jason has identified, and it's probably the -- and I think Jason will comment there's probably $10 billion of market out there that we can go actively try to replace with new technology. It's because that’s what you try to build out these cloud infrastructures, whether you want to call them private or public or whatever, that requires highly virtualized environments. Fibre Channel is a good technology for that, and we don't see that changing for a long period of time. So do you have anything else, Jason?

Jason Nolet

Yes, just to add to that and maybe reinforce what Mike said. We see a fair number of customers who will do a refresh on their SAN somewhat independent of what they're doing on the storage side. And in particular, the latest generation of products that we've been delivering, what we call the 16-gig portfolio, delivers a lot of value with respect to SAN consolidation and additional efficiencies and capabilities made to the SAN, independent of how many servers and how much storage you might add to the environment, so a fair number of that going on and as Mike also said, a lot of legacy products out there that needs to be refreshed. And again, customers are motivated to do that somewhat independently of a refresh on either side of the SAN server or storage. So that's I think the explanation that we'll give you for that.

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

And then just to follow up on that, when Cisco comes out with their 16-gig products, I don't know when that's going to be, but do you feel like that's going to be a headwind for you, number one? And then just secondly, what do you think the SAN market is growing at in calendar 2012 as you put together all your data and you see how you guys have done?

Michael A. Klayko

Yes, so just to address the competitive angle and then Dan can talk about the market growth. On the competitive side, candidly, when Cisco comes out with their 16-gigabit gear, we'll see that I think in the industry, well, as a validation that Fibre Channel continues to be the storage networking technology of choice for mission-critical applications. And as much as Cisco would have driven an FCoE agenda, that's just not seeing traction. And they're going to recognize with the introduction of a 16-gig portfolio that customers want to keep investing in Fibre Channel. So while it's good to have competition, we see at as direct validation that the customers' sentiment and the investment intent around Fibre Channel continues to be very strong.

Daniel W. Fairfax

And Jason, to answer your question in terms of market growth rates, so we still see this market growing at about 2% to 5% range, same as what we've guided to in September. We're not kind of moving off of that. And again, we see fundamentally the strength of these products, not just the bandwidth. But the enhancement to the diagnostics and the manageability and the operability of these really high-end networks is going to continue to expand its growth but in that kind of range, 2% to 5%.

Operator

Our next question is from Paul Mansky with Cantor Fitzgerald.

Paul H. Mansky - Cantor Fitzgerald & Co., Research Division

Wanted to dig a bit more into a couple of questions already been asked, and maybe I'll start with the SAN side. I mean, there wasn't too many years ago, 2 or 3 tops, that typically we think about seasonality in October being very heavily skewed towards directors that started to wane last year, and it is actually proven. And in this year, it looks like it proves to be a bit more seasonally attractive for the switch side. So as I hear you talking about consolidation projects and hiring projects and things of that nature, I would think that, that would benefit directors a bit more, particularly, since they had a more favorable sequential comparison. Is there something else going on that we're missing here on the switch side of your portfolio that you'd like to articulate?

Daniel W. Fairfax

Only that we've added all the same value in the switch products that we have in the director class products. So manageability, diagnostics, additional in-line services, some of the same consolidation capabilities. The value prop is pretty consistent across the entire portfolio. So for that reason, we see similar kind of demand in the switches.

Paul H. Mansky - Cantor Fitzgerald & Co., Research Division

I mean, do you think that, that traditional kind of mix shift up to the director class product from an end market perspective has been arrested here and probably have a more even contribution between the 2 classes going forward? Or do you think this is a temporary thing as you've increased that functionality?

David B. Stevens

I think it's hard to say, and I wouldn't point at 1 or 2 quarters necessarily as a trend. I think there continues to be a place in the network for both director class products at the very high end and switch products in kind of the medium-sized networks. And we continue to invest in both parts of the portfolio.

Paul H. Mansky - Cantor Fitzgerald & Co., Research Division

Okay. And then following up on the Ethernet side, recognizing obviously there is some inherent lumpiness there. If you look on a year-over-year basis, Enterprise x Fed is -- was down double digit for, what, 3 of the 4 quarters year-on-year this year. Recognizing, of course, that you had a campus portfolio to refresh and a go-to-market to refresh in that campus space about 2 quarters into it now, so I was a little bit surprised to see that 20-some-odd percent year-on-year decline in Enterprise x Fed. What do you think has to happen there for you to kind turn the corner to start delivering consistent year-on-year growth in that business?

David B. Stevens

Well, I think -- Paul, it's Dave. I think we have to do 2 things. I think we have to refresh and strengthen the product portfolio, which we've been in the process of doing. I think we're now in a very good place with respect to product portfolio. And then we have to continue to align the sales force to target the right customers and get channel up and running and efficient to help deliver those products into the marketplace in there. And I think that, as you know, building out a 2-tier channel organization is a long process. We've talked about it being a long process. We're continuing to make progress there. We don't see any need to change what we're doing strategically there. And we'll just continue building the strength of that program until that comes back in the line.

Paul H. Mansky - Cantor Fitzgerald & Co., Research Division

From a macro perspective, and last one for me, I just -- just to kind of follow up on that. From a macro perspective, have you seen a disproportionate weakness in more of the commercial segment versus the Enterprise that maybe aggravating some of that dynamic?

Jason Nolet

I don't think so. I think as we look across the portfolio, I think we're really happy with the products that are there. We're really happy with the sales and the channel and the go-to-market. And it's a business that tends to be a little bit lumpy. But just as an example, if you take things like the ICX switches, we sell those products into Service Provider data centers and into Enterprise data centers. We sell them into Fed. We sell them into traditional enterprises, education, healthcare facilities. And they're selling well into all those environments. There's no one environment that's stronger than another one. And as we slice and dice those numbers and report the numbers, because of the lumpiness of some of the deals, it probably artificially accentuates some of the ups and downs in those markets. But I would just say, in a broad perspective, we're doing very well in those markets. And the channel is working, the sales guys are working.

Operator

Our next question is from Aaron Rakers with Stifel, Nicolaus.

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

I want to go back to Paul's earlier question. When I look at your director business and in the context of your 3% to 6% sequential growth for the January quarter, if I look back over the past 3 years, it looks like director's been up anywhere from 13%, 18% sequentially in the January quarter. Are you kind of assuming a similar type of seasonal trend in that director business? Or I guess back to Paul's question just in the context of the switching business, how are we thinking about those 2 compared to one another?

Jason Nolet

Yes. We didn't expect any dramatic -- this is Jason. I wouldn't expect any dramatic changes in the seasonality here for either directors -- director class products or the switch products. I mean, there's nothing foundational there that's going on. They still kind of play the same role they've always played and the same markets they've always played in. So I don't think there's any foundational shift going on there.

David B. Stevens

Yes. One comment that I would make, Aaron, this is Dave, is that as we ship out and begin to ship the 16-gig products in all those OEM partners, it's not a wholesale switch over to 16-gig. It didn't happen in all products across the entire portfolio. So we're -- it takes a little bit of a period of time to roll 16-gig and the new capabilities across all the products. We're in a period of rolling out all those products. They're all rolled out now, but they came out at slightly different times, which may account for some of the lumpiness in that space. I wouldn't read more into it than that by the directors, so the switch is in the last part of the portfolio, which is where the last part of the portfolio that rolled over to 16-gig completely.

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

Okay. And then a second question, with regard to your gross margin relative to the long-term model that you'd laid out at the Analyst Day, I think 63% to 64%, you guys are obviously running a healthy rate above that target model, particularly in the product gross margin. As you look out over the next couple of quarters, I mean, is this the kind of run rate on the gross margin we should think about in the product? Is there anything that would change that here as we look out, let's say, through to fiscal 2013?

Daniel W. Fairfax

So fundamentally again, we reiterated the model we shared on Analyst Day. It's -- if we look at interim periods, its mix dependent most heavily. So the mix of Ethernet to the Fibre Channel products is the most dramatic influence there. And so that's -- depending on -- again, as you see some seasonality, we're recognizing that we have Federal seasonality in the Ethernet business Q1 that will be down a little bit. Other than that, our management of period costs, such as warranty or excess and obsolete reserve formation, are the other factors. And we've been disciplined about managing our operating expenses both in the factory as well as sales and marketing and engineering.

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

Okay, very good. Final question for me is you've been adding about 100 to 150 net new VDX customers a quarter. Over the past year, has there been any change, or this past quarter, any kind of appreciable change from some recent product launches within that net new customer base that you'd like to call out?

David B. Stevens

Changes with respect to the type of customer or size of customer, is that the question?

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

Yes, more so deal size, type of customer, deal size patterns, et cetera?

David B. Stevens

Yes. I mean, we've seen an increase. I mean, I think the success we had in the first year of shipping product was to see a lot of pilot projects in a lot of accounts. And now we're seeing a fair number of those accounts scale out into broad production use of the technology. In fact, some of the customers hitting the limits of the capacity of the technology that we had in current releases, and we'll have expanded as we introduce the VX 8770. But yes, I would expect over time, we're going to see more scale out production use of the technology, both with -- within installed base where we sold the product to date but also as we gain new name accounts going forward.

Operator

Our next question is from Amitabh Passi from UBS.

Amitabh Passi - UBS Investment Bank, Research Division

Just a couple of quick ones for me. You got to $250 million of OpEx for the January quarter, including Vyatta. Should we expect the OpEx level to stay at that level for the next couple of quarters, including Vyatta? And then just on your uses of cash, you've been delevering and buying back stock. Is there any appetite to continue to delever further? Or stock buybacks become the primary use of excess cash?

David B. Stevens

So -- make a couple of comments. So again, we're saying we'll stay within the model in terms of operating expense. And we've laid out some guidelines there as a percentage of revenue. So including the Vyatta acquisition, which we baked into the $250 million. And I think the other thing to give you a little color around our thinking is we have recognized that we made significant investments in the business kind from the end of 2010 through '11. And we said we really wanted to turn that back into additional leverage in the model. So I think that's the way you should think about operating expense. From a cash standpoint, we're certainly quite pleased that the strength of our product portfolio is allowing us to generate so much cash in the business. Good working capital [indiscernible] and control certainly helps as well. We've said -- in terms of priorities, we certainly we want to offset the dilution from our equity award programs. Beyond that, we're looking where we need to. And we don't have too many things that we don't actually have control within our engineering, around technologies we need. But Vyatta is an example of the type of acquisition you might see us make. So that's clearly on the table still. And then further use of cash would be both the strength in the balance sheet. And if we can see opportunistically a way to take shares off the market at these attractive prices, we're going to be interested in doing that as well.

Amitabh Passi - UBS Investment Bank, Research Division

And maybe just one quick follow-up, the strength in cash flow in the quarter, was that typical seasonality? Was there any specific element that drove further strength in the quarter?

David B. Stevens

I'm sorry, what was the first?

Amitabh Passi - UBS Investment Bank, Research Division

That cash flow, the strength in it...

David B. Stevens

So there's a little bit of an impact from timing. So the way our last payroll played out, it was still on our bank account rather than having been paid at the end of the quarter. But other than that, working capital -- a little bit of timing around some of the periodic payments like our interest payment on the bond, some annual interest payments due in the first quarter, not in the fourth quarter. Other than that, there wasn't much else going on.

Operator

Our next question is from Keith Bachman with Bank of Montreal.

Keith F. Bachman - BMO Capital Markets U.S.

And I apologize in advance for the background noise. I wanted to get your thoughts on -- going back to the SAN market and what you think your growth rates are, if you look at calendar year '13, and more specifically, you've mentioned upgrades to the installed base of your existing installed base, where do you think you are in that process of upgrading your current installed base? I'm just trying to understand how much run rate is left in that? And the second part of that question is there isn't a lot of mixing of environments. So where would you be winning share against Cisco, since it's hard to believe that the SAN market in of itself grew 10%, which is your numbers. So where are the share gains that you think you're getting? Or is it more a mathematical issue, where your installed base is upgrading and Cisco's obviously isn't. And then I have a follow-up question.

Daniel W. Fairfax

Yes. There were, I think, at least 3 components to that question, at least, if I can remember from memory. So I've got that -- on market growth, I'd reiterate what we said in our last Analyst Day, and that is we expect 2% to 5% in FY '13. With respect to winning share, if you look at share in this market kind of over the last 4 or more quarters, you see that we bounced back and forth between 3 and 5 points one way or the other. So some quarters will be up to 70% share and then we'll bounce back down to 65% and back and forth. And it is very circumstantial with respect to given deals and transactions where we might either be taking out an MBS account or, as you pointed out, finding a big refresh opportunity in the existing installed base. And that's maybe the second question you asked, and that is where do we think we're at in terms of mining that installed base? I'll tell you that we think there's a fair bit of that still in front of us. We have legacy 48K [ph] products and DCX products, other products having been in this market for the last 15 years, where we think there is many billions of dollars of opportunity left to mine there. So we're taking advantage of that as we work through each of our OEM partners and as they're looking at events that allow them to go back and then mine their installed base such as transitions on the storage side and putting together programs and incentives to do just that.

Keith F. Bachman - BMO Capital Markets U.S.

Okay, all right, great. And a follow-on comment, you've been growing above the SAN market for the last, well, for the year and going below your targets for the Ethernet side. Given that the sales model changes you made in the first half of the calendar year, when would you anticipate reaching your targets? I mean, is this a quarter away or 6 months away to get back onto your kind of target Ethernet growth objectives?

Michael A. Klayko

Yes. I think we have all the pieces in place now that we should be experiencing steady performance and growth across all segments of our business.

Keith F. Bachman - BMO Capital Markets U.S.

Okay. Is that a -- Mike, is that kind of a mid-year thing in calendar '13 or is that the near-term objective to reach at?

Michael A. Klayko

That's a near-term objective right now. As in -- I think we have everything we need right now to continue to grow our business.

Keith F. Bachman - BMO Capital Markets U.S.

Okay, all right. Well, last question, I'll cede the floor, is if you could just give an update on your thoughts on the potential real estate transaction. And that's it for me.

Daniel W. Fairfax

Sure. So in terms of the San Jose Campus, which is what Keith is referring to, so we have explored the value that we could unlock in terms of monetizing the campus. At this point, because of our strong operating cash flows, also availability of alternative sources of funding should we want to tap into it, we're at this point not intending to move forward monetizing the campus.

Operator

Our next question is from Mark Sue with RBC Capital Markets.

Mark Sue - RBC Capital Markets, LLC, Research Division

Can I ask a question on just the longer term, what happens to Fibre Channel after 16 gig? What are your customers indicating, recognizing that we're still in the early stages of the upgrade? And then on Ethernet, I guess the thought is there might be -- the business might benefit from some focus, whether it's end markets or verticals. Is there some thought of driving that deeper into the data center and perhaps less in the campus and less in the Enterprise just because the market doesn't seem to be growing that much? And it is very crowded.

Jason Nolet

Mark, this is Jason. I'll get started on that. So in terms of what's next going forward in SAN, first is, as I mentioned earlier, there's a massive opportunity with the installed base and get everybody up to 16-gig and all the functionality that comes with 16-gig. Beyond that, and having really established what would probably be ending up doing a 1- to 2-year lead in the platform technology, we're going to be investing fairly heavily on the software side of the portfolio to improve manageability, improve visibility, give customers kind of application end-to-end visibility in their storage networking environments. And so that's kind of the next big wave of capability you'll see delivered from us. And then candidly, we expect to see another speed bump in this technology, kind of commensurate with the timing that we've done in the previous speed bumps. I mean, customers are really very consistently asking us to continue to invest and move the technology forward. The second part of your question was with respect to Ethernet in the data center versus the campus. Is that right?

Mark Sue - RBC Capital Markets, LLC, Research Division

Just -- I mean, as you try to do many things with Ethernet, and the net result is that the business maybe could be growing a little bit faster if you focus your resources on a particular end market.

Jason Nolet

Got it. So maybe I'll start there and Dave can jump in. So I'll tell you that on the other data center side of our initiatives, we have a substantial investments in our VCS fabric technology, and that how we've been able to get to an installed base of more than 800 customers. And we're exiting FY '12 at about a run rate of $50 million. We think we can do $100 million next year in that technology. And so we think we have the optimal investment on the Ethernet fabric and VCS fabric technology part of the portfolio. And it's really not being compromised by continued investments in campus switching.

David B. Stevens

Yes. Mark, the comments that I would make -- this is Dave, the Ethernet products get sold into different parts of the marketplace, into the Service Provider space, in transport, in cloud data centers, in Enterprise data centers and then, as you said, campus and Enterprise networks. And we picked those apart individually. We'd put an appropriate level of investment in each of those areas, and we have specific go-to-market strategies in terms of what products we develop for what problems in each of those space. And I think, as Jason said, I think we feel like we're investing in the right things there in the data center. We're investing in fabrics and discontinuous technologies there that are growing very rapidly off a small base, as Jason just articulated. In the Enterprise Campus, in general Enterprise space, the growth there is slower. But we also invest less proportionately there. And then we're continuing to invest fairly aggressively in the Service Provider space. And I think what we've ultimately done is positioned ourselves where we believe that we can grow really above the organic market growth rates in each of those markets by investing in the right spots and at the appropriate level. So we're pretty happy with what the portfolio looks like today.

Mark Sue - RBC Capital Markets, LLC, Research Division

Can I just follow up on the Enterprise side...

David B. Stevens

Sorry, Mark, it looked like you cut out. Can you repeat your question?

Mark Sue - RBC Capital Markets, LLC, Research Division

Sure. If I could follow up just on the Enterprise side, it's often defined by a broader product portfolio. You need some wireless assets. You need some collaboration assets. Should we see that partnership developing for Brocade as you move deeper into the Enterprise? And then separately on application delivery control, what's the future for that business? Do you double down and increase the R&D to get new products out? Or do you kind of just hold on to your installed base? Any thoughts will be helpful.

David B. Stevens

Let me answer the first side on the Enterprise and the partnerships and other opportunities there. And then I'm going to ask you to repeat the second part because you were breaking up and I don't we can hear you and probably Ken will pick that up. The -- I think in each of those markets, we look for, as we said, a combination of things, organic internal development there. We look for the right strategic partnership, the right resale opportunities, potential small technology deals as Dan articulated. And I think in the campus space, for example, as you pointed out, we've had a partnership with Motorola there for about 3 years. I think that was 2009. That continues to get stronger, continues to generate more revenue. But we'd expect to continue to do things like that to drive revenue into those different spaces. But can you repeat the second part real quick, so Ken can hear you?

Mark Sue - RBC Capital Markets, LLC, Research Division

Sure. Application delivery, what's the future for that business? Do you double down, increase R&D? Or do you kind of keep your installed base happy? What's the future for that application, Layer 4-7 business?

David B. Stevens

Okay, got you.

Ken K. Cheng

Yes. Mark, it's Ken. So we are going to be laser focused with our ADX business on service providers. We continue to believe that the ADC is a critical component in the data center. And that space is actually going through a major disruption right now. So we are going to continue to invest in it. We're going to look for partnerships and integration into our overall data center solution.

Operator

Our next question is from Jayson Noland with Robert Baird.

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

I wanted to ask about gross margin in storage and Ethernet. First, on the storage side, can you give us a sense for the success you've had this year? How much of that is management and diagnostic tools versus 16-gig? I'm just trying to get a sense for the sustainability there.

David B. Stevens

We don't per se license the management diagnostic tools in a way that would drive that gross margin. It's really the adoption of the latest- generation technology, the 16-gig technology. Those tools are embedded in the operating system.

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Are customers paying up for that? Virtual Instruments, for -- as an example, has done really well in this category. And they're somewhat of a competitor to you. So are customers willing to pay more for those tools with this offering?

David B. Stevens

Yes. I mean, the latest generation of product does have a bit of a premium to it. And that's partly why because we've embedded natively into those products things that have similar kind of diagnostic standalone tool might provide. So yes, I think there is enough value there for customers to be looking for -- to be willing to pay a bit of a premium for that.

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Okay. On the Ethernet side gross margin, about flat quarter-on-quarter, year-on-year, should we expect that to be about the same structurally going forward with the exception of the help from mix shift toward VDX?

David B. Stevens

Yes. I think you've kind of called out the key dynamic there. VDX, which models out more like a Fibre Channel's SAN switch in the 70% gross margin range will certainly expand gross margin as it takes a larger share of the mix. But also the routing family, particularly, we just announced the 24-by-10, high-density blades for the MLX. Those products also have more Brocade intellectual property in them, and they're improving gross margins as well. And the redesign of the ICX family has allowed us to cost --engineer those products as well. So there's positive dynamics across the portfolio at this point. And volume has really been to this point at these levels. The revenue has been, if there's a drag, it's been volume related rather than per se mix. We're very bullish about the future.

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Okay. Last question for me. On VDX, just curious what type of attach rate you see to some of these SDN controller companies, like a Nicira or like a BigSwitch. Are those coming up in your conversations where you see customer interest in the VDX portfolio?

David B. Stevens

Yes that's a great question, and we are seeing some interest there. And one of the interesting things, and I may have mentioned this on the last call, I know I did at Tech Day. And we're seeing with network virtualization, in particular, that I think it's starting to gain a lot of interest. And that is when you think about adding another layer to the network, with network virtualization, you're going to add logical networks through tunnel technology. You're actually adding to the overall administrative burden of that environment. Because the physical infrastructure doesn't go away. It still needs to be scaled, maintained and managed to upgrade, et cetera. And so one of the things that people are saying customers are seeing with respect to the value of VCX fabrics is the ability to dramatically simplify and reduce the operational overhead of that underlying transport as a result of the very high level of automation and efficiency that we've built into the fabric. So that allows them to kind of spend more time on both the logical network infrastructure and think about how they're going to make use of that. It also prevents them from just doubling up their operational overhead as a result of having added that additional virtualization layer to the network environment.

Operator

The next question is from Matt Robison with Wunderlich Securities.

Matthew S. Robison - Wunderlich Securities Inc., Research Division

Can you give a little more color on how you think mix shift will offset Federal decline in Ethernet this quarter? Should we look more from Service Provider or from the Enterprise?

Daniel W. Fairfax

Yes. So Matt, this is Dan. So we're not providing that level of color in terms of within the Ethernet product families. Clearly, between Fibre Channel and Ethernet, you see the dramatic difference in the profitability of those 2 different product families or product segments. But we're not really, at this point, breaking out further detail there.

Matthew S. Robison - Wunderlich Securities Inc., Research Division

Can you comment on where you -- which side gives you more of a pipeline of visibility between the Enterprise and the Service Provider?

Daniel W. Fairfax

Yes. So I think what we would say is in Service Provider, when we're talking about the tier 1 through tier 3s, our visibility through our direct touch of the sales force to those accounts gives us reasonable visibility. Now we are coming into a part of just kind of that whole Service Provider CapEx year where things soften up a bit, and projects certainly can slip based on the macro. But there we’re tracking more kind of line of sight to specific problem -- projects. And I'm sorry, the other -- the...

Michael A. Klayko

Enterprise, there's has a lot of channel activity. And so sometimes we are not as engaged with as we would be on a Service Provider or some of these named accounts. And so we have, I think, greater visibility and the headlights into the SP deals, large Fed deals and more so, in the Enterprise.

Matthew S. Robison - Wunderlich Securities Inc., Research Division

This topic might have been touched by the earlier questions. But with Cisco purchasing Meraki, kind of --I know Motorola's got kind of a nascent cloud-managed WiFi controller. Do you have any initiatives in place to try to participate in that growing segment of the market?

Michael A. Klayko

Well, frankly, I'd -- if you look at that, one of the things we're focusing on is, here from Jason and Ken, is we've got a high focus right now on a lot of the data center activities and the Ethernet fabric activities, the SDN activities. These are things that are keeping our plate full and have a lot of activities going on for us. I think we have a product offering in the wireless space that is good enough for the customers as when we go to market. And so it's not something that was actively being pursued by us. But the fact that from a margin component, if you look at the other areas when they have a much better margins profile, and so we'll stay with more of data center focus out, then kind of the Enterprise campus in.

Operator

Our next question is from Brian Marshall with ISI Group.

Brian Marshall - ISI Group Inc., Research Division

If -- I just have one question. If we kind of step back and look big picture, it's been roughly 4 years since Foundry has closed. And since that time frame, the gross margins on the Ethernet IP business had been down about 1,000 basis points. Obviously, it's been a pretty challenging environment. But the competitors haven't declined that much, perhaps half that, maybe 500 basis points or so. So I guess the question is, can you talk about what's the predominant driver of that decline? And how much we can expect to recoup that decline back and over what time frame?

Daniel W. Fairfax

Brian, this is Dan. We can describe a significant majority of that change in gross margin to our decision to move to 2-tier distribution. So if you remember back to the Foundry model sold principally direct fulfilled through partners, so efficient from the standpoint of passing margin to the partner community. Here, we put in distribution so we have margin sharing going on at a couple of different tiers within the business. And also we've ensured our support model for scalability, so there's been other investments made there as well that have -- currently have impacted the profitability with the goal that they have a much more scalable business, that will grow with less additional below-the-line sales and marketing spend.

Brian Marshall - ISI Group Inc., Research Division

And Dan, as a follow-up, do you think half of that can come back?

Daniel W. Fairfax

We're not -- we haven't put specific objectives out there. I think it -- I guess I would say, you can see just even over the last few quarters how sensitive the business is to volumes, so overhead absorption being pretty key. So I think it's very reasonable between mix and scaling the volume without having to add a lot more costs either in the factory or below the line. But that's -- that would be a reasonable assumption.

Operator

Our next question is from Erik Suppiger with JMP Securities.

Erik Suppiger - JMP Securities LLC, Research Division

First just wanted to clarify, did you say that your VDX run rate is $50 million and you want to do $100 million in '13?

Daniel W. Fairfax

Yes, that's right.

Erik Suppiger - JMP Securities LLC, Research Division

For that $100 million, is that a run rate as you exit '13? Or is that $100 million in revenues in 2013?

Daniel W. Fairfax

Well, I think the way we would like to frame it is, we don't really think about launching a major product initiative like that without a goal of achieving $100 million of revenue. We're not giving any specific timing on when that achievement will happen. But we feel quite happy with the fact that we're -- we have this run rate of $50 million now, and it's growing.

Erik Suppiger - JMP Securities LLC, Research Division

Okay. Just to be clear, though, are you talking fiscal '13 or calendar '13 when you talk about that?

Daniel W. Fairfax

Most of our thinking is around -- typically around our fiscal year.

Erik Suppiger - JMP Securities LLC, Research Division

Okay, very good. On the channel, the ICX is performing pretty well with the channel. How -- what kind of momentum do you feel like you're getting with channel partners? And who are you attracting partners from?

David B. Stevens

This is Dave. The -- I think the momentum is actually good and getting better. I think as we've said before, it takes a while to put an effective channel program in place, get partners ramped up and engaged in the program, get people trained, get systems moved over. And then once you get that going, it tends to have a little bit of inertia to it and continues to go forward. The feedback on the channel program has been excellent over the last 18 months to 24 months, and we're continuing to see more traction. I think that the program -- the people in the program, we don't come out and name specific partners. But they're some of the best in the industry that have spent a long time looking for better business models and for better partners and for differentiated products to move into the customers outside of some of the traditional products that they've sold. And so that value proposition, the ability to make money from those channel partners and get support from us continues to resonate. And we continue to recruit people into the program.

Erik Suppiger - JMP Securities LLC, Research Division

Can you comment how much growth you've seen in terms of the number of channel partners or give us some kind of metric on how your footprint has expanded over the course of the last year?

Daniel W. Fairfax

I can't give you specific numbers and great [indiscernible]. But I would tell you that we have enough channel partners today to cover the customer base that we want to cover. And we've got the right mix of different types of channel partners within the program. We're pretty happy with it.

Erik Suppiger - JMP Securities LLC, Research Division

Okay. Last question, the accrued comp picked up -- grew pretty considerably in the quarter. Anything going on with cash and accrued comp that would have been -- have prodded [ph] your cash to pick up this quarter and then come back next quarter?

Daniel W. Fairfax

No. What you're picking up, Erik, is that our variable incentives we accrued through the end of the fiscal year and then we pay them in the first quarter. And the way we manage our workforce is that every employee has some portion of their compensation that's based on either corporate targets, the total shareholder return in the case of the executive team, and then down to the individual which would be more MBL based.

Operator

Our next question is from Rohit Chopra with Wedbush.

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

A couple of questions. Just wanted to get a sense of sale cycles now as you see them in close rates and if there's any changes going on, maybe across SAN and Ethernet, if you could answer that. And the other question is, if you could update us a little bit on the competitive environment. I know there's a question answered about discounting in the router area, but if you could just talk a little bit about that in context -- in the context of improving margins in Ethernet.

Michael A. Klayko

I'll talk about sale cycles. I actually think the -- we've become more efficient. I think we've had better tools. We can actually quote in a much more rapid manner in terms of working with the customer, designing alternative architectures. We've given the sales force a variety of new tools to make that process faster, so they can get and engaged in more activities. And so the amount of activities also we've seen is increasing the number of times we're stepping in the plate. And so those are all positive indicators. And these are based on investments we've made in the past. And so it's now just utilizing the investments, not making any additional investments. I don't think that's any different in both the IP or the SAN environment.

David B. Stevens

I'd -- the only comment I'd make on the competitiveness is I think it continues to be very competitive for deals of the marketplaces, like indicated, that's fine with us. We've been positioned for an attack as an attacker in that space for an extended period now, so we don't expect that to have really impact on us. And I would say within that environment, we continue to be able to pursue the same margin enhancements that Dan talked about by increasing volume and getting to the right mix and incorporating more Brocade technology into existing products and selling more of the VDX products. So it's kind of steady as she goes.

Operator

And our final question is from Scott Schmitz with Morgan Stanley.

Scott Schmitz - Morgan Stanley, Research Division

Just on -- I just want to go back to the $10 billion of SAN installed base. Do you have a better sense or can you give us any kind of indication as the average age or speed of that infrastructure? And how much is really the prime candidate for upgrade over the next year?

Jason Nolet

Yes, this is Jason. So it is dominated by 4-gig and 8-gig installed products. There are a number of product lines that have either achieved end of sale or will achieve end of sale. And that obviously motivates customers to do the upgrade. What was the last part of your question?

Scott Schmitz - Morgan Stanley, Research Division

I was just looking at -- if you're looking for a pipeline of trying to distill the $10 billion into what's really the -- a candidate for upgrade this year? How much of that $10 billion?

Jason Nolet

Yes, I'm not sure I could quote you a number to be honest. I mean, where we're focusing, as I mentioned earlier, is while we do have a fair number of standalone SAN refreshes that are done, we get the most momentum when we tie those refreshes to storage refreshes. And so working with each of the major OEMs, I can tell you we have incentives and programs in place with all of our tier-1 OEMs today to take advantage of either storage refreshes they've got going on or those that will come into play in the next 3 to 6 months. And so we're pretty happy with the kind of portfolio sales programs and incentives we have in place to go drive as much of that turn as we can.

Scott Schmitz - Morgan Stanley, Research Division

Okay. And just one last question for me. Just on the inventory, your OEMs. In the past, that's been -- they've drawn that down. Do you expect an inventory drawdown on the SAN side exiting the January quarter? And how much of that is factored into your guidance?

Daniel W. Fairfax

So what we've been seeing certainly over the last, I think, 4 quarters now is those OEM inventories have been running about a week to 2 weeks that stayed pretty well bounded. We've been down just above a week and in the last couple of quarters been 1.5 weeks or pretty flat. So it's a little -- it's always a little bit hard for us to guess where it might land more specific. Because each OEM, depending on the kind of projects that's working on, whether they're at a particular point in their fiscal year, all those dynamics affect it.

Michael A. Klayko

Okay, yes, thanks. Let me just finish up here. This is Mike. I want to thank you. Before the operator closes the call, I just want to make a couple of comments. First, I'm very proud of what we've done at Brocade and what we've accomplished in the last several years. And I believe we've truly enabled the era of the virtualized network through thought leadership and industry-advancing products and technologies. And I -- in addition, we've proven our strategy is working. And we've been able to execute in the face of dynamic macro conditions and market conditions, as well as ever-increasing network demands. Brocade has got a strong leadership team with many years of network experience, an outstanding financial position. And as we announced on the last earnings call just for one more time, I'm going to be transitioning out of my role as CEO once the -- my successor has been named. I look forward to a very smooth transition once such an announcement is made. In the meantime, my executive team and I will continue to drive execution, innovation, product development and financial discipline as we meet all of the objectives we've laid out for FY '13. I want to thank everybody for their time and especially, their questions today on the call. And with that, operator, I believe you can conclude the call.

Operator

Ladies and gentlemen, that does conclude today's presentation. We appreciate your participation.

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