Brocade Communications Systems Q2 2006 Earnings Conference Call Transcript (BRCD)

Brocade Communications Systems (BRCD)
Q2 2006 Earnings Conference Call
May 18, 2006, 5:00 p.m. EST

Executives:

Darby Dye, Investor Relations
Michael Klayko, President, Chief Executive Officer
Richard Deranleau, Chief Financial Officer
Tom Buiocchi, Vice President, Marketing and Support

Analysts:

Paul Mansky, Citigroup
Thomas Curlin, RBC Capital Markets
Henry Naah, Lehman Brothers
Aaron Rakers, AG Edwards & Sons
Andrew McCullough, Credit Suisse First Boston
Mark Moskowitz, JP Morgan
Mark Kelleher, Canaccord Adams
Samuel Wilson, JMP Securities
Kaushik Roy, Neuberger Berman
Brent Bracelin, Pacific Crest Securities
Min Park, Goldman Sachs

Presentation

Operator

Good afternoon. My name is James and I will be your conference facilitator. I would like to welcome everyone to Brocade's Second Quarter Fiscal 2006 Financial Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer period. Operator Instructions Ms. Dye, you may begin.

Darby Dye, Investor Relations

Thank you. Good afternoon, everyone. I am Darby Dye, filling in for Brocade's Director of Investor Relations, Shirley Stacy, who is currently on maternity leave. Joining me today are Michael Klayko, Brocade's CEO; Richard Deranleau, Brocade's CFO; and Tom Buiocchi, VP of Marketing.

Before we begin, let me cover some housekeeping items. Brocade issued a press release detailing our second quarter financial results today via PR Newswire and FirstCall. This press release is available on our website at http://www.brocade.com/. This conference call is being audio webcast and will be archived on our website for approximately 12 months. A telephone replay will be available today by approximately 6 pm Eastern Time through end of day Thursday, May 25th. To access the telephone replay, dial 800-642-1687 or 706-645-9291. The pass code for this call is 8250527.

As a reminder, the information the presenters discuss today will include forward-looking statements, including without limitation statements about Brocade's financial results, business outlook and guidance. These forward-looking statements 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, 2005, and our 10-Q for the quarter ended January 28, 2006. These forward-looking statements reflect belief, estimates and predictions as of today, and Brocade expressly assumes no obligation to update any such forward-looking statements.

Certain financial information that we review on today's conference call is presented on a non-GAAP basis. The most directly comparable GAAP information and a reconciliation between the non-GAAP and GAAP figures is provided in our Q2 '06 press release, which has been furnished to the SEC on Form 8-K, and in the corresponding Q2 '06 slide presentation posted on our website at http://www.brocade.com/investors.

In addition, the presenters will discuss sell-through information, which provides a measure of OEM and channel partner sales to end-users. Brocade does not record revenue based on OEM sell-through information, and this measure is not intended to be viewed as a substitute for reported GAAP revenue. Sell-through is a measure of demand, but is not a GAAP measurement of revenue, and therefore is not subject to the same level of internal controls as reported GAAP revenue. Please note that certain reclassifications have been made to prior-year balances in order to conform to the current-year presentation. With that, I will now turn the call over to Mike.

Michael Klayko, President, Chief Executive Officer

Thanks, Darby. Good afternoon, everyone, and thank you for joining us. Today, I will briefly discuss our results for the second quarter, highlight our performance across our product lines and growth initiatives, and give our perspective on what we're seeing in the market. Following my remarks, Richard will provide more detail on our Q2 financial results and outlook for Q3.

Our results for the second quarter of fiscal 2006 were outstanding and certainly exceeded our expectations for what is historically our seasonally softest quarter. Q2 revenue was a record $182.7 million, an increase of 7% sequentially and 26% year-over-year. This was substantially better than our revenue guidance of $157 million to $162 million for Q2. Non-GAAP gross margin for Q2 was 58.6%, and non-GAAP operating margin was 16.6%. Q2 non-GAAP diluted EPS was $0.10 as compared to $0.10 in Q1 '06 and $0.07 in Q2 '05. This exceeds our non-GAAP EPS guidance of $0.05. Our product sell-through for the quarter was also a record at approximately $178.6 million.

Now, let's look at some of the detail about Q2 performance. We saw balanced strength across all aspects of our core SAN business and continued progress in our newer Services and Tapestry initiatives. I will briefly touch on each of these, starting with our traditional SAN SilkWorm business. Q2 was the second strongest director quarter in the Company's history, trailing only our Q1 of this year. Historically, Q1 is our seasonally strongest director quarter. The SilkWorm 48,000 continues to gain momentum in the most demanding enterprises, and has become the acknowledged benchmark product in the director segment. Customers and partners are responding favorably to the strength of our vision and product roadmap and our ability to continually deliver high-quality enterprise solutions. Our director performance was fueled by a significant number of competitive wins and by broad acceptance across all geographies.

Examples of key customer wins include Swiss insurance firm Swiss Re, Halifax Bank of Scotland, Samsung Life Insurance, Korea National Tourism Organization, Countrywide Financial, Best Buy and Qwest Communications.

We saw very strong performance in our switch business with exceptional sequential growth. In fact, we sold more switches this quarter than in any other quarter in the Company's history. The performance and flexibility of our SilkWorm switches allows us to cover a wide range of very competitive price and configuration points for customers and partners, and this has increased our market opportunity.

We also had a record quarter and outstanding growth sequentially for embedded SAN switches across our major server OEM. We continue to believe that shared storage networks are a key enabler for new bladed computing solutions, and that our strength in blades enhances our overall enterprise offering. We continue to be the only SAN infrastructure provider with an end-to-end 4-Gig offering and the only provider of a common operating system across our entire portfolio of products including blades, switches and directors. This is a very clear and differentiated value proposition, and gives customers flexibility and confidence while lowering their overall complexity and cost of ownership.

In Q2, we saw strength across all of our products, across all of our partners and across all of our geographies, particularly in North America, where we had exceptional performance. We believe this translated into an overall market share gain for Brocade quarter-on-quarter.

We continue to execute well on new products and capabilities, and in Q2 announced four important new products that further strengthen and differentiate our SilkWorm SAN offering. We introduced the SilkWorm 4900, the industry's only high-performance 4-Gig switch that scales to 64 ports. Also, two new products that add the industry's first 4-Gig SAN routing and the industry's highest performance FCIP capabilities to our enterprise offering. And in addition, an iSCSI bridge that allows customers to seamlessly connect entry-level servers to their existing SAN deployments.

These new products are just completing their qualifications at most of our OEMs, and over the last week, both IBM and EMC have made availability announcements. We expect our other partners to be in the market with these products in Q3 as well.

In Q2, we continued to make significant progress in our growing Tapestry and service initiatives. Our Tapestry solutions complement our SilkWorm switches and directors to simplify the complexity and to lower the cost of managing data, both within and around shared storage networks. Historically, Brocade has focused on infrastructure solutions to help customers with their block-oriented data.

At our March analyst day, we introduced the concept of a File Area Network or FAN. This is an emerging market opportunity to help customers solve infrastructure and data management issues related to their file-based data. As reported by industry analysts, files typically account for between 60% and 80% of a company's overall data. So, this opens up a tremendous new opportunity for Brocade. The ability to identify, manage and control access to specific documents, spreadsheets or other files is key for company’s struggling to balance regulatory requirements with a burgeoning volume of files being created.

We are investing in File Area Network technologies and partnerships to bring customers the same benefits in managing their file data that we have for their block data with our SAN solutions. In the last few months, we have made significant progress in delivering technologies and partnerships to deliver enterprise file solutions.

Let me review a few of our recent announcements. As you will recall, in early March, we acquired NuView, a leader in global file management solutions. The integration with NuView has gone exceptionally well, both from a personnel perspective and also from a technology and product perspective. NuView brings us a suite of software products and technologies that help to globally manage a company's growing population of files. These products, like our Tapestry WAFS product, are based on Microsoft Windows Server 2000 platform and tightly integrate with our WAFS solution to give Brocade the unique ability to deliver global file solutions across an enterprise, from data centers to remote offices.

On May 9th, we announced a new partnership with Packeteer, the leading supplier of WAN optimization solutions, who recently announced their agreement to acquire Tacit Networks, a provider of WAFS solutions for branch offices. Brocade and Tacit initially entered into a product and distribution agreement in May of 2005. And this new partnership with Packeteer will drive enhanced product capabilities for our WAFS solution while also preserving Brocade's exclusivity in providing this solution to our OEM partners.

Now, partnerships are critical in the emerging File Area Network space, and we continue to work with other leading partners globally to deliver enterprise file solutions. Our existing SAN partnership with Network Appliance has expanded, as we now are providing NetApp the technology for their VFM products based on NuView technology. In addition, we are partnering with Nortel on WAFS technology and branch office solutions, and have recently expanded our partnership with Microsoft as part of their branch office initiative.

During Q2, we added several new customers to our Tapestry application resource manager, or ARM early access program. And we expect to begin to recognize revenue for this solution in Q3. Based on their early experience, these customers are telling us that ARM enables breakthrough efficiencies in the data center. As one customer told us, and I quote, "I am now able to bring up newly configured servers in a matter of minutes versus what would have taken one or more days." In all cases, we're hearing that ARM can greatly reduce the cost of dedicated servers and staff.

Likewise, customer interest in our Tapestry Data Migration Manager or DMM continues to grow. At our April executive customer council, several of our largest North American enterprise customers remarked that they viewed this capability as a major differentiator when evaluating Brocade's complete enterprise offerings. A number of our customers have opted for Brocade to deliver a data migration service based on Tapestry DMM, and in these cases, we utilize our growing professional services team to deliver an efficient and predictable migration across heterogeneous storage devices. We have achieved a very high customer satisfaction rating for these services thus far, and expect that this will continue as an important component of our overall offerings going forward.

On the subject of Services, we had strong results and metrics in Q2. We continue to find that our customers resources are stretched, and that both they and our partners value our expertise and experience in proactively architecting and optimizing shared storage networks. In Q2, we achieved almost 200% growth in our service bookings year-over-year and strong growth sequentially. In addition, we increased our professional service engagement by three times over last quarter, some of which were performed in conjunction with our OEM partners. These positive results demonstrate and validate our Services expertise and capability, both for customers and for partners.

Earlier in the year, we had projected we would exit the fourth quarter of fiscal 2006 with Tapestry and Services each comprising 5% of our total revenue. We are very pleased with the progress we're making on these initiatives. And while we are still on track for them to represent a combined 10% of revenue as we exit Q4, the mix may shift a bit more to Services as customers choose to procure some of the new Tapestry technologies through our Services offering. We will continue to monitor this and provide you with updates in order to help you assess the progress of these important new initiatives.

Before turning the call over to Richard, I would like to step back and briefly provide a few perspectives that I believe are driving Brocade's growth and performance, both from an industry and a company perspective. First of all, the market fundamentals driving the need for shared storage networks and data management are healthy. The amount of digital information that companies produce today is at an all-time high and growing rapidly. If you look at any industry report or talk to a few companies, you will find they are reporting between 60% and 100% data growth every year, and expect this high data growth rate to continue for the foreseeable future. It's driven by e-mail, it's driven by globalization, it's driven by the need for business continuity and compliance.

Not only is the volume of data growing, but companies must retain records longer, manage them more carefully and provide access to them for more people in more places than ever before. This pertains to both block and file-formatted data. And the volume of data, particularly the file data, is often very decentralized, creating enormous data management challenges across the enterprise.

Finally, the visibility of these challenges has never been more obvious to senior management. Compliance and corporate governance is driving unprecedented accountability for data well beyond the IT organization. It's now at the CEO level, the CFO level and the General Counsel level.

When you look at these macro trends together -- the data growth, the need to retain data longer, the need to better manage decentralized data across the enterprise and the heightened accountability for this data. The bottom line, there's a long-term, growing need to more efficiently store and manage data. And this provides a tremendous opportunity for Brocade.

A second important factor in the market now is that the transition to proven, high-quality, 4-Gig solutions has accelerated. There are both product and service implications within this market dynamic.

Several of you have asked us to judge the pace of the transition to 4-Gig technology, so we look at some historical Brocade figures. It took Brocade over five years to sell our first million 1-Gig ports. It took us about 24 months to sell our first million 2-Gig ports, and I'm pleased to report that recently we have passed our first million 4-Gig ports in approximately 16 months. This speaks to a combination of market acceptance, compelling price performance, strong customer confidence and choosing a supplier that offers superior solutions and a clear vision and roadmap for adding value to the SAN without compromising quality, ease-of-use or interoperability. We expect the rate of change to new 4-Gig platforms to continue to accelerate in the second half of 2006, as 4-Gig HBAs and storage arrays gain momentum in the market. We led the transition to 4-Gig, and have established a very credible leadership position with the performance and quality of all of our 4-Gig products, and expect to continue to drive and to benefit from this ongoing market transition.

But much of the market acceleration and momentum is not just 4-Gig as a technology. It's about helping the customer to assess, to architect, and manage change required to move to a new technology platform and shared storage infrastructure. This is an area where Brocade truly differentiate by bringing over ten years of best practices to customers worldwide. This also highlights the importance of our expanded Services offerings, as we realized it is equally important to help customers optimize their investment in these new technologies with deep expertise and assistance.

Finally, one very important trend we're beginning to see, and one that specifically pertains to Brocade's market position, is that customers are beginning to view us in a broader context with broader relevance, which in turn leads to broader opportunities. We are obviously pleased with the results stemming from our SAN product line position, our technology lead and our compatible 4-Gig top-to-bottom offering. But we are equally encouraged that customers are now beginning to look to Brocade to address broader challenges in their enterprise.

Let me give you some feedback and an interesting data point from 50 recent North America customer meetings in Q2. While all of the customers were interested in our director and switch roadmap, there were over 100 requests for proposal and follow-up on services, file management, data migration, ARM and distance connectivity. This means we generated two new opportunities per customer from customers who know and trust us. This is a small sampling of our very large installed base, but it demonstrates the compelling value proposition of our strategy and our investments in incremental, high-value capabilities. This is a major shift from even six months ago, and begins to paint the picture of our opportunity to help customers solve broader data center and data management challenges.

Customers are interested in our full story: the industry's most complete SAN product line, an architectural roadmap for emerging file area network solutions, software to help manage and optimize their shared storage infrastructures, and services to help assess, architect and optimize their next-generation data centers.

One final note. As you saw from today's press release, we're pleased to announce that Richard Deranleau has been named Brocade's CFO. I will now turn the call over to Richard for a review of our Q2 financial results, and then I will be back with some concluding remarks and Q&A.

Richard Deranleau, Chief Financial Officer

Thank you, Mike. I will now turn to a review of our Q2 results, beginning with our income statement. Q2 revenues were $182.7 million. This represented an increase of 7% sequentially from $170.1 million in Q1 ‘06, and 26% year-over-year from $144.8 million reported in Q2 ‘05. Q2 sell-through was approximately $178.6 million, an increase of 3% sequentially from sell-through of approximately $173.6 million in Q1 ‘06 and an increase of 23% year-over-year from sell-through of approximately $145.4 million in Q2 ‘05.

Non-GAAP diluted EPS was $0.10. This compares to non-GAAP diluted EPS of $0.10 in Q1 ‘06 and non-GAAP diluted EPS of $0.07 in Q2 ‘05. Reporting on a GAAP basis, Q2 ‘06 EPS was $0.05. This compares to GAAP EPS of $0.04 in Q1 ‘06 and GAAP EPS of $0.08 in Q2 ‘05. Our effective non-GAAP tax rate in Q2 was 26%.

Non-GAAP net income for Q2 excludes charges of approximately $6.4 million in net stock-based compensation expenses; $0.6 million for amortization of stock compensation expense related to prior acquisitions; $3.8 million in lease loss for facilities, based on recent valuations of our global lease holdings; $0.5 million for the amortization of intangible assets; and $0.6 million in compensation expense related to our acquisition of NuView; $3.2 million in costs associated with the ongoing SEC investigation; and $2.1 million associated income tax effect of the non-GAAP adjustment.

In Q2 ‘06, the impact of FAS 123(R) was $4.6 million, and is included in the $6.4 million in the net stock-based compensation expense, which we have excluded from our non-GAAP results. The difference between the two is the $1.8 million in stock compensation expense for certain stock awards accounted for on a variable accounting basis. Non-GAAP gross margin for Q2 ‘06 was 58.6%, above our guidance of 56% to 57% and at the high end of our target model of 55% to 58%. This compares to non-GAAP gross margin of 60.2% in Q1 ‘06 and 57% in Q2 ‘05.

Q2 ASP decline were in the low single digits, similar to Q1, again reflecting a more favorable pricing environment. Q2 ‘06 non-GAAP operating expenses excluding the items referred to previously were $76.8 million, an increase of approximately $4 million from Q1 ‘06 of $73 million, and compared with operating expenses of $62.8 million in Q2 ‘05. These expenses were at the high end, but within the range of our Q2 target of $75 million to $77 million. Non-GAAP operating margin for Q2 ‘06 was 16.6%. This compares to Q1 ‘06 non-GAAP operating margin of 17.3% and Q2 ‘05 non-GAAP operating margin of 13.7%.

Now, let's turn to our balance sheet. Our cash and investment balance at the end of Q2 ‘06, which includes restricted short-term investment, was $780.9 million. As a reminder, the restricted short-term investment represents funds set aside for the retirement of our outstanding 2% convertible note in August 2006. Cash and investments including restricted short-term investments net of convertible debt was $502.1 million, down a bit from $510.2 million last quarter.

Cash flow from operations in Q2 ‘06 was a robust $55.7 million, compared to $32 million in Q1 2006. Cash flow from operations benefited from strong profitability and lower DSO. In Q2, we used approximately $60 million in cash for the acquisition of NuView, and used approximately $14.9 million to repurchase 2.5 million shares of the Company's stock under the Company's $100 million stock buyback authorization. To date, we have repurchased 3.7 million shares for approximately $22.1 million under this program, and we expect to continue to be active in repurchasing our stock.

Over the last three years, our sales have become more linear and predictable, which has allowed us to continue to improve our DSOs. Days sales outstanding in Q2 ‘06 was 38 days, once again below our target range of 50 to 60 days and compared with 41 days in Q1 ‘06. Our on-hand inventory was $8.2 million in Q2 ‘06, unchanged from the prior quarter and in line with our range of $8 million to $10 million, as projected last quarter. CapEx for the second quarter were $7.3 million, which is consistent with our target range of $6 million to $8 million. And finally, deferred revenue increased to $56 million in Q2 ‘06, as compared to $51 million in Q1 ‘06.

Now for our outlook. As you compile your models and estimates, there are some factors to consider. Looking forward to Q3, we expect the market to experience its historical seasonal trend for the summer months. And accordingly, we see end-user demand as relatively flat between our fiscal Q2 and Q3 quarters. This was the case even last year, when our end-user sell-through and overall demand were approximately equal quarter over quarter. Our competitive position within the industry has continued to strengthen, and we remain confident in our ability to execute.

Our end-to-end 4-Gig lead continues to afford us many opportunities. Nevertheless, our competitors have publicly announced that they will come to market with their 4-Gig director platforms in Q3, which will intensify the competitive dynamics of the market. We expect ASP declines to return to the levels in the mid single digits, as our competitors come to market with their full 4-Gig product lines.

Finally, we will continue to invest in our Services and Tapestry businesses, and expect continued revenue growth and progress in these initiatives.

When we take all of these factors into consideration, our outlook for Q3 is as follows: We expect our reported revenue in Q3 to be in a range of $174 million to $183 million. We expect non-GAAP Q3 gross margins to be in the 57% to 58% range. For Q3, we expect total non-GAAP operating expenses to be in a range of $80 million to $83 million. As Mike indicated earlier, we are beginning to see the benefit of our new initiatives in both Tapestry and Services. We plan to continue to increase Tapestry development investments, and to build out our service team and delivery capabilities. We expect other income, other expense net to be approximately $5 million in Q3. We expect our Q3 non-GAAP effective tax rate to be in a range of 25% to 27%. We expect diluted shares outstanding to be in a range of 272 million to 276 million shares.

Before addressing EPS guidance, I would like to remind you of the following with respect to FAS 123(R). In Q1 ‘06, we adopted FAS 123(R), which requires us to include expenses related to stock compensation based on their fair values. We are providing non-GAAP EPS estimates without option expenses for comparability purposes. We adopted FAS 123(R) prospectively, and as such we are not restating prior-period results. We expect the impact of FAS 123(R) related to fixed stock options to be approximately 4.5 million to 5.5 million per quarter in fiscal 2006. In addition, we account for certain stock awards on a variable accounting basis, so changes in stock price will impact the amount of the compensation expense.

We expect Q3 ‘06 GAAP EPS of $0.03 to $0.04. We expect Q3 ‘06 non-GAAP EPS of $0.07. We expect capital investments to be in the $6 million to $8 million range. Given the improved linearity of our sales, we expect day sales outstanding in Q3 will be in a range of 40 to 50 days. We expect inventory levels for Q3 to be in the $9 million to $11 million range. We expect to remain cash flow positive, and we expect to generate an average range of $20 million to $40 million in operating cash flows per quarter throughout the remainder of the year. Non-GAAP results for Q3 are expected to include the same categories of items that we excluded for Q2.

I would like to reiterate our commitment to our long-term financial model target, which includes a gross margin of 55% to 58%, non-GAAP operating expense range of 38% to 40% and non-GAAP operating margin range of 15% to 20%. While we have met and in most cases exceeded this performance in the first half, we also want to reiterate that we will continue to invest for growth. We are committed to non-GAAP operating margins to be in a range of 11% to 12% as we exit the fourth quarter of this year, and to operate within the target model in the second half of 2007.

Before I turn the call back over to Mike, I would like to cover an additional item. On May 12th, Brocade filed a tender offer that is intended to address recent changes to tax laws that could have serious unfavorable personal tax consequences for some of our Brocade employees who have received certain stock options that were or may have been granted at a discount from fair market value at the date of grant. The tender offer provides affected employees with the opportunity to amend or cancel their affected options to remedy the unfavorable personal tax consequence of the tax law change. Many companies have been and will be facing the impact of this new tax law, called Section 409A, on their employees. And Brocade has elected to proactively address this issue, so that affected employees can mitigate the impact of unfavorable tax penalties.

At this time, the Company expects that the financial impact of the tender offer will include a one-time GAAP expense of approximately $1 million to $2 million in the third quarter of fiscal 2006, or approximately $0.00 to $0.01 in GAAP earnings per share. The Company expects the cash payment to employees to be approximately $3.5 million to $4.5 million. These estimates are reflected in our Q3 guidance. And now, I would like to turn the call back to Mike.

Michael Klayko, President, Chief Executive Officer

Thank you, Richard. So, before I open up the call for questions, I would like to recap the highlights from our Q2 results and reiterate the comments I made at both our Analyst Day and our Q1 earnings announcement.

First, we're executing very well in our base business. We had an excellent quarter, as evidenced by our performance.

Second, Brocade is executing on our strategy for growth and diversification. We will continue to extend our leadership in traditional SAN switching, and we are leveraging this foundation to expand into high-growth adjacent markets with innovative, differentiated products and offerings. Our investments in Tapestry solutions and Service offerings are showing promise, with strong differentiation and customer interest. Through these initiatives, we believe we now participate in a broader total available market opportunity, from a Fibre Channel switch TAM of 1.8 billion to a much larger TAM that is approximately 5.4 billion. This opportunity lies within the same data center, with the same customers who know us and trust us. It involves bringing to the table a different set of capabilities to help them solve broader problems. We will continue to drive initiatives in these areas.

Third, our belief and strategy is that shared storage has an increasingly important role in driving next-generation efficiencies across the enterprise. And Brocade will be a leading supplier of these solutions.

And finally, our team is focused and committed to delivering exceptional results for customers, for partners and our shareholders.

Thank you again for spending time with us today. Operator, please open the call for questions.

Questions & Answers

Operator

Thank you sir. Operator Instructions. Your first question is from the line of Paul Mansky with Citigroup.

Q - Paul Mansky

Hi, great, thank you, excellent quarter. I got on just a moment late, but did you happen to mention what the NuView contribution was in the quarter, both at the top line and the expense line?

A - Michael Klayko

Richard, do you want to let him know what that is?

A - Richard Deranleau

Yes. So the revenues from NuView were not significant to Brocade in Q2, and we have not broken that out, we don't break out product line revenues. We're not expecting the revenue to be material to Brocade in 2006, but we are expecting to recognize revenue in Q3 and Q4.

Q - Paul Mansky

And what was the impact at the expense line?

A - Richard Deranleau

We're not really breaking that out, but it was not a huge number.

Q - Paul Mansky

Given that expenses appear to come in at the high end or within the range that you provided previously, despite the significant top line upside, can you talk to us a little bit about what is going on there within the expense lines?

A - Richard Deranleau

Sure. As we had talked about earlier in this year and at our Analyst Day, we are making a concerted decision to invest in both Tapestry development and in Services. The Tapestry initiatives, very important to our strategy to drive topline growth, and on the Services, we're continuing to build out our services personnel and our delivery capabilities. And really, those two initiatives are what’s driving the growth incrementally over the normal growth you would expect to see along with revenue as part of our layer two business.

Q - Paul Mansky

I guess, maybe stated a little bit differently, it occurs to me that, obviously, you beat the top line relatively handily, but you're in line with respect to expenses. Clearly, you did not capitalize on the opportunity to spend a little bit more heavily in this quarter. How should we be thinking about expense management over the next several quarters?

A - Richard Deranleau

So, I think what we had said earlier is we would expect expenses to be at about up to 84 million as we exit Q4. But again, we are committed to the Tapestry and to the Service investments that we discussed.

Q - Paul Mansky

Great, and then finally, just quickly -- headcount at the end of the quarter, please?

A - Richard Deranleau

Sure. The headcount at the end of the quarter was 1,316 employees.

Q - Paul Mansky

Great, thank you very much.

A - Michael Klayko

Thanks, Paul.

Q - Paul Mansky

Thank you.

Operator

Your next question is from the line of Tom Curlin with RBC Capital Markets.

Q - Thomas Curlin

Hi and congrats, good quarter.

A - Richard Deranleau

Thank you.

Q - Thomas Curlin

The Cisco 4-Gig offering has been announced, but have you seen it in the field at all? I would not have expected to see it for a few more months, anyway, just given the timing of qualifications.

A - Michael Klayko

I'll let the marketing guy here -- Tom, do you want to answer that?

A - Tom Buiocchi

Yeah. I think it's in qualification, but don't expect to see in the field in deployments at least for a couple months, I guess.

Q - Thomas Curlin

Okay. And then, on the Packeteer stuff, is there anything that changes about how you go to market with Packeteer versus Tacit as a standalone business, either just in terms of branding or rev-rec etc.?

A - Michael Klayko

No. In fact, we had a relationship with Tacit, as you know, for product distribution. And that has transferred across also. In fact, we have enhanced it quite a bit with some of the WAN offerings. And so we're actually getting some more products that we can bring to market, so it's not going to change anything. In fact, it's going to make it even better.

Q - Thomas Curlin

And then, with the switch business, that seems to be coming on strong, after maybe -- at least relative to the director piece, some more subdued trends on a trailing basis. Is that just a function of the new offerings that are out there, or is there any other dynamic that would be contributing to that?

A - Tom Buiocchi

Hey Thomas, this is Tom. And so in Q2, the market was pretty healthy for switches. We didn't get the same seasonality blip we normally got, so the overall market was pretty healthy. And you probably heard a couple of our key OEMs announce pretty nice quarters, especially in some of their midrange business. So that helps us along the path of the switch business. And the product line is strong, right? So we cover a lot of those price performance points, and so we're able to gain some share as well as the market demand being up there this quarter.

Q - Thomas Curlin

You had a new port count offering, right? A higher port count that would go into the switch category, right?

A - Tom Buiocchi

That's right, Tom. The 4900, SilkWorm 4900, goes up to 64 ports with flexible ports on demand. That product is just exiting qualification, and it is probably going to be in the market in Q3 through most of our partners.

Q - Thomas Curlin

Okay. So that really was not much of a contributor for the April quarter but, I guess, adds to visibility going forward?

A - Tom Buiocchi

Absolutely correct.

Q - Thomas Curlin

Okay, thank you.

A - Michael Klayko

Thanks Tom.

Operator

Your next question is from the line of Henry Naah with Lehman Brothers.

Q - Henry Naah

Hey guys, congrats on a good quarter. And Richard, congratulations on the new role.

A - Richard Deranleau

Thanks, Henry.

Q - Henry Naah

Hey, I got a question for Tom or Mike, maybe, here. It seems like in the director space, you guys obviously seem to benefit from your 4-Gig product. Can you give us any sense, in terms of accounts? How many new accounts are you selling directors into? Is there any way you can kind of frame that for us?

A - Tom Buiocchi

It's tough to tell. We really don't break that out. We do internally track competitive wins and obviously have programs for competitive wins. It’s -- I can tell you it's increasing, right? I don't want to give you an order of magnitude here, but it is increasing. And it is very, very visible within the Company. It's a very big badge of honor, obviously.

Q - Henry Naah

Okay and then I guess in terms of the embedded business, is there any way we can think about how much this is contributing to you guys right now?

A - Richard Deranleau

Well we, the embedded space was really strong for us this quarter, again with last quarter as well. As Tom had indicated, we're not breaking that out. But suffice to say we had some good growth there.

Q - Henry Naah

And then lastly, I missed it, but how much cash did you guys use to buy back stock this quarter?

A - Richard Deranleau

So, in the stock buyback, we used just a little under $15 million to repurchase about 2.5 million shares.

Q - Henry Naah

And what does that leave you in the plan?

A - Richard Deranleau

So that leaves us roughly $78 million, in round numbers, left on the program.

Q - Henry Naah

Great, thanks guys.

A - Michael Klayko

Thanks Henry.

Operator

Your next question is from the line of Aaron Rakers with A.G. Edwards.

Q - Aaron Rakers

Yes, also congratulations on the quarter and to Richard as well. A couple of questions -- I guess, one, at your Analyst Day you provided some guidance for your full fiscal year. I think it was 665 to 680. Obviously, you're coming in well ahead of that. First of all, can you give us any update there, in terms of how we should think about looking at the October quarter in terms of fiscal seasonality trends?

A - Richard Deranleau

So, I mean clearly, we performed very well in Q1 and Q2. And in addition, we are raising the guidance from our original estimates for Q3. We expect that the market is going to remain healthy through the remainder of the year, and we also expect to execute very well through the remainder of the year. However, we typically don't give guidance. It's just the one quarter out is what we do. And in keeping with that practice, we're not providing any full-year guidance.

Q - Aaron Rakers

But clearly, from a seasonal perspective, you would say that your fiscal Q4 typically is up on a sequential basis? That's fair?

A - Richard Deranleau

Yeah. In fact, at Analyst Day we showed that to everybody, and Q4 is our second-strongest quarter.

Q - Aaron Rakers

Okay. And then also, I guess, getting at the expense line, it looks like your head count was up quite a bit this quarter. I think if you back out NuView, it may be up 40 or 50 persons on an organic basis. So, maybe you can give us some color in terms of what you see in terms of headcount investments, as you continue to maybe capitalize on some of this upside growth here?

A - Richard Deranleau

I guess, I wouldn't really speak to headcount, but I would go back to with my prior comment, would say that we would probably be looking at a maximum of $84 million exiting Q4. And those would probably the head count we would be adding would be in the Tapestry and Services, particularly in the Services area.

Q - Aaron Rakers

And then final thing, on just the April quarter, can you talk about any specific trends month by month, from a linearity perspective, and maybe on a high level give us some thoughts on what you have seen thus far in the month of May?

A - Richard Deranleau

Well, if we talk about Q2, it was one of our most linear quarters ever, and that is reflected in our DSO, the 38 days. And it's pretty early. We're only a couple weeks into it for May. But certainly, we're very linear in our prior quarter Q2.

Q - Aaron Rakers

Thank you.

Operator

Your next question is from the line of Andy McCullough with Credit Suisse.

Q - Andy McCullough

Thanks guys. In the guidance, you talked about an expectation for prices or price reductions in the traditional mid single digits in the director market, in the July quarter. Mike, is this based on a hunch that competing products actually hit the market on time, or is this coming as a result of some feedback you are getting from the OEMs?

A - Michael Klayko

It’s just something that we look at and as we plan out. So we based, we put this into our plan. And as we go forward, frankly, there's not a hunch behind it. It's just what we're seeing in the industry right now, and we just had to plan it in. It's reflected in our guidance.

A - Tom Buiocchi

Andy this is Tom, just you know, obviously, the other guys going to be going through a product transition, which sometimes results in moving some of the older product at lower prices and trying to compete on that, and then moving in the new product at aggressive price as well. So, I think it's a dynamic of a product transition.

Q - Andy McCullough

Okay. And just an unrelated question. This is the second quarter, and I know you guys have had pretty good upside. Have there been any component availability issues over the last two quarters at all?

A - Michael Klayko

Everything that we have been needing, we're getting right now. We have got a really good operations team, and they have been on top of it. So, we have not had an issue.

Q - Andy McCullough

Got it. Thank you.

A - Michael Klayko

Thanks.

Operator

Your next question is from the line of Mark Moskowitz from JP Morgan.

Q - Mark Moskowitz

I want to get back to Andy's first question there, with respect to kind of the guidance. It just seems to me that you're being maybe conservative again with respect to the revenue outlook. We have had two quarters now where you really blew past your previous guidance going into the earnings report. And your body language seems to almost mirror what you said a few months ago when you were talking about the April quarter, in terms of increasing competitive pressures and the chance for more ASP erosion. Are you just putting us all into the stew, in terms of just trying to be conservative as you go through the summer time?

A - Richard Deranleau

Well, no, the answer is we're not trying to be conservative. We're just trying to be balanced. And I guess I would reiterate a couple of things that we've talked about before, which is, yes, Q1 and Q2 we did -- they're very strong quarters. But again, we saw strength in the SAN market in Q2 that we did not expect. That's one. Secondarily, from a seasonal basis, if you go back and you look at what we have done historically, Q2 and Q3, our experience is that demand is flat. In addition to that, we're heading into summer months. And I think anybody who looks at what happens in EMEA and more and more in the US, you need to take a balanced approach with respect to the summer. And finally, we're going to have a different dynamic in terms of competition this quarter versus last quarter. We have our competitors publicly announcing that they are introducing a product. So, when you pull all of those things together, I think what we're giving you is a rational and balanced revenue guidance.

Q - Mark Moskowitz

Richard, when do you expect the competitors --in terms of Cisco and then, probably a little later, McData -- when they do fill in the holes, when do you expect to really butt heads against them with these 4-Gig solutions? Is it more in the October quarter versus the July quarter?

A - Tom Buiocchi

This is Tom. I think they have said publicly they are talking about the June timeframe. And again, I don't have a whole lot of insight as to where they are in their respective power cycles. But plus or minus 30 days from there is probably when you are going to start seeing the products in the market.

A - Richard Deranleau

And I guess I would just add to that that, once a vendor has publicly announced, they are already kind of in the pre-sell mode anyway. So you have got to think about that as opposed to the day the first product ships.

Q - Mark Moskowitz

Okay. And then just lastly here, as far as gross margins, how should we think about your gross margin profile a few quarters out here, as the Services ARM becomes a bigger piece of the pie, given just they're below Company average?

A - Richard Deranleau

Sure. The way we would look at that is we really have two different dynamics going on, which is really you have the service initiative going on, which traditionally would carry a lower gross margin. But on the other side, you also have the Tapestry, which is primarily software, which is traditionally would have a higher gross margin. So, our feeling is that when you balance all of those together, you are still in the range of our long-term model, which is 55% to 58%.

Q - Mark Moskowitz

Okay. Thank you.

A - Michael Klayko

Thanks, next question.

Operator

Your next question is from line of Mark Kelleher with Canaccord Adams.

Q - Mark Kelleher

Thanks, great quarter, guys. I just wanted to go back to your comment that sales were becoming more linear and more predictable, and try to match that up with the fact that you have come in fairly strong in the last two quarters. You indicated that some of that upside was coming from strength in the SAN market. How much of the overage was attributed to that? And doesn't that sort of imply that there is a fairly significant unpredictable part still in your revenue stream?

A - Richard Deranleau

Well, I think anybody who is in the tech industry would probably say that the revenue streams are relatively unpredictable. But I think, when we look at things, we try to triangulate where we are against competitive announcements on their revenues and try to triangulate. And we're doing this kind of, as the quarter goes on, and toward the end of the quarter we certainly have more information about what has occurred in the market. We really don't have the advantage of that at the start of a market, because the data just isn't there. So we're basically trying to understand the trend line.

Q - Mark Kelleher

And I might have missed this, but did you say what the ASP reductions were in the quarter?

A - Richard Deranleau

In Q2, the ASP reduction was in the low single digits, and then we also said that we would anticipate in Q3 going to the mid single digits.

Q - Mark Kelleher

And can you tell us which grew faster quarter-over-quarter, the switches or the directors?

A - Michael Klayko

We actually had record quarters in directors, for our second-largest in the Company's history. Q1 was our largest. We also had record in switch products. It was fairly balanced also Mark. We had a growth around all geographies and partners, so it's not just one product in one set. It was a fairly balanced contribution.

Q - Mark Kelleher

And just one final question, there are some new product launches coming from IBM, from EMC. Do you anticipate that -- those are 4-Gig products. First of all, you have in the past given out what percent of revenue was 4-Gig. I don't know if you could provide that again. And then, how do you think that that will be driven higher by these new products coming out?

A - Richard Deranleau

Sure this is Richard. The transition pretty much has happened for us. In Q2, we had over 90% of our revenue was 4-Gig. And I would expect that the non 4-Gig, the 2-Gig product, would continue to drop as a percentage of revenue from this point out. I mean, the transition for us has already occurred.

Q - Mark Kelleher

So, these new products will more particularly drive? It will just be a natural transition going --

A - Richard Deranleau

Again, 90% of our revenue is already 4-Gig.

A - Michael Klayko

Its an extension in some new markets with some of these new products, too, which actually expands some of our offerings.

Q - Mark Kelleher

Okay. Great, thanks very much.

Operator

Your next question is from the line of Samuel Wilson with JMP Securities.

Q - Samuel Wilson

Good afternoon gentlemen. Just a few small questions, most have been answered. And normally, you give us some kind of ports -- number of ports shipped throughout the quarter or cumulative ports shipped to date. And I'm sorry if I missed it, but I just wanted to get that number.

A - Tom Buiocchi

Yes this is Tom. I don't think we called that out this time. We grew about 9%. We were at about 7 million cumulative ports.

Q - Samuel Wilson

Can you just describe -- and this is kind of a technical question. But I have read now and I have heard from sources that a lot of what Cisco is talking about on their high-density new switches deals a lot with oversubscription. And historically, you have not been big in oversubscription on the directors. Do you think the industry dynamics on the technology is changing here? Or do you think it's just a lot of marketing spin on their part?

A - Tom Buiocchi

Well, do you want me to answer that honestly, Sam? Come on. So let me just give you one indication, and I think we feel pretty good about being able to compete as their new product comes out, right? The new product, as we understand it is over 500 ports and 4-Gig. The key to remember, though, is that it cannot be 500 ports and 4-Gig at the same time, ports at 1-Gig or 130 ports at 4-Gig.

Q - Samuel Wilson

Yes, they are running four times oversubscribed, right?

A - Tom Buiocchi

Right.

Q - Samuel Wilson

And do you think the customers are moving -- because traditional guys from networking backgrounds understand oversubscription. But typically, in the SAN market -- they haven't liked it. So do you think the market is transitioning at all?

A - Tom Buiocchi

I believe it is going to present some limitations, some architectural limitations in how you can build fabrics, especially large fabrics, where these products are targeted for, in fairly high-performance environments. I think customers are going to look for full bandwidth capabilities.

Q - Samuel Wilson

Perfect. Okay. And then last question can you give us a sense of international versus domestic business, how the international stuff has been doing?

A - Richard Deranleau

Sure. We had good strength across all geographies. We did particularly well in North America. We continue to be about 60% domestic and 40% international.

Q - Samuel Wilson

Thank you very much gentlemen.

Operator

Your next question is from the line of Kaushik Roy with Neuberger Berman Technology.

Q - Kaushik Roy

Congratulations, guys, great quarter. Can you give us any color as to how much your directors, switches or blades were as a percent of revenue, or how much they grew sequentially?

A - Richard Deranleau

Unfortunately, we're not breaking out our product revenue like that. Our revenues were up sequentially about 7%, I believe.

Q - Kaushik Roy

Yeah, but can you give us like how much directors grew or switches grew as a percent? No?

A - Michael Klayko

Kaushik, we can't do that.

Q - Kaushik Roy

Okay. Another question, the 4900, are you seeing that as a replacement for directors or as a switch consolidator?

A - Michael Klayko

Actually, it's going into a couple spots. And I'll have Tom answer it after my comment. When I have been talking to customers, what's interesting is they are building out these core edge networks. Some of the edges are getting pretty big, and what they need is they need a lot of devices at the edge. And so we're seeing a brand new space that didn't exist, and so we're participating in a white space market there. And in a lot of cases, customers are -- they need the port density, they just don't need the robustness of a director. So we're seeing some there, but we're seeing kind of a balanced approach on both sides. So I think we have got a nice product because it fits multiple places.

A - Tom Buiocchi

Actually, he nailed it, nothing more to add to that. I would say, number-one use case Kaushik is port density on the edge, especially in blade environments and high-density server environments. So that's probably where we are going to see the sweet spot first.

Operator

Your next question is from the line of Brent Bracelin with Pacific Crest Securities.

Q - Brent Bracelin

Thanks for taking my question. I guess trying to better understand what is driving the growth and how sustainable are the trends you're seeing in the business. Obviously, you put two quarters here together pretty solid. Obviously, you are citing kind of a rebound in the SAN market, which obviously McData had a mixed quarter, Emulex had a mixed quarter, QLogic's quarter was okay. So, is some of the strength driven by kind of this common OS across directors, fabric switches and embedded? Is that starting to resonate with the customer base and perhaps putting you in a better position to gain share? Is there any other kind of explanation for -- to give us some insight into how sustainable this business and growth you're seeing is?

A - Michael Klayko

Brent, that's a really good question that we could talk about for a long time. But frankly, it's a variety of things we're seeing, and it is -- as more and more bladed servers come to market, it drives more and more connectivity not only at the edge, but at the director space. Having a common environment, we just came back from talking to our end-user councils, and the common OS and the common management system and the lower overall operating cost resonated huge. Simplification, eliminating complexity eliminates costs, and so that is resonating very, very well. So, we heard that. In the enterprise space, what's interesting -- our new 48000 is a -- from an environmental standpoint uses a lot less electricity in cooling, and it's easier to cool. Now, that doesn't sound like a lot until you put quite a few of these in. And customers like that, too. And so there's a whole -- if you have to look at the segment, under each one of these segments there's buying criteria, there's different decision criteria that customers are going through. And so when you combine it all together -- common operating system, common environment and our customers are telling us from our presentation we're giving on our roadmap that it's exactly what they are needing.

Q - Brent Bracelin

Great, and then just one quick follow-up if I could, obviously, you referenced this 50 customer meeting kind of survey that you went out and looked at. And obviously it does look like there is kind of interest in growing into some of the new services and software offerings. What is that imply, as you start to layer on new software and services to your existing customer base? Is that another hook or another barrier to entry to kind of prevent the competitors from making a dent in the installed base? Or how should we interpret that, first? And then, second, given the response that you have from those 50 customers, would you look to accelerate your offerings on the software side through additional acquisitions?

A - Tom Buiocchi

I'll take the first part. It's clearly showing that there's broader problems to be solved in data centers, and fortunately we're in a very trusted place in the data centers today. So, most customers have a lot of confidence looking to us to get a larger footprint and solve some of their broader problems. So, I think it – how is that stickiness thing or an advisory or problem-solving thing, but it does give us a different dialogue with the customer, a different conversation in terms of how important we become long-term, we believe.

A - Michael Klayko

One last comment. Customers have a lot of problems, they are trying to solve right now. There's not just one way to do it. What we can do is we can bring some commonality in across our platform that they currently are comfortable with, and they can build on top of that investment and actually get a better return on the existing investment. So, it's a good story right now.

Q - Brent Bracelin

And would you look to accelerate the technology path and roadmap through additional acquisitions, or do you have enough on your plate now to focus on?

A - Michael Klayko

We're always looking at acquiring technologies and products and services that will help solve customer problems. So, we're constantly surveying the market.

Q - Brent Bracelin

Thank you.

A - Tom Buiocchi

Thanks. Last question.

A - Michael Klayko

The last question. Operator.

Operator

Yes sir. Your last question is from the line of Laura Conigliaro from Goldman Sachs.

Q - Min Park

Yes, thank you. This is Min Park on behalf of Laura. Just a couple of questions. First, could you please give us a few more specifics on what really differed this quarter versus what you were expecting headed in that really drove the out-performance? And how much of the outlook, your stronger outlook is really a function of your expectation for share gains versus an accelerating SAN environment? And then I have one follow-up.

A - Michael Klayko

Sure. Let me start on that one. So, when you take a look at the Q2, we had expected to see a much more historical seasonal impact than actually occurred. So basically, we're expecting to see a seasonality trend, which we didn't see. We're expecting to see that our product on a quarter-over-quarter basis would be lower, which is traditional. So, there is two impacts we did see, and we saw a stronger market in the SAN market than we had anticipated seeing. We also had expected to see our competitors in the market with their products. It turns out that they weren't able to introduce their products until they publicly announced it, which was Q3. Those were the three things that really changed our actual versus what we had expected. What was your second question?

Q - Min Park

Yeah. As far as your stronger outlook, is it much more a function of your continued share gains or your expectation of the SAN environment accelerating?

A - Michael Klayko

So, I guess we're not expecting to take huge amounts of share, but we are not expecting to actually lose any share either.

Q - Min Park

Okay. And lastly, with the sell-in roughly 4 million higher than your sell-through, could you give us an indication of your channel inventories right now and where you think it might settle out?

A - Michael Klayko

Sure. So, if you look at what we did in revenue, our reported revenue was $182.7, which was higher than our sell-through. Now, if you look at last quarter, it was the other way around, where we actually had higher sell-through than we had sell-in. So, there is this natural variability in it, but it basically stays in equilibrium. And so there's not going to be a tremendous impact on OEM inventories given the fact that we cannot control inventories, we don't report on the OEM inventories. But it is basically an equilibrium.

Q - Min Park

Great. Thank you.

Darby Dye, Investor Relations

Thank you, everyone, for joining the call today. This concludes our second quarter conference call. We look forward to speaking to you again at upcoming conferences, including Morgan Stanley's Enterprise Computing Symposium on May 22nd and the Bear Stearns technology conference on June 13th. As always, our presentations and breakouts will be audio webcast on our website. If you have further questions, please contact Brocade Investor Relations. Thank you.

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