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Fusion-io (NYSE:FIO)

F2Q13 Results Earnings Call

January 30, 2013 5:00 p.m. ET

Executives

Nancy Fazioli - Investor Relations

David Flynn - Co-Founder, Chief Executive Officer and President

Dennis Wolf - Chief Financial Officer and Executive Vice President

Analysts

Katy Huberty - Morgan Stanley

Mark Moskowitz - JPMorgan

Kulbinder Garcha - Credit Suisse

Andrew Nowinski - Piper Jaffray

Brent Bracelin - Pacific Crest Securities

Ben Reitzes - Barclays

Bill Shope - Goldman Sachs

Edward Parker - Lazard

Aaron Rakers - Stifel Nicolaus

Amit Daryanani - RBC Capital Markets

Alex Kurtz - Sterne Agee

Jason Adler - William Blair

Rajesh Ghai - Craig Hallum

Srini Nandury - Summit Research

Nehal Chokshi - Technology Insights

Roxane Googin - Global Investment Research

Operator

Welcome to the Fusion-io second quarter 2013 earnings call. [Operator instructions.] I’ll now turn the call over to Nancy Fazioli. Nancy Fazioli, you may begin.

Nancy Fazioli

Thank you, operator. Good afternoon, everyone, and welcome to Fusion-io's fiscal second quarter 2013 earnings conference call. On the call today are Fusion-io's CEO, David Flynn, and CFO Dennis Wolf.

Please note that a replay of this call will be available on the Investor Relations page of our website at fusionio.com within a few hours and will be available for at least a week from the time of this call. Unauthorized recording of this call is not permitted.

During today's call, we will be referencing both GAAP and non-GAAP financial measures and wish to note that a copy of the press release and financial tables, which include a GAAP to non-GAAP reconciliation and other supplemental financial information, is available on the Investor Relations page of our website.

Some of the statements we will make during this call constitute forward-looking statements within the meaning of the federal securities laws. Accordingly, we wish to caution you that such statements are just predictions based on current expectations and assumptions regarding future events and business performance, and involve risks and uncertainties that could cause actual results to differ materially.

We refer you to the registration statements and reports that we file with the U.S. Securities and Exchange Commission, which are available on our website and identify important factors that could cause the actual results to differ materially from those contained in our projections and other forward-looking statements. Fusion-io undertakes no obligation to update any forward-looking statements to actual results or changes in the company's expectations.

With that, I'll turn the call over to David.

David Flynn

Thank you, Nancy, and thank you everybody for joining us today. Our results in the second quarter were strong, with record revenue of $121 million. A higher percentage of that revenue came from the broadening base of our core business.

We had 10 customers place orders in excess of $1 million, including a large Chinese gaming and social networking company, a rapidly growing cloud-based company, and two of the U.S.’s largest telcos. EMEA orders nearly doubled year over year and Asia-Pac orders grew more than 130% year over year.

Strong demand, and highly differentiated products, led to a 62% gross margin. This enabled us to expand our earnings per share to $0.13, up from $0.05 in the same period last year, while making healthy investments in product development and growing our market presence.

Let me address what is certainly top of mind, our guidance for the second half of the year. Our core enterprise business grew at 67% year over year in the second quarter, and our guidance reflects that strong growth. The change in our guidance is the result of a shift in the timing of bulk purchases from our two key accounts, specifically for the next two quarters.

When building out data centers, and expanding into new application areas, these customers have purchased in large volumes. They are now achieving greater efficiency thanks to our products, which has led to a shift in their near term demands. At the same time, they are now finding new applications, services, and data tiers in which to leverage our products.

While our guidance reflects a cautious outlook in the balance between these two conflicting forces, over the past seven quarters, their orders have frequently exceeded our expectations, as they often move more quickly in developing new ways to add additional value using our solutions.

Our key accounts are managing an exponential increase in data, while simultaneously managing their bottom line. These divergent business demands cause lumpy buying patterns that are indicative of a market going through a radical transformation. This transformation is made possible by new memory architectures that are driving an unprecedented increase in capability and efficiency.

Fusion-io is at the forefront of this transformation. As Facebook noted at the Open Compute Summit, the big data problems Facebook is dealing with today are rapidly becoming a challenge for the rest of the market, perhaps more rapidly than expected.

Hyperscale companies are facing these big data challenges first. Earlier this month, we announced a product line specifically targeting these hyperscale markets, the ioScale. ioScale uniquely meets the specific needs of this market, with ultra high capacity density, reliable, low-latency performance, reduced power consumption, improved rack densities, and notably, because the server can be one of the from ioScale, one can remove all of the baggage of mechanical storage and go to an all-Flash architecture.

This results in a product that has four times the performance and more than 10 times the reliability and endurance of alternative Flash solutions. ioScale provides compelling price points through an all-new, simplified design. As a result, we expect ioScale to deliver healthy gross margins comfortably within our 56-58% target range.

The introduction of ioScale has shatter the perception that our products are price-prohibitive for hyperscale customers. The pipeline for ioScale is robust. A number of large customers have recognized the ROI and are now at various stages of adoption. Several are now in the final stages.

In fact, five of the 10 orders over a million dollars this past quarter were for ioScale. However, the specific timing of their strategic scale deployments could change, given that, in their newness to the deployment of all-Flash architectures, we are not currently factoring their bulk purchase into our guidance.

In summary, we are pleased with our strong performance in the quarter, and are excited to continue to lead an industry going through a radical transformation. The sheer scale of this transformation, as customers move wholesale to all-Flash architectures can lead to lumpiness in our revenue quarter to quarter as customers learn to extract the full potential of Flash to drive efficiency in their infrastructure.

With the launch of ioScale, we expect a broader base of companies to follow the lead of the early adopters of Fusion-io technology, driving growth in our business and shareholder value. I now turn the time over to Dennis to provide some additional color on our financial results. Dennis?

Dennis Wolf

Thank you David, and good afternoon everyone and thank you for joining us today. First, as a matter of housekeeping, I’d like to remind you that all financial results discussed are on a non-GAAP basis unless otherwise indicated. I’ll turn first to revenue.

Our revenue was $120.6 million in the quarter and represented 43% year over year growth. The business grew approximately 50% in the first half of this fiscal year compared to the first half of last fiscal year. Facebook, Apple, and HP combined represented 69% of total revenue, and 34%, 16%, and 19% respectively.

Turning now to gross margin, in the second quarter our gross margin was 61.9%, exceeding the high end of our target range. The sequential increase was primarily a result of cost of goods improvements, manufacturing efficiencies, and the unique ROI value proposition of our solutions.

I’ll move now to operating expenses. Our expenses totaled $53.1 million for the quarter, up 12% or $5.9 million from the prior quarter. Our operating margin was 17.8% this quarter. Sales and marketing expenses were $26.2 million, or 22% of revenue in fiscal Q2, an increase of $3.3 million from the prior quarter. We now over 200 revenue-generating personnel, and added approximately 20 sales people during the quarter.

R&D expenses were $17.2 million, or 14% of revenue, an increase of $700,000 from the prior quarter, primarily due to continued buildout of the engineering team. Our total headcount in R&D increased 38 employees.

G&A expenses were $9.7 million, or 8% of revenue, an increase of $1.9 million over the prior quarter due to personnel costs and depreciation associated with our infrastructure.

Net income in Q2 was $13.7 million, or $0.13 per share. This compared to first quarter net income of $14.9 million, or $0.14 per share.

To move now to the cash flow, our cash flow statement, our operating activities provided $10.2 million of cash during the second quarter, and our capital expenses, our purchases of property and equipment and lease hold improvements in the fiscal second quarter, were $3.5 million. This is roughly on track with our expectations for $20-25 million in expenditures for the year.

I’ll now turn to the balance sheet. Our cash and cash equivalents were $368.5 million, up $14.6 million sequentially. Our deferred revenue in the second quarter was $38.1 million, up $3.7 million sequentially. The growth in deferred revenue is attributable to the sale of support and maintenance services.

Accounts receivable stood at $56 million this quarter, a decrease of $9.7 million from the prior quarter. Net DSOs were 44 days, down from 54 days last quarter, due primarily to revenue linearity. Our total inventory at the end of the second quarter increased to $74.2 million. That’s up $7 million sequentially. We expect our inventory levels in the third quarter to be up approximately $10-15 million.

Turning to headcount, we ended the quarter with total headcount of 803 people. That’s up 70 employees from the prior quarter.

Now turning to guidance, we expect our core enterprise business to continue to grow in excess of 50% for the full year. Our change in guidance is, as we have said, a result of a shift in the timing of both purchases, and so therefore, for the fiscal third quarter of 2013, we expect revenue to be approximately $80 million. Our gross margin is expected to be approximately 58-60%.

We expect to have a loss this quarter of approximately $10-15 million. We expect diluted shares outstanding to be approximately $111 million. For the full fiscal year 2013, we expect a revenue range of $420 million to $440 million. We now expect gross margin to be higher than our target range at about 58-60% for the year. Our operating margin is now expected to be approximately 6-8%, and we expect diluted shares outstanding to be approximately 110 million shares.

We believe that our industry is at the cusp of a major transformation that the market is only now absorbing. With our enterprise and hyperscale products, we believe we are well-suited to address this shift to next-generation infrastructure.

With ioScale, we have introduced a solution enabling us to drive even wider scale adoption. We anticipate a rapid adoption cycle, but we just can’t call it yet, and thus can only forecast what is currently in our line of sight.

Thank you for your time and interest. We’re now going to turn it over to you. Operator, we’re ready for the first question.

Question-and-Answer Session

Operator

Thank you. We’ll now begin the question and answer session. [Operator instructions.] And we have Katy Huberty from Morgan Stanley on line with a question. Please go ahead.

Katy Huberty - Morgan Stanley

Last quarter you talked about maybe having less visibility into the strategic account orders. So the first question is what gives you confidence and visibility that that business, at Facebook and Apple, will come back after the six-month digestion period that you’re talking about?

David Flynn

We work with these customers very closely, and have an understanding of what new applications are coming online and how they’re scaling them. So this is based on information with our interaction with those teams, and the fact that never has really the use of our product been the question. It’s the question of when their deployments happen. So this is really about the timing of when they put in new infrastructure, not whether or not Fusion-io is a key part of that infrastructure. It still is up to them on when they deploy these things, but we provide guidance based on the best that we see.

Dennis Wolf

And we started to see some of these bulk purchases pushing out a little bit, but it’s really a more cautious stance only on short term guidance. When you think about it, we’ve sold roughly $500 million to these key customers, and you know, that type of deployment doesn’t happen without a radical transformation in compute, like we’re seeing, and it’s really pretty tough to call.

Katy Huberty - Morgan Stanley

Is there any risk that those customers are taking a step back and rethinking their architecture and maybe considering or inviting new competitors in to bid for their next round of business? Do you have visibility into that?

David Flynn

We don’t see any risk at this point from competition in these accounts, and these architectures. It’s a major investment. As you heard Jeff Rothschild, at the event, say, that the partnership with Fusion-io is a major investment. They have not made that investment with other folks at this point.

So we don’t see a risk from the competition from that point of view. The real question comes into play is when do they make these investments in the infrastructure. And ultimately it boils down to success of their new application offerings and growth in their business, which is why we can’t necessarily call it.

But one of the things that is most exciting to me is that with the ioScale launch, and the pipeline that’s building for that, there are many opportunities that will be shaping up. Some of these are nearing final stages. We can’t, at this point, call when those bulk purchases would fall, but there’s lots of reasons to have optimism for the second half of the year.

Katy Huberty - Morgan Stanley

And then just lastly, it sounds like ioScale, with the lower price point, there’s clear elasticity, and you’re seeing new demand at existing customers as well as new demand at new customers. And the real risk is just not having any historical precedent to guide for that. And so you’re not baking any meaningful ramp of ioScale into the numbers for the next two quarters. Is that a fair characterization?

David Flynn

That is a very fair characteristic. You know, we saw this with Facebook and Apple as the newer lithographies of NAND allowed for higher density points that they adopted it into larger-capacity tiers in their infrastructure. So having the ability to get higher density at lower cost points absolutely drives demand.

As a matter of fact, Facebook, at the Open Compute project summit, just a couple of weeks ago, was talking how excited they are about the day when mechanical disks are not even used for their archival and image storage. And so we see the point where the elasticity tips to where, even for sheer capacity, performance aside, that Flash will ultimately displace disks. And we expect to be at the forefront of that in how we structure our product offerings for this market.

Operator

We have a question from Mark Moskowitz from JPMorgan.

Mark Moskowitz - JPMorgan

My question is around the go-to-market strategy. Given this apparently temporal shift, if you will, in the bulk purchases, is this incentivizing you to accelerate your go-to-market strategy where you try to minimize your customer concentration risk longer term by becoming more of a direct provider to certain customers out there?

David Flynn

The hyperscale market has different purchasing, and behaves very differently than the traditional enterprise IT market. They’re early adopters. They want to get the latest and greatest NAND flash, or the highest-density stuff, as soon as possible. They would prefer support directly from us because we build the stuff. Frankly, they don’t value the middlemen as much in that relationship.

So ioScale, in many ways, represents that reality that we experienced as kind of one-offs with Apple and Facebook to make that more institutional. And by the way, by doing this, we can actually structure it in a way where we still participate with the server systems vendor partners, because they have sales teams and sales models that address the hyperscale market, where they have accepted the reality of that market.

For example, the DCS group within Dell, and the hyperscale group within HP. And how they source and provide products into that market is very different, and this is very much aligned with that.

Mark Moskowitz - JPMorgan

And then my other question for Dennis, if I could, around the gross margin. I presume the overperformance here, or outperformance, in the gross margin is temporal as well, if you’re able to get back these two customers that your gross margin would actually go a little lower potentially, after the June quarter?

Dennis Wolf

No. I don’t think so. Our last quarter we had a significant amount of key customers, as you know. We just have had an expanded gross margin, and it’s come about as a result of our cost of goods has come down. We’ve worked really hard on the supply chain and manufacturing efficiency, while at the same time we’ve had a pretty differentiated product that enables us to hold prices at a relatively constant level.

So we did have a margin expansion this quarter. What we’re assuming for the next couple of quarters is that will come down a little bit as we use that pricing lever, if you will, to expand market. Because we still think that to optimize market adoption is it’s a 56-58% gross margin range.

Operator

We have a question from Vlad Rom from Credit Suisse on the line.

Kulbinder Garcha - Credit Suisse

Kulbinder’s actually on the line. I want to clarify just on the Facebook and Apple situation. I guess just going back to the first question you answered today, is how confident are you that in the second half of this calendar year those customers will actually start spending? And just to be clear, you’ve got really nothing in for those customers for the next six months. Is that what you’re trying to say as of right now?

Dennis Wolf

We do have some amount, run rate if you will, for each of these customers. You could assume it to be roughly $10-20 million. So we’re really just assuming what their sustaining rate is.

Kulbinder Garcha - Credit Suisse

Okay. And then just in terms of going back to the issue of visibility, this is not competitive or it’s just a change in how they view your architecture? What are the various proof points you’re going to be looking for over the next, let’s say, three months, that these will be customers that come back and start materially spending?

David Flynn

Here’s the interesting thing, as we’ve worked with these customers, it’s rather ironic that the efficiencies attained through leveraging our own products is what allows them to extend the efficiency, allows them to extend the timeframe, for which they need to put in more equipment. So as they balance their business between investing to extend capability versus driving efficiency to reduce expenses, it’s just rather ironic that the product is kind of our own competition. And that has extended that time period.

To answer your question, I can’t necessarily give you too many of the details, other than to say we’re very confident that the uniqueness of our product, and more importantly the relationship with these customers, means that when they decide to do their next step function in building new data centers or moving to new apps, that it will be with Fusion-io.

Kulbinder Garcha - Credit Suisse

And then on the issue of just, outside of these customers, there were various initiatives that we were thinking going into this year that would start to have an impact on sales, whether it was Cisco and NetApp, whether it was the newer customers you were signing up last year.

Just in terms of the guidance for the next six months, what’s baked in for, let’s say, the new channel partnerships with Cisco and NetApp? What’s baked in for the additional customers like China Mobile, Pandora, Salesforce.com, all of which got announced at various points last year? Do you have a ramp for them? Or do you not? Or how does that work?

David Flynn

We’ve built a lot of that into the model in looking at the growth rate of the non-key customer growth, that being 50%-plus. Many of those are taken in there. However, the ones where they have an opportunity to actually rival those existing key customers, because those are very large step functions and the timing of which is hard to call, because they’re new to really deploying these all-Flash architectures.

So while the architectures can be bake, they’re still working on software efficiencies, that type of thing. When they actually pull the trigger for deploying is not in our control. And so we tend to be on the conservative side with calling when those things will happen.

But what I can say is that pipeline of strategic scale, additional customers outside of our existing is very healthy, and that’s exemplified in the fact that five of those 10 $1 million-plus customers were for the ioScale. And many of these are customers that we have been working with for a while that are now able to make that leap toward an all-Flash architecture.

Kulbinder Garcha - Credit Suisse

I guess what I’m getting at is some of these customers you announced almost a year ago. I guess they were testing for a period of time before that. What’s the hiccup there? Or is it just it takes this long for them to ramp up? Because some of them could be potentially quite large buyers, I would imagine. It surprised me, I guess, a little bit, how long this whole thing has taken.

David Flynn

It’s not so surprising from our point of view when we look at how Apple and Facebook moved along. We worked with Facebook from when we were less than a year old as a company, grew alongside them, and watching how they learned to leverage solid state technologies in their infrastructure, these things simply do take time, and have major implications. It is a huge transformation in the capacity of the data center and its efficiency levels.

So the fact that it takes a little longer, because they’re looking at how things are rearchitected, also, they’re having to optimize and decide, well, how much does it take? We had one customer tell us recently that their estimations were wrong, that they were able to determine that they could use one-third fewer servers than what they had even previously calculated, because now they were able to get additional throughput from it. Luckily, they have a very, very large deployment, so that’s not a material impact to the size of the thing, but it’s indicative of the fact that they are still tweaking and tuning and extracting every last ounce of efficiency that they can get.

Operator

As a reminder, please ask one question per analyst. And we have Andrew Nowinski from Piper Jaffray on line with a question. Please go ahead.

Andrew Nowinski - Piper Jaffray

I’m just trying to understand the timing of this two-quarter shift. So if I go back to some comments you have made in the past about your strategic customers, you’ve stated that you have about a 12-month rolling forecast with Facebook and Apple, though you don’t always know the timing of the deployment. But when you reiterated in your annual guidance in October, I guess why didn’t you see this two-quarter shift at that time, and then take the appropriate action on that call, since that should have fallen within that 12-month window?

Dennis Wolf

Andrew, we actually didn’t see it. What our best visibility is for our strategics is about six-month visibility. What we found, of course, in the first six months of this year, is that it’s spot-on to what we had anticipated it to be. But even a quarter ago, we did not have any visibility that would tell us otherwise. The visibility started to take form over the last 90 days, and an understanding of when they were going to place their orders became clearer to us.

Andrew Nowinski - Piper Jaffray

And then just last question from me, what impact, if any, do you think Seagate’s investment in [Virnet] will have on your competitive landscape, given that they’re targeting all the major OEMs?

David Flynn

The business is not driven at the OEMs. The business is driven at the end user customer. So having companies that build components, really they won’t be at the point where the competition is actually happening, and that’s with the end user.

Operator

And we have Brent Bracelin from Pacific Crest Securities. Please go ahead.

Brent Bracelin - Pacific Crest Securities

The question I have is on the strategics, Facebook and Apple, and as we think about this kind of two-quarter shift, and thinking about them coming back, you did talk about kind of open-sourcing your ioScale card. When those strategics come back in six months, could there be also a shift in those customers buying cards and potentially licensing the software from you? Should we think about that now? How should we think about the impact that potentially software licensing has six months from now when these strategics come back and start using your technology in a broader fashion?

David Flynn

Let me take a step back from that. That’s a great question. Thank you for queuing that up. The reason why we contributed the ioScale, and the flagship, the 3.2 terabyte card, into the Open Compute project wasn’t so much about the licensing model, although that does present opportunities for driving additional business in the hyperscale market by fostering other sources of our same technology.

But the main reason for that is because of the innovation that can happen in an open forum. We still own the critical pieces that it takes to make this stuff work, and working with the ODMs and other participants in the Open Compute to innovate in form factor and how to get the highest rack densities, that’s what’s so exciting about this, is the ability to collaborate at a faster pace than through proprietary standards bodies. So this is exciting more about how innovation occurs than the shift in a business model per se.

Brent Bracelin - Pacific Crest Securities

You would not expect a change in procurement at a Facebook or Apple impacting your model, at least for the short run?

David Flynn

We don’t see that happening in the short run, no.

Operator

And we have Ben Reitzes from Barclays on the line with a question. Please go ahead.

Ben Reitzes - Barclays

If you could just walk us through a little bit more on how you’re going to grow revenue 40% or so, I believe, in the fourth quarter, if I imply that from your guidance?

And can you talk a little bit about the next fiscal year? The Street was looking for about a mid-30s revenue growth next year, and with a shock like this to the system, there’s no telling where we should go. Should we just stay at 33% or 35% next year, because the market is blazing? Or should we give you a break and give you a much lower growth rate to see what’s happening at these strategic vendors.

So first, you can reconcile the fourth quarter a little bit, strategic versus non, and then what we should do with the out year model. That would be great.

Dennis Wolf

Our core growth has been growing at a faster rate - even though our strategic revenue has grown very fast, our core growth has actually grown at a faster rate than the strategic. So we anticipate that the shift to primarily core, secondarily strategic is starting to happen this quarter and will continue next quarter. But the growth rates there, and the pipeline there are actually very strong.

We do also believe that the strategic accounts are a two-quarter shift. We don’t see this as a permanent dysfunction, if you will. It’s just a shift in what we expect the demand to be there. We’re not giving guidance yet on 2014, but nothing has really changed. We’re in the middle of a major transformation in the industry. We think that the new products - our ioScale is also going to be very helpful to us. We have to wait and see what that does.

Ben Reitzes - Barclays

Why not cut price and take the gross margin down if you’re going to lose money anyway in the near term to try to stimulate sales and maybe avert multiple challenging quarters on the top line?

David Flynn

You know, we think that the appropriate balance is around the 56% to 58% blended for the company. That doesn’t mean we don’t take opportunities on strategic deals from time to time that balance out.

But to do it wholesale, we don’t think would be an efficient use of the capital compared to doing it based on pinpoint deal dynamics. One of the advantages we have with a direct enterprise sales team is that we’re interacting with these customers and can tell where their price sensitivities are to where they can convert a new tier that was using mechanical storage to use Flash.

So we will use the price leverage strategically, but do not see it as helpful to throw it so far out of whack that it doesn’t allow us to create a very stable business.

Dennis Wolf

And again, to expand on that, we will use the pricing lever as much as we have to use it. We’re not shy about it. At this point, where we optimize market capture is in the 56-58% blended range.

David Flynn

It’s also important to note that one of the bigger factors to this is actually the ability to adopt the new geometries, the new lithographies in NAND very quickly, because that’s where the step functions come. And it’s not just in the price point, but also, almost more importantly, especially in hyperscale, the capacity density, being able to get to those higher capacity points.

So it wasn’t just the price per GB that allowed, say, Facebook to go to an all-Flash database tier. They were showing off at the OCP summit their all-Flash database server that used Fusion-io. And that’s what we helped them do a little over a year ago.

It’s actually the capacity density that makes that possible, because now they can put the sufficient-sized data set on the same server. Interesting little note there, because you’re increasing the amount of content the server can serve, the performance of the server, you need to be able to increase the amount of capacity. If you put twice as many users on the server, you need to put the data for those users with it.

And so the performance density drives the need for capacity density, and that’s what ultimately unlocks being able to go to these all-Flash architectures, away from mechanical storage. So it won’t necessarily help to reduce pricing without having the commensurate density bumps as well.

Operator

We have Bill Shope from Goldman Sachs on line with a question. Please go ahead.

Bill Shope - Goldman Sachs

I know you’re not providing guidance for the next fiscal year, but I just want to make sure we’re all clear here. If we followed your answer to Ben’s first question, the Street would model a fairly remarkable jump in revenues for the second half of the calendar year. Is that what you’re pointing to? I mean, effectively that would be consensus staying put beyond this disruption we’re going to see in the next two quarters. And if so, I guess is it fair to say you’re fairly confident these bulk orders are going to show up in two quarters?

Dennis Wolf

Let me take you through the actual forecasting. And again, we’re expecting to do $80 million this quarter and a range of $100-120 million in the fourth quarter, to your point. In order to get back to the growth rates that we have enjoyed up until now, we expect our core will grow in excess of 50%, and that our new customers are now becoming a significant possibly for it. It really does depend on the hyperscale buildouts. We do see new customer deployments that may be forming. And they’re key strategic scale kind of customers.

So we look at our key customers. We think there will be more. Our new products and partnerships are sturdy. Our product introduction for ioScale is very positive. We’ve had more new products introduced over the last couple of quarters than we’ve ever had, and they’re starting to gain some traction. We have expanded partnerships. We have 200 sales people who are going to be improving their own ramp on their sales productivity. So taking all of that into account, we believe that the megatrend for us is very strong.

David Flynn

Backdrop to that is, of course, the main market driver, which is the increase in processing horsepower, the lower cost of Flash memory driving toward a transformation away from mechanical storage, while at the same time, you have this trend of moving from a traditional IT world to a more cloud scaled out world, where all of that data gets aggregated centrally and can benefit from moving away from those mechanical storage. So we see these trends all lining up so that, especially as we look averaged over time, over longer periods it’s very bright.

Operator

We have Edward Parker from Lazard Capital Markets on line with a question. Please go ahead.

Edward Parker - Lazard

Just a clarification and then a question. Sorry to go back to the guidance, but since six months does fall beyond the horizon of what you guided to, you saw your strategic customers bounce between about $40 million and $60 million on any given quarter, so is it okay to assume that by September and December we’ll sort of be back within that ballpark?

Dennis Wolf

Yeah. We do expect that you have the right onramp there.

Edward Parker - Lazard

And then maybe just turning to the enterprise side of the business, and just maybe a software update, are there any more cues or metrics that you can help us assess how the software value proposition is being received by customers? And maybe an update on ION as well?

David Flynn

Sure, starting with that latter question, ION sales more than doubled this quarter. Of course, it’s still early in the ramp. But very positive signs. And in this quarter, we’re introducing some of the key functionalities that will expand its abilities in this market. ioTurbine is ramping well, and is now rounded out to where it supports a broad enough set of platforms, both in terms of guest operating systems and hypervisors that we see much more market opportunity there.

So can’t necessarily give you quantitative. We don’t break out revenues from software separately, because this is a system sale, where the value of the software and the hardware together is ultimately what drives the ability to maintain pricing.

But I guess one of the interesting statistics around the momentum within the enterprise IT world is a recent survey - I guess we’ll have to make a shout-out to Morgan Stanley here on it. With 50% of CIOs responding that they expect to increase their spend on FIO, in the future, that was more than any other vendor.

So we’re very excited about how the business is growing there in the enterprise space, and that’s largely driven by being able to have a more complete package of solutions that can allow people to conveniently drop in server-side Flash and have it interoperate either as shared storage with ION or as a cache in front of their legacy shared storage with ioTurbine.

Operator

And we have Aaron Rakers from Stifel Nicolaus, who has a question. Please go ahead.

Aaron Rakers - Stifel Nicolaus

First, just kind of building on the visibility discussion, given what you’ve said about your strategic customers, I’d be interested in your visibility and how you think about what looks to be a fairly sharp - just to get to your revenue guidance - implied ramp into the June quarter for your non-strategic customers. So can you talk a little bit about what kind of visibility going into a quarter relative to the six-month number that you have on those customers?

Dennis Wolf

Yeah, we’re getting better visibility there. You know, they start as proof of concept, and with the ioScale rollout, and as David was explaining regarding the overall transformation, they’ve been working with us for some period of time. And some of these are very significant accounts that we are beginning to become more hopeful with. We actually talked about this on the last earnings call, where we said we’re beginning to see greater visibilities for some of these other hyperscale buildouts that could be significant. So they are beginning to form.

Aaron Rakers - Stifel Nicolaus

Okay. And then the final question for me, on the gross margin line, it looks like your mix actually changes and swings favorably to obviously the non-strategic customers. Historically, though, it’s been a much higher gross margin in your strategic. So not to push here a little bit, but why would gross margin not be up unless you’re actually seeing a decline in the gross margin structure and those non-strategic customers?

Dennis Wolf

I know that there is a theory on that. It really depends upon what the actually product is, between hyperscale and enterprise. I think during this quarter we will be seeing more hyperscale than enterprise, and we’ve said before that that usually has a couple hundred basis points pull one way or the other.

Operator

And we have Amit Daryanani from RBC Capital Markets on line with a question. Please go ahead.

Amit Daryanani - RBC Capital Markets

Just two questions from me. One, could you maybe just clarify, when you said $10-20 million revenues from your two big customers, was that meant per customer, per quarter? Or was that a combined number for six months?

Dennis Wolf

That’s the aggregation, per quarter.

Amit Daryanani - RBC Capital Markets

And then could you maybe just talk about, and I’m trying to just understand this dynamic, but I’m sure each of those customers had different reasons why they pushed out the product purchases. But given the fact it happened simultaneously, could you just maybe talk about what were the drivers between each one of them leading to defer the purchases at about the same time?

David Flynn

You know, Facebook is more open about this kind of stuff, in that we work with them, but even there I would be loath to make assessments about why they might be focusing on efficiency in the cost of their business. But you guys could probably infer that. And of course Apple is extremely private about it, so I won’t really make any speculation on that point.

What I will say is if you look at those two customers, and how they have performed in the seven quarters since we IPOed, and look at the relative sizes to each other, they have tended to be oscillating, to where one does 70% while the other one does 30%, and then the other one does 30% and the other one does 70%, of the pool of strategic.

So the variability in their purchasing patterns is inherent. What you have here is just the opposite of the law of large numbers. The law of small numbers means that things don’t always line up. And so I think that’s maybe a better way to think of this. There’s going to be things pushed in a quarter or pulled in a quarter, or pushed out a quarter. Sometimes they offset each other, and that’s been the case up until now.

Amit Daryanani - RBC Capital Markets

Fair enough. And then just on ioScale, can you talk about where are you seeing the traction right now? Is it largely with existing customers, newer customers? And then the applications that it’s getting deployed with, can you just give us a flair on what kind of applications do you think that are most likely going to go with ioScale versus ioMemory and some of your traditional products?

David Flynn

Well, it’s interesting that you ask that, because many of these, our customers that we have done lots of business with in the past, what’s different is that this allows customers to use it in application tiers that are more capacity oriented than performance, and have larger capacity point requirements and to be competitive against mechanical storage need to be at lower cost points.

So much of this is going to be to where the price point hits the tipping point for customers to adopt all-Flash architectures from where they had been focusing on just using it in smaller areas within their infrastructure. The apps that this tends to be used with are the same type that we’ve been talking about all along, things like databases, both RDBMSes, structured data, the no-SQL unstructured database type of stuff, and search.

I’ll say one of the most interesting things about ioScale and the go-to-market model, and the cost structure of the product being designed to lower cost in the lower touch model to get it to market when it comes to partners, that has allowed us to now shift to where we can better address the hyperscale market where the data is transient.

There’s kind of two divisions, I think, of hyperscale. One is the hyperscale where the data is mission-critical. That would be the case at Apple and Facebook. This is holding the crown jewels kind of thing, right? But there’s search tiers at those customers and others, where the data is just there to make searching fast. And if you log into Google and some result doesn’t show up, you’d never know it’s missing, right? And it gets refreshed every day. So the data is transient.

So when we look at ioScale, it’s allowing us to move further into the world of hosting not just the mission-critical data, but transient data type of apps. And that would go more toward search stuff.

Operator

We have Alex Kurtz from Sterne Agee on the line with a question. Please go ahead.

Alex Kurtz - Sterne Agee

Just a question about the ioScale comments from earlier. It sounded like you had five customers in the quarter with over a million dollar in purchases. Was that right? And why not include that in the guidance for fiscal ’13 and think about that as far as a growth driver into fiscal ’14? Just take us through the thoughts on that.

Dennis Wolf

So yeah, five of our million-dollar customers were ioScale customers. We do have assumptions for some of those, and behind those there are some that even have a potentiality of even more. It’s too early for us to be able to call them, so we can’t call them.

Alex Kurtz - Sterne Agee

But you think it could fall into fiscal ’13? You’re just not guiding to it?

Dennis Wolf

We can’t guide to fiscal ’13. We don’t know.

Alex Kurtz - Sterne Agee

With ioScale?

Dennis Wolf

Yes.

David Flynn

The main reason for this is that a lot of it is outside our control, in terms of when those customers have the rest of the story put together, and are ready to pull the trigger. So it’s kind of our work is done in terms of the design-in, and showing the ROI and value proposition, but there are many, many factors that decide when the trigger is pulled on making these large investments.

Alex Kurtz - Sterne Agee

My last question here is it looks like the Facebook capex was down sequentially. They just reported. Is potentially some of this macro-related, or something broader than just the absorption of all the revenue, product they’ve [offered me] in the last year?

David Flynn

I’ll leave that to you to speculate. I will say that our products allow them to get more from their infrastructure. It’s an efficiency play.

Operator

We have Jason Adler from William Blair on the line with a question. Please go ahead.

Jason Adler - William Blair

I wanted to go through the math on the Q4 implied guidance. Like $110 million at the midpoint. If you said the strategics were going to be somewhat silent for two quarters, I would assume - you said $10-20 million run rate for the strategics, so let’s just take the top end of that range and say $20 million. That leaves about $90 million for the core. And you just did $60 million in Q2 and the implied guidance, if we take the midpoint in the March quarter, is about $65 million for the core. So it would be $60-65 million to $90 million. And that can’t be right. So I must be missing something. I wanted to see if you could help clarify that.

Dennis Wolf

First of all, we don’t know how large strategic is going to be. Strategic is comprised of Facebook, Apple, and any of the others that we’re starting to talk about right now. So while we don’t really conclude much in that, we think that there’s other core buildouts that are occurring. We look at our pipeline and we get comfortable around that growth rate.

Jason Adler - William Blair

So for the December quarter, so the breakdown was about $60 million for core and $61 million for strategics. Is that correct?

Dennis Wolf

Correct.

Jason Adler - William Blair

And Apple and Facebook combined were 50%, is that correct?

Dennis Wolf

Yeah, they were 51%.

Jason Adler - William Blair

So in the December quarter, then, there was really nobody else besides Facebook and Apple in the strategic line. Is that correct?

Dennis Wolf

That’s correct.

Jason Adler - William Blair

So it’s almost really just in the second half of the fiscal year you’re starting to have strategic customers that are significant enough that they’re going to start going into that line?

Dennis Wolf

It’s potentially there.

David Flynn

And that’s where it gets a little bit fuzzy, because how do you define that line? What we’re seeing is that an increasing number of customers are increasing the size of their orders.

Jason Adler - William Blair

What’s the threshold, David, on when you include somebody in the strategic?

Dennis Wolf

By definition, of course, it’s 10%, but it’s also they’re strategic when our technology is part and parcel of what they do, and they’re instructive to us. And some of these ioScale customers have that potential. Basically what it comes down to is a bulk purchaser.

David Flynn

And where we have to prioritize their orders above others. That’s really, internally, how we use the term, so that people understand that these guys get priority on shipments and that’s because their infrastructure is in some way dependent on us. So the term is used loosely. There’s the strict definition of a 10%-plus customer that we will disclose, and then there’s this other, fuzzier concept of the relationship being such that we have to prioritize them above others, and where we are more partnering with them for the design and buildout of the data center.

Jason Adler - William Blair

Okay, and then just final point, is it fair to assume that you expect a decent ramp from March to June on the strategics, then, just as you have more of these hyperscale guys come into the strategic mix?

David Flynn

I’d say on the boundary of that graduation from what would be core size to strategic, yes.

Operator

We have Rajesh Ghai from Craig Hallum on the line with a question. Please go ahead.

Rajesh Ghai - Craig Hallum

Just wondering if you could give us some more color on the enterprise business, the strength that you saw. And also refer to where you’re seeing the strength, if it’s at any particular OEM. And if you saw any contribution from Cisco and NetApp this quarter.

David Flynn

Cisco’s mezzanine form factor for their blade system is now in the market, generally available. so we are seeing, especially, some of the pent-up demand that was waiting for that now come unlocked. There is still some demand pent up for a standard form factor for their regular form factor servers. They sell mostly their blade systems, because that where they can create more value, but Fusion-io often, because of the high density points, benefits from the standard form factor servers.

So there’s some interesting opportunities there when we drive high capacity density that are right now untapped because they don’t have those standard form factor cards available for the standard form factor servers. We expect that to be remedied with time, and we should see significant contribution from Cisco.

What we’re starting to see is that it’s going to be the sort of trifecta of Cisco, NetApp, and Fusion-io that can drive some significant business, due to the partnerships that are there already around virtualization and these high-density systems. So we’re quite excited about that.

I’m not sure if that covered your full question.

Rajesh Ghai - Craig Hallum

Yes. [unintelligible] the partnership with NetApp contributed anything during the quarter?

David Flynn

We have been doing a lot of work with ramping those teams up, and there’s very good collaboration in lead flow and opportunities. A lot of this boils down to making sure that both parties are involved, so that we can solve a customer’s needs for both best-in-class data management and capacity and best-in-class performance with Fusion-io. So the fact of the matter is, we are seeing the business pick up from this, and it is showing up in terms of deal and opportunity flow.

Rajesh Ghai - Craig Hallum

And my other question was regarding your investments going forward, recognizing that you will have lumpiness in your business. By my math, your guidance implies that you’re going to continue adding about $5 million a quarter in opex over the next two quarters. What kind of timeframe do you have in terms of reaching your operating model targets that you had [unintelligible] in the past?

Dennis Wolf

Our model at stride would be 20-25%. We’ve almost done that, or have done that a few quarters now. You see that it’s had its fits and starts. And that’s the nature of a company that’s really growing very fast. We intend to continue to invest in our people, and that would be in R&D, primarily, and also in sales. This is a market capture story, and while we would like the 20-25% to be presented right now, our first bias is going to be toward growth. We are not giving guidance for 2014 at this point in time, so I can’t really go beyond that, except to tell you that we have it in our sights. But we have growth in our sights too.

Rajesh Ghai - Craig Hallum

One last question, in follow up to Brent’s question about the [changes in the business] model that the potential open sourcing of your hyperscale design could do. You don’t see any likelihood of Facebook or Apple, that obviously have great relationships with ODMs, of kind of looking at that model to procure from you in the future. Is that the right assessment?

David Flynn

No, not at this point. It requires our IP to make the whole thing work, and having options of others who can manufacture the product is a good option, but we don’t see that being used in the near term.

Operator

We have Srini Nandury from Summit Research on the line with a question. Please go ahead.

Srini Nandury - Summit Research

If you look at your [$2 million a year] [unintelligible] hyperscale and enterprise data center, what are the main differences for the products that serve these markets?

David Flynn

The products are different in many ways. One is the design and simplicity of the card. It’s kind of like the difference between an Abrams A1 tank and an armored personnel carrier. One is meant to be nimble and lightweight and the other one is made to last forever. So when we look at this, it’s different types of NAND, single controller, with lots of high-density. The board design, less layers. It’s not made, necessarily, to the specifications of the OEMs.

So it’s a more commercial grade versus enterprise grade design. But the biggest single thing would be the type of NAND that’s used, and the ability to use the newest lithography, which often means lesser quality NAND, very quickly, without waiting for qual cycles.

Srini Nandury - Summit Research

Back in the Open Computing Forum, you talked about hyperscale guys that are replacing their servers every two years. What is the likelihood that they might reuse some of your cards? Because the card is going to be roughly 50-60% of the bill of materials for the server.

David Flynn

That is definitely a possibility. Our technology has been proven to last well, and so that’s possible.

Srini Nandury - Summit Research

One final question, if I may. You haven’t talked about the VDI opportunity.

David Flynn

We consider that part of the virtualization space, addressed by ioTurbine. And we do have many wins in that space, and partnerships as well, with, like, [Newtonics] and others.

Operator

And we have a question from Nehal Chokshi with Technology Insights on the line with a question. Please go ahead.

Nehal Chokshi - Technology Insights

Sorry to continue to move on this Facebook and Apple topic here, but when you talked about your own technology has enabled better efficiency to allow them to effectively delay their purchases, are you talking about things within your software development kit, like [atomic] rights and other features? And I’ll have a follow up to that, if you could elaborate on that please.

David Flynn

Those things do stand to enhance the leverage you can get from Flash, for sure. Not currently applied, so that wouldn’t be the case for these here. Often it’s their own tuning of their own applications to be able to serve more on fewer servers.

Nehal Chokshi - Technology Insights

So can you walk us through why it’s a six-month delay instead of, say, a nine-month or 12-month delay? What’s the math giving you that confidence that, hey, it’s a six-month delay?

Dennis Wolf

You know, we work with the customer. They give us the math.

David Flynn

Deployment schedules are up to them. We just follow what they say, and sometimes that changes, as we see. Most of the time it’s a surprise to us, in that they pulled it in and they’re often bigger. This time they’re tuning for something different.

Nehal Chokshi - Technology Insights

Okay, and then you also mentioned that you expect this maintenance level to be about $15 million or $20 million per quarter. What’s driving that? Is that the expansion of the number of servers that are hosting these applications? Or is there something else going on there?

David Flynn

There’s normal run rate business that is based on just the expansion of their number of users, etc. Then there’s the step functions that occur when new data centers or new applications get converted. So this is more the run rate business, standard growth in user base, etc.

Operator

And our last question comes from Roxane Googin with Global Investments. Please go ahead.

Roxane Googin - Global Investment Research

I have two questions. One, if we assume that hard drives are really going to mutate to Flash storage systems, and the real question, ultimately for you, is how much of that transition you get, could you just describe, at a high level, how ioScale separates you from your PCIE card competition relative to ioMemory? That’s question one.

David Flynn

The ioScale sort of allows us to address the unique needs in the hyperscale market, which is extremely important when you view the greater trend toward cloud aggregated infrastructure versus the traditional IT.

So here we have had the opportunity, by working closely with Apple, Facebook, and other companies that are building these infrastructures to know exactly what they need. For example, single controller, very simplified design, no memory chips and supercapacitors and all of that kind of [foo].

So the complexities of the trappings, or the baggage, that comes with legacy storage systems really are contraindicated in the hyperscale world, where they want very simple servers, where they get reliability from simplicity, not from over-engineering it.

And so these design points are critical, and we’ve been privileged to be iterating now to where this is the fourth data center that we’ve done with Facebook, and have refined those requirements into a product that we think really hits the sweet spot for that hyperscale market.

Roxane Googin - Global Investment Research

And on a more boring note, you mentioned some telcos were buying your product, and they’re pretty late adopters. Could you just highlight anything interesting about either the sales cycle or the use case that you’re seeing there, and the potential?

David Flynn

I highlighted two U.S. telcos, two of the largest here, as million dollar plus customers. The fact is that we’re doing brisk business with telcos across the globe, from China Mobile we talked about last year and throughout. Those types of things tend to be what you might expect, accelerating billing systems, even SMS messaging systems, managing all the texting on iPhones in certain whole countries. It’s kind of cool.

So the data demands of telcos, as you know, are huge. But the footprint there has largely been in terms of database acceleration. As we introduce the ioScale card, there’s the opportunity to move into some of their broader businesses, where they’re supplying more platforms.

Operator

I will now turn the call back over to Nancy Fazioli for final comments.

Nancy Fazioli

Thank you, operator. Regarding events for the quarter, David and Dennis will be presenting at the Stifel Nicolaus Technology Conference on February 5, and at the Barclays Big Data Conference on February 11. David will present a morning keynote at the Pacific Crest Emerging Technology Conference on February 12, and both David and Dennis will also attend the Goldman Sachs Technology Conference on February 12. Dennis and Lance Smith, our COO, will present at Morgan Stanley on February 27, and Lance Smith will also present at the Credit Suisse Next Generation Data Center Conference on March 5.

Each of these presentations will be webcast, and available on the investor relations page of Fusion-io’s website. Please contact the investor relations department with any follow up questions. You can reach us at ir@fusionio.com.

This concludes our call. Thank you for your participation and support, and good evening.

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