Brocade Communications Systems, Inc. F1Q09 (Qtr End 01/24/09) Earnings Call Transcript

Brocade Communications Systems, Inc. (BRCD)

F1Q09 (Qtr End 01/24/09) Earnings Call Transcript

February 19, 2009 5:00 pm ET

Executives

Alex Lenke – Director, IR

Michael Klayko – CEO

Richard Deranleau – VP of Finance and CFO

Dan Fairfax – VP of Business Operations

Marc Randall – SVP of Products and Offerings

Analysts

Mark Moskowitz – JPMorgan

Mark Sue – RBC Capital

Samuel Wilson – JMP Securities

Kaushik Roy – Pacific Growth Equities

Min Park – Goldman Sachs

Andrew Nowinski – Piper Jaffray

Aaron Rakers [ph] – Stifel Nicolaus

Keith Bachman – Bank of Montreal

Munjal Shah – Jefferies

Ryan Hutchinson – Lazard Capital Markets

Presentation

Operator

Good day ladies and gentlemen, and welcome to the first quarter 2009 Brocade Communications Systems, Inc., conference call. My name is Michelle and I will be your coordinator for today. (Operator instructions) As a reminder, this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today’s call, Mr. Alex Lenke. Please proceed.

Alex Lenke

Thank you, operator, and good afternoon everyone. Joining me today from Brocade are Michael Klayko, CEO; Richard Deranleau, CFO; Marc Randall, Senior Vice President of Products and Offerings, and Dan Fairfax, Vice President of Business Operations. Before we begin, let me cover some housekeeping items.

Brocade issued a press release today detailing its first quarter financial results via Business Wire and First Call. The press release is available on our Web site at www.brcd.com. A copy of the slide presentation will be posted just after the conference call concludes.

This conference call is being webcast and will be archived on our Web site for approximately 12 months. In addition, a telephone replay will be available at approximately 5:00 p.m. Pacific Time today through 5:00 p.m. Pacific Time February 26. To access the telephone replay, dial 888-286-8010 or 617-801-6888. The pass code is 16413424.

As a reminder, the information the presenters discuss today will include forward-looking statements, including without limitation, statements about Brocade’s financial results, plans, business outlook, integration of the Foundry acquisition 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 25, 2008. These forward-looking statements reflect beliefs, assumptions, 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 are provided in today’s press release, which has been furnished to the SEC on Form 8-K and in the corresponding slide presentation on our Web site.

With that, I will now turn the call over to Mike.

Michael Klayko

Good afternoon, everyone. Thank you for joining us. Q1 was a great quarter as Brocade achieved record revenues of $431.6 million growing 24% year over year and 8% sequentially. Our disciplined operational execution also drove better than our long-term model operating margins and overall financial performance. We exceeded the Street EPS estimates for the 14th consecutive quarter, as Richard will discuss in a few minutes.

Before I talk about how we performed from a product and market segment standpoint, I want to provide an update on several positive developments since we completed our acquisition of Foundry Networks in December. First, the integration of foundry into Brocade is progressing very well, and in fact, we are ahead of schedule. I'm pleased to report that we were able to retain a vast majority of the Foundry employee base, including key members of the executive team. Initial survey feedback from the acquired Foundry employees has been overwhelmingly positive. Upon the transaction close, we organized the company in such a way that we were able to hit the ground running faster and with many external stakeholders’ thought possible. We are now one company with one vision and everyone is excited about the opportunities that are developing.

Second, our product and engineering teams have been working closely together and have finalized a combined roadmap, which will deliver industry-leading end to end networking solutions while providing customer’s choice. From an operations perspective, we are now very comfortable that we can achieve the cost synergies within the time frames we have committed to. With the opportunity to consolidate contract manufacturers moving Foundry products and services into our lifecycle management and quality processes, we should be able to achieve or exceed product cost targets while increasing the overall quality and production quantity. We will keep you updated on our continuing progress throughout the year.

One of the most positive surprises that emerged as a result of this acquisition has come from talking to and visiting our customers and prospects. We have discovered that many of the industry's large Ethernet installations are quite inefficient and cost burdensome. In times when customers are citing cost as their number one, number two, and number three concern, these inefficient networks equate to opportunities for Brocade. We have found the companies who may have been loyal to past vendors are now eager to look at alternative of suppliers, like Brocade, in order to save money. Because of the breadth of our IP networking and data storage solutions we now offer, our immediately challenge is to prioritize the opportunities which offer the greatest long-term revenue and market share opportunities.

Lastly, we’ve aligned our business to take advantage of the market segments where we predict growth. As you know, Marc Randall joined Brocade in December to head up the newly formed Products and Offerings Group. Marc was previously the CEO of Force10 and brings to the company over 25 years of experience in the IP networking space. We have put all the product divisions under Marc. Data storage, which includes the DCI and sever product portfolios; IP Layer-2 and Layer-3 and the newly formed application, delivery controllers, and files group. In addition, Marc is leveraging the now larger and more experienced engineering, product marketing and global services teams to deliver very competitive, robust and cost-effective products and solutions to the industry.

Brocade's focus for this year is on three market segments. First, Enterprise Data Center Solutions, which includes directors, switches, HBAs, top-of-rack switches, end-of-row and backbones, file management solutions, application delivery, converged network products and virtualization solutions. Second, the Enterprise LAN Campus, while we will deliver lower-cost, high-performance solutions than our competitors, including stackable 1GigE and 10GigE solutions, enhanced Power over Ethernet+ 1GigE and 10GigE density, as well as security and wireless solutions. Third, Service Providers, where we will offer metro Edge and Aggregation solutions, Ethernet Backbone, MPLS, 10GigE density, we believe that with this focus, combined with our robust roadmap and expertise will enable us to not only continue our momentum in this core SAN business, but also position us competitively in the IP networking space where we seek to increase market share.

Now to update you on our product mix that drove first quarter revenues as a combined company. We saw continued strong growth of our DCX Backbone and increasingly acceptance of our full family of 8Gig switch and 8Gig sever blade offerings. Revenue from our 8Gig family of offerings grew 16% quarter over quarter. During the quarter, we also recognized an additional market segment that required a more modular director product. To satisfy this market requirement, we introduced the DCX-4S, another cost-effective version of the DCX, but with half the normal port count of the DCX. Our HBA business, where we continue to secure Tire 1 and Tire 2 OEM designs ramped up nicely in Q1. We are winning large data center opportunities with high-performance RX, MLX, XMR IP products. Overall, I believe our products continued to be widely adopted by the largest companies in the world, and I'm pleased with our performance, especially in light of the current macroeconomic conditions.

While our crystal ball is no clearer than anyone else’s in this economy, we do believe that Brocade has a lot of opportunities in our target markets because of the inefficiencies of today's installed Ethernet network that I mentioned, and our customers’ singular focus on reducing costs. And while customers realize they need to do something about this, we have found that many of them are confused about what direction to take and what comprises the next generation data center and is the optimal architecture in order to handle the massive growth in network traffic and data traffic. They know that they need to design purpose-driven networks that address their particular issues that will enable them to scale, and at the same time will reduce costs.

Some suppliers are telling them the converged virtual data centers are the way to go. Brocade also believes that eventually this will be the case, and we're ready to ship products when the time is right. But with solutions such as FCOE costing more than twice that of traditional fiber channel solutions according to some industry analysts, customers who are focused on reducing costs are backing away from this design. In fact, we have customers asking us to commit to our technology for at least the next two product cycles to ensure the longevity of their next-generation data centers. Brocade also believes that the most efficient and guaranteed way to drive cost out of data center is to provide choice. Customers need a choice in their virtualization solutions, their management solutions, and their server and storage solutions. How do they get this choice? Brocade offers best of breed solutions by partnering with the largest server and storage providers in the industry. Supplying solutions from such a large, wide ecosystem of world-class partners that are tested in Brocade's industry-leading, comprehensive interoperability lab environment.

Combined with the robust product and solution portfolio is just one more example of what sets Brocade apart in our market. By talking with customers we know what their networks require. They have to be high-performance to handle the massive data and network traffic growth. They need to be intelligently designed to be purpose-driven and future ready, but optimized for a faster ROI and lower total cost of ownership. They need to be reliable, easy to manage, and consume less power, and above all they need to protect customers’ current investments by ensuring interoperability in hardware and software.

Networks must have an open non-proprietary architecture, leveraging the best of hardware, software and services from a wide range of providers. Customer feedback to our solutions that meet these challenges has been overwhelmingly positive.

So what's next? I've already mentioned that our Products and Offerings Group has been aligned to address the growing market segments of Enterprise Data Center Storage, Enterprise LAN Campus and Service Providers. They will continue Brocade's history of innovation with our consistent goal of deriving 60% to 80% of our revenues from products and solutions that have been introduced in the last six quarters. And they plan to leverage the successes we have had in the data center and apply the same high-quality standards, performance and reliability to the rest of the solutions we are targeting for the entire network. In addition, we have formed one global sales organization under Ian Whiting, our Senior Vice President of Worldwide Sales. During the recent meeting with the entire Foundry sales team, the excitement in the room was very high as we walked through some of the opportunities that lie ahead of us.

As most of you will remember when we first announced the Foundry transaction, there is less than a 5% overlap of customers buying both Brocade and Foundry products and solutions. This represents a huge opportunity in terms of selling IP networking gear into traditional SAN customers, and SAN gear into traditional IP customers. Both sales teams are excited because customers who would have not typically reached out to stand-alone Brocade or a stand-alone Foundry are now eager to have us come in with proposals for the entire networks, proposes that offer the end to end solutions they need while reducing costs. One thing that we hear over and over from customers is that they would be financially negligent if they did not consider Brocade's cost advantage given the current macroeconomic environment. This same macroeconomic environment is also working in our favor in terms of vertical markets. For example, the healthcare industry where Brocade and Foundry have large customers stands to benefit from a $20 billion technology stimulus in 2009 from the federal government to upgrade their networks in order to make medical records available online and offer the ability to transfer large data files, including images and video between hospitals and doctors’ offices. I think you can understand why I am so pleased with the results of this acquisition and what opportunities this will afford Brocade in the future.

I would like to now turn the call over to Richard for some more detail on our Q1 and our outlook going forward, and then I will return for a few concluding remarks.

Richard Deranleau

Thank you, Mike, and thanks to all for joining us today. We are particularly pleased with our Q1 ‘09 results, given the extraordinary economic environment that exists today. As has become our practice, we have included a significant amount of detail in our earnings press release. So I will not be repeating that information on today's call. Now, let's look at our financial results beginning with the income statement.

Our record revenues in Q1 included approximately one month of Foundry revenue. Revenue was driven by strong demand for our DCX platform, embedded switches for bladed servers, and global service offerings. On a geographic basis, performance was generally consistent across all geographies. In Q1, our international revenue percentage normalizing for those large OEMs will take delivery of internationally destined products within the US was approximately 54%, down from 59% in Q4 2008, reflecting the fact that roughly 60% of our IP product demand is from the US.

Moving on to our business segments; data storage revenues were down 7% quarter over quarter but up 5% year-over-year. Our DCX backbone revenue increased to approximately 57% of overall Director sales in Q1. Embedded switch revenues were up 1% quarter over quarter and 20% year-over-year, which represents a fifth consecutive record quarter. HBA revenues ramped up nicely in Q1. IP product revenues represented 12% of total Brocade revenue. As the acquisition closed December 19, 2008 approximately five weeks or $60 million of Foundry revenues were included in Brocade Q1 2009 results. Normalizing Foundry revenue for Brocade's fiscal Q1 09, Foundry revenue would have been approximately $146 million. Global services revenues were up 9% quarter over quarter and up 38% year-over-year.

Moving on to gross margins; on a non-GAAP basis, gross margin for Q1 was 59.7%, squarely within our long-term target model range of 58% to 61%. Margins were negatively impacted by the non-cash purchase accounting adjustments from the Foundry acquisition. The Q1 purchase accounting adjustment included an increase in product cost of $8.8 million for inventory and a reduction of $9.6 million for deferred revenue. Please refer to the net for the quarterly impact of the Foundry purchase accounting adjustments.

Non-GAAP gross margin in our global services business was a healthy 47.4%, up from 40.1% in Q4 2008, reflecting the inclusion of Foundry high gross margin support revenue and the result of the cost restructuring in the classic Brocade global services organization completed in Q4 2008. From an operating margin perspective, Q1 non-GAAP operating expenses were 33.7% of revenue versus 37.9% in Q4 2008, well below our long-term model goal of 38% to 40% of revenues, driven primarily by spending controls and the incremental Foundry revenues. Non-GAAP operating margin for Q1 was 26.1%, well above our long-term model of 19 to 23%.

Moving on to our operating results on an earnings per share basis, Q1 non-GAAP diluted EPS was $0.15. Reporting on a GAAP diluted basis, Q1 EPS was a loss of $0.07, reflecting significant non-cash charges related to the acquisition of Foundry. The difference between GAAP and non-GAAP net income is reconciled in today's press release and in today's webcast slides.

On a non-GAAP basis, diluted shares in Q1 2009 were 416 million shares. Typically, our non-GAAP and GAAP diluted shares are the same. However, as we were in a GAAP loss position, we have used a more dilutive share count and our non-GAAP results to represent a more normalized EPS calculation. Please refer to the next slide for a reconciliation of diluted shares.

Now, turning to our cash flow and balance sheet; Accounts Receivable normalized DSO was 44 days. Actual DSO was 52 days, computed on a partial quarter of Foundry revenue. Normalized inventory turns were 11 days, reflecting the differences in the Foundry supply chain. Cash flow from operations in the first quarter was approximately $46 million, adjusted for the Accounts Payable movement related to the funding of the acquisition and the previously announced Class Action settlement payment. Outstanding acquisition term debt balance was $1.06 billion, net of debt discount of $44 million. Adjusted EBITDA was a healthy $138.7 million.

Now, turning to our outlook for the combined company for fiscal 2009 and our target for 2010; first, let us leave visit our combined long-term financial model. While we have made some minor changes to reflect what we have learned from our integration of Foundry, we have left the Brocade total targets the same. Our operating margin target remains a healthy 19% to 23%. We have prepared our outlook based on the following planning assumptions.

Our planning assumption is that the current IT spending environment will remain adversely impacted by the current macroeconomic environment. We expect IT spending to begin to improve in Q4 2009 and throughout fiscal 2010. We expect our markets to return to normal historical growth rates in 2010. We expect to see normal to greater than normal seasonal declines in Q2 2009. While our core markets remain competitive, we believe the product advantages and momentum and our installed base advantage keeps us in a uniquely strong competitive position. We believe we will maintain market share in our core SAN market, grow market share in the LAN markets and we expect to be a leading supplier of HBAs.

From a pricing perspective, we expect quarterly ASP declines to remain in the low single digits through 2010. Our data storage planning assumption includes the market will remain slower than typical due to the impact of the global economy in fiscal 2009. We believe Directors and embedded switches will grow faster than switches and the overall SAN market. We believe HBA products will significantly ramp with qualifications of the 8 gig HBAs at our OEM partners in the second half of fiscal 2009.

Our IP and ADC assumptions include an expectation for market share gains. Our global services assumptions include expectations of growth of 10% to 15%, driven by professional services and support and maintenance contracts which are tied hike to product revenue to ramp through 2010.

Given these considerations, here is our updated FY 2009 annual outlook for the combined company as compared to the company's long-term financial model. We expect annual revenue to be in a range of $1.9 billion to $2.0 billion. We expect FY 2009 non-GAAP gross margin to be between 57.5% and 58.5%, which is on the low end of our long-term model range. Again, please refer to slide 17 on the detail of purchase accounting adjustments for their impact on gross margins. For FY 2009, we expect total non-GAAP operating expenses to be in a range of 38% to 39% of revenue, well within our targeted long-term model. The company plans to continue to carefully manage expenses and headcount, but plans to continue to invest in order to maintain our product cycle momentum. As a reminder, Brocade is on a 52-53 week calendar. Q2 2009 is a 14 week quarter and will have one week of extra expenses.

We expect our non-GAAP operating margin to be in a range of 18.5% to 20.5%. We expect other income expense net to be in an expense range of $95 million to $100 million, which includes interest expense on our acquisition-related debt. We expect our tax rate for FY 2009 to be in a range of 31% to 31.5%. We would expect some level of volatility in the GAAP and non-GAAP tax rates. We expect non-GAAP diluted shares outstanding to be in a range of 440 million to 450 million shares, including their dilutive impact of 12.1 million shares of net data convertible debt. Based on these factors, we expect FY 2009 and Brocade non-GAAP diluted EPS to be in a range of $0.40 to $0.50.

Turning to fiscal year 2010, I would like to share some of our planning assumptions. We are modeling a revenue range of $2.1 billion to $2.2 billion for fiscal 2010. We expect FY 2010 non-GAAP gross margin, operating expenses, and operating margins to fall within our long-term model.

Before I turn the call back over to Mike, I would like to review the potential revenue synergies from the Foundry acquisition, which we have not included in our revenue target.

Assuming we realize a moderate level of success, the range of revenue in FY 2010 could be $2.2 billion to $2.6 billion. That could result in EPS growth over our FY 2009 guidance of 30% to 45%.

I would also like to review where we are on the committed cost synergies from the Foundry acquisition, which we have also shared with you in the past. While we have made minor adjustments to deferred revenue related to updated purchase accounting, we currently believe we are on track to achieve our committed synergies with respect to both the amount and the timing.

In summary, in Q1 2009, we ended a good quarter with great operating margins. We have shared our fiscal year 2009 outlook for the combined company and our goals for fiscal year 2010. We are very optimistic in the future of the combined company, despite the current economic headwinds. We remain committed to delivery of shareholder value and to our long-term financial model.

Thank you everyone. And with that I will now turn the call back over to Mike.

Michael Klayko

Thanks, Richard. Over the next three months, Brocade will be on the road, visiting customers and holding investor Q&A sessions both across the US and internationally in EMEA and in Asia-Pacific. This is a chance for you to see our complete range of products and solutions, our technology strategy, and a chance to meet with the members of the management team to ask questions. Please visit our website for details regarding the extraordinary networks tour or contact our Investor Relations department to attend one of these events near you.

With that, thank you for joining us today. And now we would like to open up the call to take your questions. Operator?

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Mark Moskowitz with JPMorgan. Please proceed.

Mark Moskowitz – JPMorgan

Yes, good afternoon. Thank you. Appreciate the update on the Foundry to my model here with Brocade. Richard, I wanted to get a sense in terms of the wider EPS range, it seems a little different than usual. You guys always are pretty conservative. I just want to get a better sense of the wider range on the EPS versus the tight range on revenues. Can you talk about some of the swing factors there I would really appreciate that.

Richard Deranleau

Sure, Mark. Appreciate the question. What is really driving the range is where we are with the economy. I think a lot of people are saying visibility is tough, so what we're trying to do is provide a great other than normal range on the EPS and still give you a visibility on where we think we are going to be on revenue and that is what is really driving it. Obviously, the top line impacts the bottom line significantly. Also, with a lot of the purchase accounting, there is going to be some variability on gross margins. We feel pretty good on our expense forecasts.

Mark Moskowitz – JPMorgan

Okay, and then Mike, could you talk a little bit more about Ian’s division as far as (inaudible) sales. What are some of the mileposts that that you have in place for him in terms of just educating the (inaudible) and the channel, how the two operations are going to work over the next 12 to 18 months?

Michael Klayko

Yes, Mark. What we did is we put all the operations under one organization for a variety of reasons. When we look at the Venn diagram, when we first started doing this last year, we found that about 5% of the Brocade customers actually had Foundry products installed and so there was a great opportunity to do some cross-selling. And so what we have done is we have one team now that is going to be responsible for selling the joint products to not necessarily the same people, but one team. And so, what we found is many of the processes and the tools in the organizations did quite nicely into the things that we are doing today and so we anticipate it may be doing towards the end of the year we are able to do a lot faster and remove this altogether under Ian's team and frankly we had a kickoff meeting with the sales team in January. We now saw the changes and we began the integration process and we are well on our way of getting that done well ahead of time.

Mark Moskowitz – JPMorgan

And then just lastly, thank you for the last response. I just had a question in terms of your commentary on Director growth and the embedded business, you seemed pretty constructive there. Does that reflect maybe a broader product type of (inaudible) where IT budgets we know are definitely going to dust on to here or at least in emergency breaks a lot of corporations, but are there some pockets still strained where the budgets but there is still places that are still pieces that have a more resilient spending either because of one, customers seeking greater efficiency and higher ROI or customers just trying to finish out and place a bid again late last year?

Richard Deranleau

Well, Mark it is a good question, but it is a difficult answer in many respects. There is a lot of transactions that (inaudible). However, many of those have been landing. What we're finding though is there is a maniacal focus on costs. This is not new news. Everybody is really taking a look, how do I take cost out of the environment and so we still see a very large number of consolidations going on for that reason to take cost out and when they are consolidating, a lot of times what you're doing is, you're bringing in larger director and backbone systems and that just takes cost out of the environment, makes it more efficient. So we're getting some benefit out of the folks trying to reduce cost because we are – that is one of the value props that we bring to the table is we do take a lot of offset of current environments.

Michael Klayko

Next question please, operator.

Operator

The next question comes from Mark Sue with RBC Capital. Please proceed.

Mark Sue – RBC Capital

Mike, maybe just on this major cost advantage that you speak of, any simple way to quantify that and then maybe the question is just on the visibility fiber channel versus Ethernet and how that kind of ranks in terms of what you're seeing and if you could quantify what normal seasonality is for Q and then lastly, what your cash flow operations are for your fiscal 2009. Thank you.

Michael Klayko

There are three or four questions there, Mark. Let me take a couple of them and then I may even ask Mark and Richard to jump in. I think the first one is cost advantage. One of the things that we are talking to customers about is as we go in and take a look and do an assessment and took take a look at some of the infrastructure that has been bought over time and implemented, we can actually go in and what we are – our statement is, if we can't take credit percent of the cost out, we literally will go on to another opportunity, because at 30%, customers do get excited. And so that is one of the benchmarks that we use right now and because we have such a highly-integrated product set with our own A6 and we do have very low cost of manufacturing, we can actually go in and take a look at these environments and do that and so that is what I refer to have taken cost out. Second question, repeat it again one more time, Mark.

Mark Sue – RBC Capital

Sure. Normal seasonality as we enter 2Q, how should we look at that for the combined entity?

Michael Klayko

I will have Richard go through it because it is pretty historical. Richard?

Richard Deranleau

Yes, so the couple of answers for you. Seasonality typically would be down 68% percent Q1 to Q2. As a reminder for some of the new people on the call, our Q1 is a strong quarter, up 68% over Q4 and then Q2 is then down 68%, Q3 can be flat to slightly down and then a big step up again in Q4. So what we're looking and we don't expect Foundry to change that seasonal pattern. So we're expecting to see that kind of a pattern in Q2.

You had a question about visibility I might just jump in and talk about. Both Brocade and Foundry use salesforce.com as a funnel for deals. For Brocade, that is obviously at the Director level. And so we use that so we have visibility of the next two quarters out on deals. What we have also this time, those who have taken that view, that bottoms-up view from the field sales force and have reconciled that really to the analyst reports of what is happening in both the LAN or the Ethernet market as well as the SAN market.

I think the last question you asked was about cash flows. And from a cash flow perspective, we have a seasonal pattern that is pretty typical. Q1 and Q3 are weaker cash flow quarters. In general, it could be in the range of $40 million to $60 million in those quarters. Q2 and Q4 are much stronger quarters for us from a seasonal perspective and you should look at anything from $75 million to $125 million in those quarters.

Mark Sue – RBC Capital

Okay. Thank you, gentlemen.

Operator

Your next question comes from Samuel Wilson with JMP Securities. Please proceed.

Samuel Wilson – JMP Securities

Good afternoon, gentlemen. A couple of small questions for you. First, speaking of executives, where is Tom B., he isn’t on the call; and did Bobby Johnson make a trip across or not?

Michael Klayko

Sam, the answer to both those questions they both are on to different careers.

Samuel Wilson – JMP Securities

Okay. In that quarter that was just closed, the January quarter, did the company have five days off with no pay over the extended holiday break?

Michael Klayko

Over the extended holiday break? No, during our extended holiday break we have a normal – we had for the last three or four years in the US, we actually do a corporate shutdown at Christmastime.

Samuel Wilson – JMP Securities

Okay so I guess I'm trying to figure out OpEx for the quarter, sort of on a normalized basis, do you think that was the revenue was quite ballpark were there any sort of one-time actions taken in the quarter to affect OpEx?

Richard Deranleau

Yes, Sam, this is Richard. I think from a Brocade classic point of view, the answer would be no. It is pretty routine; although clearly we are watching every nickel. So that is that perspective. Because the acquisition closed kind of in the middle, there is a distortion between the revenue and the expenses in Foundry. So that makes a little bit harder. But other than that, there have been no structural changes or special action taken in our last quarter.

Samuel Wilson – JMP Securities

Okay, got it. Last question, how did US government do for the combined company?

Michael Klayko

I'm going to introduce we have Dan Fairfax, who came over from Foundry and he is in the room and he was close to it when he was at Foundry, so how did it do?

Dan Fairfax

Sure. So what we told everyone coming into the year, principally from the Foundry perspective was a significant part of our revenue line is that we expected a strong back half of the year, which we did see and the Q3 numbers supported that. We saw good fourth quarter numbers. As Richard mentioned, because of the way the transaction closed, the way we commissioned the sales force to get them tied up or matched up with the new fiscal quarters, we can’t give you really a precise number there. There's going to be on trend but we did hit the part as we said, the second half of the year was much stronger than the first half. We saw that normal seasonality.

Samuel Wilson – JMP Securities

Do you think in Q2 the April quarter normalized combined company with the US Federal government be a 10% customer for the combined company?

Michael Klayko

Hard to tell at this point. Richard?

Richard Deranleau

The trick thing will be how much of that ends up going through distribution, because remember right now the Foundry is business and that direct federal business has been diluted because Brocade's revenue has been so much higher. So even if they were exactly the same, it could – whether they end up 10% or under 10%, we will really be a function of how much business is direct versus how much ends up going through distribution.

Samuel Wilson – JMP Securities

Got it, okay.

Operator

Your next question comes from the line of Kaushik Roy with Pacific Growth Equities. Please proceed.

Kaushik Roy – Pacific Growth Equities

Thank you. Can you comment on the Ethernet and the fiber channel revenues, like where are you seeing more weakness and what is the dynamic there?

Richard Deranleau

Where we are seeing more weakness? Kaushik, I'm reading the papers all the time, it is a tough market, but it is an interesting market at this point in time. We continue to win and I will tell you the transactions are going on. One of the things we're seeing and I wouldn't call it weakness, is our customer set seems to be buying what they need at that point in time instead of buying ahead. And that started say in the fourth quarter, maybe even late third quarter and it has continued forward right now. So it is not losing transactions, it is just buying what they need, when they need it.

Kaushik Roy – Pacific Growth Equities

Okay. And then inventories jumped to $85 million. Can you comment why and what you're seeing in the channel and OEM inventories?

Michael Klayko

Yes, we normally don't go through all that but I will let Richard go through it because it does make a difference this quarter.

Richard Deranleau

Yes, Kaushik, Richard. I think two parts to your question. The inventory that we hold rose significantly and you saw that also I mentioned our turns were down to 11 times versus our typical higher 20s to lower 30s. That is really a representation of how the supply chains are quite different between Foundry and Brocade. Foundry basically does their own final manufacture and assembly and test here in California and as a result they have much higher inventory levels to service their demand. Brocade does basically just-in-time shipments and we keep a very low inventory levels because we take delivery of product upon that getting the order ready to ship.

And that is another reason why for Brocade book-to-bill ratio doesn't really mean anything anymore because our model is basically to ship on order. The second part of your question really relates to sell through versus sell in, and for the old-timers on the call you will remember we used to every quarter go through what was sell-in and versus sell-through. We got out of that because that reporting because there really wasn't any difference. And if you remember, the last time we were talking about that inventory at our OEM partners, we’re running at about 2.5 weeks. This quarter, we were a little bit surprised to see the OEMs reduce their inventories significantly from about that 2.5 level down to nearly 1.5 weeks. So that ended up taking about $17 million out of inventories, and basically led to a sell-through, which was a fairly healthy $449 million approximately versus our reported revenue. So this is one of those situations where I think the OEMs are looking at costs and trying to manage their inventory ever more tightly. And we did see that the result of that being our sell-through was significantly higher than our reported revenue.

Kaushik Roy – Pacific Growth Equities

Thank you

Operator

Your next question comes from the line of Min Park with Goldman Sachs. Please proceed.

Min Park – Goldman Sachs

Great. Thank you very much. Just looking at the near term outlook from HBA vendors, it seems like the growth for server to switch connectivity is slowing fairly dramatically here in the first quarter. Is there any reason why we shouldn’t see a corresponding decline in switch ports in the first half of 2009 as well?

Michael Klayko

You know, Min, I haven't done the analysis you are talking about there, but from our perspective we have a large variety of switch products now all the way from relatively small Edge products to 80-port switches and we have a lot of products you could consider switches that are bladed products which are ramping nicely. And so a bladed doesn’t require some of the HBAs that you're referencing there. But I can’t make the same correlation that you are making right now because it doesn't seem to impact directly our business.

Min Park – Goldman Sachs

Okay, great. And then just following up on Mike's comment on customers buying behavior, could you just give us a sense of the utilization rate of ports installed in the field at least in a broad sense and how that might have changed over the last few quarters?

Michael Klayko

Yes, go ahead Richard.

Richard Deranleau

Yes, Min, the struggle we have with that is because we're an OEM company and it goes through, we really don't have visibility into that level of detail to our customers. So, I'm afraid we really can’t give you much more of an answer than the color Mike had given you.

Min Park – Goldman Sachs

Okay, great. Just lastly one last question. When we talk to some of our CIO panels, it seems like a number of customers may be responding to a tough environment by stopping or at least pushing out new data center projects. So I'm wondering if you can give us a sense of your pipeline for new data center build outs, what it looks like now versus maybe in October or even a year ago.

Marc Randall

It’s an interesting thing. We are a living example, we just bought a company named Foundry, and Dan came across, and what are you doing right now?

Dan Fairfax

So one of our three major integration efforts is, one, first and foremost, focus on our people making that integration work, and Mike made some comments as to how that’s working nicely. Back to integration, Richard mentioned that we have had some benefits in terms of we have some common back-office systems that made this process go ahead of our plans. But we are in the process of consolidating our data centers to get the efficiencies we need to run the business and make our model happen here.

Michael Klayko

Yes, I’m actually seeing some renewed interest believe it or not, Min.

Min Park – Goldman Sachs

Okay, great. Thank you very much.

Michael Klayko

You're welcome.

Operator

Your next question comes from Andrew Nowinski with Piper Jaffray. Please proceed.

Andrew Nowinski – Piper Jaffray

Hi, congratulations on a good quarter. Thanks for taking my call. Quick question, just want to follow up on the HBA side, with regard to the competition, Emulex and QLogic both said HBA revenues are down between 6% and 15%. And you guys are seemed to be growing revenue in that space. Just wondering, it appears like you are taking some market share I guess on HBA. Is that a function of vendor consolidation of the data center, i.e., customers looking for a vendor that can provide an end to end solution versus just a point product?

Michael Klayko

Andrew, this is a journey we've been on around the HBAs. It did get launched from our customer request who wanted a singular solution from an end to end perspective, not only from a hardware perspective but from a management and support and so forth. So we've just been building the products. In fact we are actually ahead of our internal timelines on what we want to go ahead and deliver to the marketplace. And so we do plan on being a leader in this space. Frankly we have the – I think we have a leading edge technology right now. And we’re going to simplify the operation to the customer and if you can simplify the operations, it typically reduces costs and that seems to be a driving point today that gives us a little bit of confidence there.

Andrew Nowinski – Piper Jaffray

Sure, thanks. And just to follow up on the 10% customers, it looks like it slowed as a percentage of revenue I guess. Is there any change in that trend with regard to your three largest customers?

Michael Klayko

No, it's still the same. It still is the same big three.

Andrew Nowinski – Piper Jaffray

Okay, thanks.

Michael Klayko

You're welcome.

Operator

Your next question comes from Aaron Rakers [ph] of Stifel Nicolaus. Please proceed.

Aaron Rakers – Stifel Nicolaus

Yes, thanks for taking the questions, a couple as well. First of all just a clarification, did you give a headcount number exiting this last quarter?

Michael Klayko

I don’t know if we did. Did we give one? Aaron, we didn’t but I will give that right now if you bear with me for just a moment. At the end of the quarter, we had 3,950 employees, which is up about 1,116 employees that came across from Foundry. Barring that we were roughly flat to a couple of extra heads.

Aaron Rakers – Stifel Nicolaus

Okay, perfect. And then I would like to go back to the gross margin question, on the fiscal 2009 guidance of 57.5% to 58.5%, if I compare that to what you guys had laid out at the Analyst Day for your target for fiscal 2009, can you help me bridge the gap between the differential? Is that predominantly the changes in purchase accounting or is there something else in terms of mix within that that caused that reduction?

Richard Deranleau

Yes, if Aaron, if you go back to slide 17 and you look at the inventory step up from purchase accounting, that's the lion's share of it.

Aaron Rakers – Stifel Nicolaus

Okay. And then in reference to the inventory question earlier, very interesting that you’ve seen the OEMs take inventory levels down so dramatically, is it your belief that that's the new levels that we stay at here going forward or is there a quarter over the next few quarters, where you see that built back up?

Richard Deranleau

That's a really good question Aaron. And to be honest with you I don't know. I think it's – it feels awfully low to me. But what I'm also doing is I'm not planning on it getting better. So if they decide to take inventories back up to 2.5 weeks, maybe there is some upside to the model, but I'm just assuming we're going to live in a world where inventories are at that level as far as I can see.

Aaron Rakers – Stifel Nicolaus

Great. And then finally question from me on the HBA side, asked a little bit earlier, but I want to ask it a little bit differently. As you move forward, it looks like you've won the business at IBM, is your more constructive commentary the assumption that you get further Tier 1 OEM relationships announced over the next few quarters by the exit of fiscal 2009.

Michael Klayko

Yes, one of the comments we made was that we expect more Tier 1 OEMs, because we have a variety of other tertiary players that have qualified our products. So our assumption is we will get continue to win Tier 1s –

Aaron Rakers – Stifel Nicolaus

But the IBM win, that's the same win that you had referred to last quarter?

Michael Klayko

Yes, that was – we announced the IBM win. That's correct.

Aaron Rakers – Stifel Nicolaus

Okay. Thanks guys.

Michael Klayko

You're welcome.

Operator

Your next question comes from Keith Bachman with Bank of Montreal. Please proceed.

Keith Bachman – Bank of Montreal

Hi, I have a couple if I could, too, on your slide you talk about your adjusted cash flow, or adjusted cash flow was approximately $50 million, or $46 million. When I go back to the actual financial report, I actually have free cash flow was a negative number even if I take out the lawsuit. What is in the adjusted cash flow, and is that how you’re going to report it going forward? That's my first question, thanks.

Richard Deranleau

Yes, sure, that's a good question, Keith. Let me clarify that for you. The cash was cash from operations, which is an adjusted 46. There is $160 million that we paid, so you've already got that. The second item really is if you look at on our cash flow statement and you look at the accounts payable line, when we were expecting the integration, or I'm sorry, the acquisition to close, we had worked – made quite a bit of changes in our working capital along the AP line and working with our vendors. And that was all in preparation for closing the acquisition without any incremental financing. We're basically using vendor financing if you think about it. When the acquisition is closed we then had to true that all back up. That was about I believe I said on the slides, about $50 million. So you adjust those two that one-time items, and I would suggest if you go back you can compare our typical AP balances and you can see that they were quite high last quarter and now they are back to normalized rates. And that's the only adjustment and because of that’s now trued itself back up; there is no need to further adjust that going forward. It should be pretty clean.

Keith Bachman – Bank of Montreal

Okay, so we will get a clean cash flow number going forward? We won’t have adjustments like that?

Richard Deranleau

Not unless we have something similar, but at this point all of that has worked itself through the system.

Keith Bachman – Bank of Montreal

Okay. Then second question is on the HBA side, you mentioned share, but could give the revenue levels that you currently have, just so we keep the kind of share in perspective.

Richard Deranleau

Not at this point, Keith. I think what we are going to do is we said before it's relatively small because we're growing. If you look at it percentage it's growing rapidly but if you look at the revenue amount it’s still negligible. When it becomes meaningful I think we will break it out and we will talk about it. But at this point, it's still relatively small.

Keith Bachman – Bank of Montreal

Okay. Finally question, and then I will cede the floor. I think in the past, you've talked about towards the end of calendar Q4 of this year that you have some aspirations for HBA revenues. Is that something that you care to comment on what your target levels are that you are thinking you can get to?

Michael Klayko

Yes, I think we said we are going to end at 10% market share exiting the year and that hasn't changed.

Keith Bachman – Bank of Montreal

Right, let's try that again. I mean, 10% I'm not sure if that was Greenfield, I'm not sure if it’s go to market.

Michael Klayko

It’s go to market, Keith.

Keith Bachman – Bank of Montreal

Okay, all right. I will cede the floor then. Thank you.

Michael Klayko

Okay, we have one more question, operator.

Operator

Your next question comes from Munjal Shah, Jefferies. Please proceed.

Munjal Shah – Jefferies

Hi, guys. Thanks for taking my question here. Is it fair to assume that all OEM sales are Brocade products at this time? Fiber channel products? And then could you give us a qualitative update on your conversations with your OEM partners on IP products? And any comments on – if you can update us on the revenue synergies, I know you had laid them out at the Analyst Day and (inaudible) acquisition, but if you could just update us on that.

Michael Klayko

In terms of OEM, nothing has changed in the distribution model of how we go to market and how my competitors go to market. So, the server and storage OEMs still have multiple products they can offer in the fiber channel space, and so that hasn't changed. In terms of the Ethernet opportunities, still kind of early to tell. We have got six weeks under our belt. We feel real confident and moving forward, but it is too early to tell about what could transpire in that space.

Munjal Shah – Jefferies

Okay. And then just one on the Foundry side. Could you give us some color on routers versus switches, is it fair to assume that as the DCX did better, probably the routers did better on the Foundry side, and switches is getting impacted more by the economy?

Michael Klayko

I don't know if we’re actually breaking out the router. We are a little new yet again, because, again we’ve only got I think we had six weeks of revenue or something like that. We are actually going to start looking at it around enterprises and data center – Enterprise Campus LAN and Data Center and Service Providers. So you will start seeing us talking in those types of revenue projections and such going forward, but I don't have all the details. You have a little thing you want to add, Dan?

Dan Fairfax

Yes, I think what we can say, again because of the way the quarter was truncated in this a slow period, we're not going to break those numbers out until we get a disciplined quarter for you, the routers grew as you would have seen in line with rest of the business.

Michael Klayko

Okay. Good.

Munjal Shah – Jefferies

Okay. All right, thanks a lot. Good luck.

Michael Klayko

Operator we have time for one more question, please.

Operator

And your next question comes from Ryan Hutchinson with Lazard Capital Markets. Please proceed.

Ryan Hutchinson – Lazard Capital Markets

Great. Thanks for slipping me under the wire there. I was away from my desk, so I just ran back. First off, just on Foundry, the $60 million in revenues reported, how much of that was product and services? And the reason I'm asking is as you've written down the deferred, how to we model that moving forward?

Richard Deranleau

Right, this is Richard. The product revenue was something along the lines of $46 million, the residual being services and then if you go back to our slide 17, we've laid out for 2009, 2010 by quarter for you. So that should help you on the amortization of the deferred revenue adjustment.

Ryan Hutchinson – Lazard Capital Markets

Okay. And then finally, just at a high level here, obviously there's a lot of market chatter around Cisco entering the blade server market. Any comments you could provide there in terms of how you think it is going to change the competitive dynamics as it relates to Brocade?

Michael Klayko

Yes, a lot of chatter going on there Ryan. But I'm not sure if they've announced anything or not. And I just continue to execute against the strategy that we laid out and there is a lot of opportunities for us. So I'm not spending – I don't get a lot of energy sent back my way from the customer base on this. So until they announce something and we really know what it is, we just execute to our plan.

Ryan Hutchinson – Lazard Capital Markets

Okay, great. Thanks guys.

Michael Klayko

You are welcome.

Alex Lenke

Thank you, operator.

Operator

Thank you, ladies and gentlemen. This concludes the question and answer session. And I would like to thank you for your participation in today’s conference. You may now disconnect and have a wonderful day.

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Comments

[Wilson Crai...:]

See video of Mike Klayko adding color to today's earnings call comments at www.youtube.com/watch?....

Best regards,

Wilson Craig
Brocade PR

Feb 20 12:02 PM