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Brocade Communications Systems, Inc. (NASDAQ:BRCD)

F2Q09 Earnings Call

May 21, 2009 8:00 am ET

Executives

John Patun – Investor Relation

Michael Klayko - Chief Executive Officer

Richard Deranleau - Chief Financial Officer

Marc Randall - Senior Vice President of Products and Offerings

Analysts

Mark Sue – RBC Capital Markets

Anthony Luscri – JP Morgan

Kaushik Roy – Wedbush Morgan

Min Park – Goldman Sachs

Kathryn Huberty – Morgan Stanley

Aaron Rakers – Stifel Nicolaus

Jeff Evanson - Sanford Bernstein

Munjal Shah – Jefferies

Brian Marshall – Broadpoint Amtech

Scott Craig – Bank of America-Merrill Lynch

Keith Bachman – Bank of Montreal

Operator

(Operator Instructions) Welcome everyone to Brocade’s Second Quarter 2009 financial results conference call. Mr. Patun you may begin.

John Patun

Joining me today from Brocade are Michael Klayko, Chief Executive Officer, Richard Deranleau, Chief Financial Officer, and Marc Randall, Senior Vice President of Products and Offerings.

Before we begin, let me cover some housekeeping items. Brocade issued a press release today detailing its second 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 website for approximately 12 months.

As a reminder, the information the presenters discuss today will include forward looking statements, including without limitation, statements about Brocade’s financial results, plans, and business outlook, as well as the integration of Foundry Networks. 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, and 10-Q for the quarter ended January 24, 2009.

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 website.

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

Michael Klayko

Q2 is an outstanding quarter, as Brocade achieved record revenues of $506.3 million, growing 43% year over year and 17% sequentially. We continue to drive strong operating margins through our continued focus on cost synergies and expense management. We exceeded the street EPS estimates for the 15th consecutive quarter and as Richard will discuss, our cash generation was again outstanding.

While these positive financial metrics bode well for us, especially in light of the global economy, we remain even more optimistic that our corporate strategy is on target and that we are gaining significant traction in the market due to several proof points that happened during the quarter. First, as I discussed briefly on our last earnings call, Brocade launched and completed a worldwide road show called the Extraordinary Networks Tour, where we shared the company’s strategy, technology, and product directions to customers, partners, and investors.

Traveling to some 40 cities in the US, EMEA, and Asia Pacific, we hosted thousands of attendees with roughly a 50/50 split between those who were LAN or SAN focused. The response far exceeded our expectations since we didn’t know how travel budgets might be impacted during this time. However, many attendees told us that the Brocade event was the only one that they were attending that quarter because they believe the ROI would greatly outweigh any travel costs.

The Extraordinary Networks Tour also gave us several other customers and industry insights. Here are some common themes that we heard. First and foremost, cost continues to be the number on concern in decision making factor among IT professionals. This group is eagerly look for an alternative supplies of networking solutions who can significantly reduce their overall IT spend, without having to completely tear out all of their existing infrastructure. Brocade is actively demonstrating how we can reduce their IT infrastructure costs by a minimum of 30% and improve their operational performance.

Second, while they want to protect their IT investments, these attendees also realize that their current requirements in future solutions need to be able to handle the massive growth in network traffic and data. They responded very positively to our end to end product portfolio of higher density and higher performance LAN and SAN solutions, and said that what we are delivering today in planning for the future is exactly what they need.

Third, while customers expect innovation from Brocade, they also remind us that they need to transition to new technologies on their own timeline. That means we must continue to support and enhance fiber channel and IP Ethernet technologies. Customer feedback on our recently launched FCOE and CEE top of rack switch product was very positive but we must also respect their view that the adoption of FCOE and CEE technologies will not happen until the latter part of 2010. Customers feel confident that we have a solution that supports every step of their IT timeline for the foreseeable future.

Lastly, the networking supplier landscape is changing. Customers and partners view Brocade as a clear leader in delivering complete and competitive enterprise networking solutions to the market. They are not longer tied to their incumbent vendors and we believe this is evidenced by shifting market share in our space, which I will discuss in a moment.

Another important proof point that our strategy is on target is the positive momentum in our sales channels. Brocade has always been known for our long term commitment to our OEM partners. We believe this strategy delivers the full promise of next generation enterprise networking solutions to customers in a way that offers them cost effective, non-proprietary choices.

One example of this is our partnership with HP. As an HP virtual connect partner for their new C-class blade system solutions. We have worked together to deliver a low cost converged infrastructure that meets today’s goals to reduce costs in tomorrow’s requirements for simplified secure and highly virtualized data centers.

The addition of IP Ethernet products has opened many doors for Brocade and we continue to work with some other key partners to deliver end to end solutions to customers. Some the world’s largest data center and network service providers and campus LAN customers are now asking for us by name. We’ve been able to assess their environments to show them how we can save costs and update their infrastructures with higher energy efficient and higher performance products.

During these meetings we have also witnessed a certain amount of fatigue toward other vendors who have not recognized the restraints that IT professional space in terms of having to do more with less. Our solutions and pragmatic approach to implementation resonate well with these customers.

One of the most significant affirmations of our strategy was last month’s IBM announcement that it had selected Brocade Enterprise IP Ethernet networking family of products to re-brand and sell through its global sales force and authorized IBM business partners. As one industry analyst noted, “This global agreement secured a significant new go to market route for Brocade’s Enterprise IP Networking Portfolio. It has also provided one of the most tangible proof points of the business growth strategies that were identified when they acquired Foundry Networks.” I would have to agree with that statement.

In addition to our far reaching OEM strategy, Brocade has implemented a very robust channel partner program to help us with the demand generated from a broader base of customers. Recently, we held two partner summits where we met with approximately 300 channel partners including those who carry our IP Ethernet solutions. We believe we are on track to deliver long term mutually beneficial and profitable business relationships through the channel and are excited by the momentum and shared vision that we have seen in this part of the business.

In addition to these sales channels, we’ve had increase in activity from some of our direct customers, most notably in the federal space. Earlier this month I visited with several key customers who endorsed our acquisition of Foundry and are eager to work with us. In fact, our existing data storage customers who have never purchased Foundry IP Ethernet product have purchased over $12.6 million in IP Ethernet networking equipment from Brocade this quarter. We’re very pleased with our pipeline for both SAN and LAN for the second half of 2009.

What has been driving the growing momentum that is demonstrated by our increase in revenue, customer and partner activity? As I said earlier, our expanded portfolio has opened many doors into the IP Ethernet networking space. In addition to that, our traditional SAN business remains solid. When we look at this segment our server business portfolio continues to perform well and now contributes approximately $30 million per quarter to our overall revenues.

This business is comprised of HBAs and CNAs, Mezzanine cards and Embedded bladed switches. The revenue contribution of this business competes with some stand alone companies in this space and so we’re quite pleased with our ramp. Looking at the overall SAN market and data reported by others in this space we believe we have significantly increased market share this quarter, with what we believe our double digit gains in the director space. Looking at the IP Ethernet segment of the market, we believe we also have increased market share there.

The rapid integration of Foundry’s engineering, operations, and sales teams has helped make the increase in IP Ethernet market share and customer demand possible and we are pleased that the combined company is firing on all cylinders. We believe that all these data points show that our strategy is working and our market penetration and customer traction are moving in the right direction.

We will provide an in depth review of our combined product and technology road map to address the enterprise data center, the enterprise LAN campus and the service provider markets at our upcoming Technology Day on June 2nd, which Richard will provide details on in a moment.

I am thrilled by what the company has accomplished over this first six months of our fiscal 2009 and I’m extremely excited as we continue the execution of our business strategies in the second half. The proof points and metrics are all positive and make us very optimistic about the opportunities on the horizon and we believe we can meet or exceed our long term business model goals even in today’s uncertain economic environment.

I would now like to turn the call over to Richard, to provide more details on our second quarter results, then I will return for a few concluding remarks.

Richard Deranleau

Let’s take a look at some financial highlights from our Q2 results. We had record revenues in Q2 of $506 which included the first full quarter of Foundry revenue. Revenue was driven by stronger than expected demand for our IP Ethernet products and continued growth in Global services. On the SAN side, the business performed well in spite of the challenging IT spending environment. We saw strength in the DCX platform and continued up tick on eight gig revenues.

On a geographic basis, North America was particularly strong, offsetting weaker demand in EMEA. The strength in North America and the concentration of our IP Ethernet business increased our domestic revenue percentage to 69% in Q2’09 from 64% in Q1’09.

Moving on to gross margins, on a non-GAAP basis gross margin for Q2 was 56.2%, reflecting faster progress on the supply chain, product cost synergies then we expected. Although below our long term target model range of 58% to 61% we are pleased with the progress we’ve made to date in the integration of our supply chain.

As a reminder, margins were negatively impacted by the non-cash purchase accounting adjustments from the Foundry acquisition, as shown on the purchase price adjustment slide provided in the backup to the webcast slides.

Non-GAAP gross margin in our Global Services business was 50.5%, up from 47.4% in Q1’09, reflecting the inclusion of a full quarter of the IP business unit high margin support revenue. From an operating margin perspective, while we focused on controlling our operating expenses, we also picked up a full quarter of operating expenses from Foundry. As a result, operating expenses were 37.4% of revenue versus 33.7% in Q1’09 on a non-GAAP basis. This is better then our long term model goal of 38% to 40% of revenues.

At the end of Q2 we made certain small realignments in our business which resulted in a GAAP restructuring charge of approximately $3 million. In addition, we took a non-cash charge by writing off the goodwill and intangible assets on our balance sheet related to our files business in an amount of approximately $53 million, as we have take the files business into sustaining mode.

The resulting non-GAAP operating margin for Q2 was 18.8% in line with our long term model of 19% to 23%. Our performance in Q2 again demonstrates both the speed of our integration and the strong earnings capability of our financial model.

Moving on to our operating results on an earnings per share basis. Q2’09 non-GAAP diluted EPS was $0.11. Reporting on a GAAP diluted basis Q2 EPS was a loss of $0.16 reflecting non-recurring restructuring charges and the non-cash write off of the files business related goodwill and intangible assets.

Consistent with our Q1 presentation, our non-GAAP diluted shares in Q2’09 were 432 million shares which include the impact of equity awards and convertible debt that would be dilutive on a GAAP income basis. The difference between GAAP and non-GAAP net income is reconciled in today’s press release and in today’s webcast slides.

Now turning to our cash flow and balance sheet. Accounts receivable DSO was 49 days. Inventory turns were 15 times, this represents an improvement in the LAN business of 2.7 times and typical performance in the SAN business. Cash flow from operations in the quarter was strong at approximately $107 million. Adjusted EBITDA was a healthy $123 million, this yields a four quarter trailing adjusted EBITDA number of approximately $535 million.

Gross outstanding acquisition term debt balance was $1.025 billion before the debt discount of $41 million. This reflects principal payments during the quarter of $75 million, well above the payments required under the debt agreement. Senior debt to EBITDA ratio at the end of Q2 was 1.94.

Our fiscal 2009 outlook is based on the following assumptions. Our planning assumption is that the current IT spending environment will remain the same through the balance of our fiscal 2009 due to the uncertain macro economic environment. We expect IT spending will improve and those markets which we serve to return to normal historical growth rates during 2010. We expect to see normal seasonal patterns in our Q3’09 revenues. Typically, Q3 seasonality is flat to down 2%.

While our core markets remain competitive, we believe that product advantages and momentum, our strong OEM partnerships 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. We believe directors and embedded switches will grow faster then switches and the overall SAN market. We expect to be a leading supplier of HBAs and CNAs. Within the IP Ethernet market we expect to begin to see the benefit from our IBM OEM partnership in our fiscal Q4’09.

From a pricing perspective, while we have seen some additional pricing pressures resulting from the macro economic environment, we continue to expect quarterly ASP declines to remain in the low single digits through the end of our fiscal 2009. Given these considerations, we remain confident in our ability to exceed our fiscal 2009 outlook that we shared with you during our last earnings call.

Now I would like to review the potential cost and revenue synergies from the Foundry acquisition that we shared with you on our last earnings call. Due to a fast and smooth integration we expect to achieve the committed cost synergies by Q1 2010 which would be one full quarter earlier then originally announced, adjusting for the delayed acquisition closing date.

On the revenue side, the largest opportunity we pointed out was selling more IP Ethernet products through Brocade’s OEM channels. We are pleased with the progress we have made in this area including the IBM OEM announcement Mike referred to earlier. There is slight pricing and margin pressure with the OEM model but we feel comfortable then in a couple quarters when these programs are fully ramped we expect to be within our long term model. In addition, we are pleased with the progress we have made in sales of IP Ethernet products to Brocade customers that resulted from the acquisition, as Mike had mentioned earlier.

In summary, in Q2’09 we ended a strong quarter with great operating margins. We are confident in our ability to exceed our prior full year guidance and deliver on the cost synergies one full quarter earlier then originally committed and have made significant progress on delivering the potential revenue synergies. We are very optimistic about the future of our company despite current economic headwinds. We remain committed to delivery of shareholder value, and our long term financial model.

We invite all of you to join us for the Brocade Technology Day at the Computer History Museum in Mountain View, California on June 2nd. As we get closer to the date, we will update you on the details of Brocade’s analyst day planned for this fall. Please visit our investor website for additional information regarding these events or contact our investor relations department if you would like to attend.

With that I would like to turn the call back over to Mike.

Mike Klayko

We are very pleased with our financial results and the execution of our strategy as evidenced by the successful completion of the Foundry integration. Another key metric for me that we don’t always talk about is employee satisfaction. On of our corporate long term goals is to be one of the top 50 US employers of choice. I am pleased to announce that we continue to make progress on this quest and we ranked number two in the San Francisco Business Times Best Places to Work in the Bay Area for large sized companies. We were also the highest ranking high tech companies.

Employees gave us top marks for our corporate climate and culture and management policies. Our internal employee surveys conducted on a global basis give us similar data. The common theme we hear from employees is they like being part of a winning company with a winning strategy.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Mark Sue – RBC Capital Markets

Mark Sue – RBC Capital Markets

Maybe you can place some parameters on your confidence to exceed your original $1.9 to $2.0 billion in revenues for fiscal ’09. In a neutral IT environment with growth in HBAs, share gains in Ethernet and IBM as a new partner on that side, does it look more like $2.0 to $2.1 billion? Does your planning include additional Ethernet OEMs, I ask since generally one usually follows the other?

Michael Klayko

We got a lot of confidence because there are a lot of good things going on. On the storage side our storage area networking products, classic Brocade business is ramping quite rapidly, as I mentioned is still doing well. As I mentioned before, I think we took double digits in the director space just on the sheer strength of our product line. That business is doing very, very well on a long term basis too.

I think also then it’s really difficult to predict the OEM, as you mentioned IBM, when that starts to ramp, its difficult to predict the total impact long term. Whether its ‘x’ number or “x times 2” or “x times 3” it will be tough to frame. It gives us great confidence though that it is beginning to ramp. Yes we have had some excitement and some interest from some other folks. In fact, Dell just announced with their EqualLogic products they’re going to start selling some of our fixed form switches, complementary to their product set. I just didn’t put it on the earnings script earlier.

There are a lot of good tail winds behind us. Even in this really tough market we’re getting a lot of interest in just a variety of products, not only just the SAN products but the IP Ethernet product and then the emergence of some of the CNAs and HBAs is getting good traction too. Challenging to go ahead and put it into buckets when you put all these variables in play but yet in the other economy but we continue to do quite well.

Mark Sue – RBC Capital Markets

On EPS I think in the prior quarter you talked about $0.40 to $0.50 for the fiscal year. Any thoughts on a new bracket now with your cost cutting?

Richard Deranleau

With what Mike was saying, its very difficult because what we’re looking at is huge opportunities from our OEM relationships, we’ve announced two of them, IBM and the Dell one, there are others that we’re talking to. It’s hard to put brackets around that because it’s a brand new go to market really in this space. Going back to your other questions, I think we’re very confident on our ability to exceed the guidance both top and bottom line that we gave you on the last call.

We went into this quarter, we went into it with kind of an uncertain economy and we are going to fighting seasonality trends. We have definitely going into the second half a much higher run rate then what we had thought about coming into the quarter.

Operator

Your next question comes from Anthony Luscri – JP Morgan

Anthony Luscri – JP Morgan

I wanted to dig a little bit deeper into gross margin trends. I believe you mentioned in your comments that you’ve seen some supply chain synergies. Can you talk a little bit more about the timing of the supply chain consolidation Foundry into box com and the timing as well as the impact? Do we see full impact by the first quarter of 2010?

Richard Deranleau

From an integration, the integration is gone phenomenally well and around here we’re kind of thinking it’s done, from a lot of different ways organizationally and from that perspective. When you take that and you translate when do you start seeing that into our financials? While we have the road map and we’re executing to the road map on the supply chain consolidation you really start seeing those hit the P&L in the next several quarters. We did better then we expected to this quarter because we were able to leverage some costs.

My comment in the script was by Q1’10 we expect to be fully completed so you’re going to see these benefits rolling in over that time frame.

Anthony Luscri – JP Morgan

Can you comment more on the cash flow trend line? How should we think about it over the next couple of quarters? Was the second quarter one off or was this more normalized cash flow?

Richard Deranleau

This is fairly normalized at this point. Just a reminder, Q1 and Q3 are seasonally weaker cash flow quarters for us. Q2 and Q4 are our strong quarters. What you saw in Q1 was an abnormality because of the one time payments we made, so it was artificially low. For Q2 this was a nice strong and fairly typical cash flow quarter for us.

Operator

Your next question comes from Kaushik Roy – Wedbush Morgan

Kaushik Roy – Wedbush Morgan

Can you give some idea how much IBM could be in fiscal 2010 in terms of revenue contribution, this OEM relationship? What is the gross margin and operating margin for that OEM?

Michael Klayko

I just came back from a pretty extensive road trip as part of this extraordinary networking tour and met with lots of customers, measured for me personally in the 100s but we did thousands of customers on this tour. I will tell you the feedback from the customer base was very, very positive having the ability to buy products from IBM as part of a buying process or an approval process especially in some sectors such as the Federal Government, as well as some oversees customers who like the idea of having one support organization around the world to support a common product base.

It’s right out of the gate. Keep in mind that although they’ve got 30 plus years of designing networking solutions and have been in this space for a while and having your own branded product its going to take a while to get genned up. As you know, IBM is a very, very credible company with deep relationships. It is difficult to go ahead and say how large the opportunity with them is. However, we gave some guidance I think it’s a quarter ago where put a chart and we said how big it could be and what some of the opportunities are.

If you just look at the volume that can go through an OEM channel, not necessarily just the IBM channel but its measured in the billions, $2 to $4 billion could be available in that channel space. I think its there that we need to go ahead and execute with them and to realize that potential. The timing on it is challenging which is we’re very bullish, we’re very positive. However, the timing is the one that’s really tough to nail down.

Kaushik Roy – Wedbush Morgan

On OpEx for fiscal Q3 because of the headcount reduction do you expect OpEx to go down in Q3 or because you’re ramping up these programs you expect OpEx to increase sequentially in Q3?

Richard Deranleau

One of the things we did was did obviously take a look at performing and non-performing assets in our portfolio. One of the things we decided to do was to do relatively small but we did rebalance and we are really re-deploying as opposed to necessarily permanently reducing. As you know, we were able to run our operating expenses nicely below our model. We are still based on that model. There will be obviously a ramping as we do this re-deployment of assets it’ll take time.

Operator

Your next question comes from Min Park – Goldman Sachs

Min Park – Goldman Sachs

Your performance in the storage sector, your storage market suggests significant share gains versus Cisco. Is the magnitude of the share shift we really haven’t seen in the market before? Can you just give us a little detail on competitive dynamics there and what really enables you to drive some share in the quarter?

Michael Klayko

We’ve got great products it starts with. As we mentioned before we’ve got a healthy percentage of our director products now the DCX line. The DCX line gives customers lots of flexibility from the ability to add basically the highest performing, best cost points around eight gig, technology and there’s a rapid movement there.

The ability to go ahead and put some intelligent blades for security as well as other applications. Also, the ability that as future proved already so that as a customer wants to move at their time table to converged enhanced Ethernet they can go ahead and do that. A lot of traction in that space and so that’s one reason.

The second reason is I think even foremost is we’ve got great partners. When you take a look at the partners we have around the world we’ve been very, very true to our business model around the partnerships and so you put those two things together and I think you’ve seen the results.

Min Park – Goldman Sachs

Could you just give us a little bit more linearity in the quarter just on your demand trends if you saw any atypical inflection points in demand in the quarter at all?

Richard Deranleau

We tend to be incredibly linear. This quarter we are a little bit less linear which is a little bit reflection in the DSO, given the DSOs are still 49 days. We’re still very good compared to others. Typically it was a little bit less linear then we have been in the last say five quarters.

Operator

Your next question comes from Kathryn Huberty – Morgan Stanley

Kathryn Huberty – Morgan Stanley

You said that the IBM impact begins to show in the fourth quarter. How many quarters from there should we think about to get to a full run rate?

Richard Deranleau

That’s going to be a tough one because as Mike alluded to what we would consider the tam for the OEMs including IBM for that go to market is such a large number. I think what we’re going to be seeing is in Q4 we’re going to get a sense of what traction there might be. What is the high and how long does it take to get there I think that’s the big question that we’re going to take time to answer.

Kathryn Huberty – Morgan Stanley

As it relates to guidance, is there a point where you become comfortable adding in some of the revenue synergies/OEM relationships into the formal guidance or should we think about it as incremental up side each quarter?

Richard Deranleau

I’m hoping it’s the latter. I hope every quarter is better. What we plan to do is that we have an analyst day its going to be in the fall like we usually do and then we hope to share with you both our view of 2010 and more detail on where we are in all these go to market initiatives including, by the way, our channel initiative which is very important to us as well.

Kathryn Huberty – Morgan Stanley

Given that you’ve spent a ton of time on the road with customers and channel partners for the last several months, what’s your thinking or what are you hearing about when IT budgets might loosen up and therefore we start seeing some adoption of the new technologies?

Michael Klayko

It depends on the sector and it depends on the geography. I think loosening up is a tough term. I’ve actually had a lot of folks that are wrestling with one issue, how do they manage this data growth and this network growth, relatively flat to down budgets is what they’re telling me. When you take a look at it, they’re all spending capital, they’re all managing their expenses, and they have ROI targets that have changed. Many of the ROI targets are measured in quarters or they have to be done within the year or within that budgeting cycle.

Some of the metrics have changed, people are still spending money. I just think that the world has changed on a long term basis. I think, maybe not for good, but for the foreseeable future that people are very pragmatic on their architectures and what they’re going to do and how they’re going to deploy it. It’s not going to be this all of a sudden we wake up one day and there’s a pile of money. It’s going to be very thoughtful and pragmatic on how they architect and then how they implement.

We’re operating on the environment that cost is going to go ahead and be a major concern for at least another couple years. We believe in that and that’s how we’re running the company.

Operator

Your next question comes from Aaron Rakers – Stifel Nicolaus

Aaron Rakers – Stifel Nicolaus

On the SAN switch business I think last quarter you had noted that you saw OEMs take down inventory levels to probably the lowest levels we’ve ever seen. Can you talk a little bit about that, did you see a replenishment, I think you even quantified as much as $17 million there if they replenish back to normalized levels.

Richard Deranleau

The actual inventories at our OEMs went up very slightly. They’re keeping a reign on things. I think they’re keeping focus on what they’re inventories are. Last quarter we were probably close to a week and a half, they’re a little bit higher then that now. I would say that they’re very careful managing their working capital.

Aaron Rakers – Stifel Nicolaus

On the synergies I’m trying to understand, I think when you had acquired McData you kind of consistently gave us some quantifications of where you were at. Relative to your total cost synergy targets of $40 to $45 million; can you help us understand how much you’ve seen so far? That way we can track this as we move forward.

Richard Deranleau

You have to divide it a bit so if you divide it into the OpEx part of it, the $10 to $12 million you’re going to see that number probably over through the end of this year. The cost is probably going to take us into on the cost of goods sold into our Q1. As I said, we should be finalized and you’ll have seen everything roll through the P&L by Q1 2010.

Aaron Rakers – Stifel Nicolaus

In reference to your commentary around typical seasonal patterns in the July quarter, flat to down 2%. I’m trying to understand your comfort with Q4 that to get to that $2 billion number you’d be talking somewhere around low double digit 12% type sequential growth. When if I look at the combined model over the last few years you’ve grown more in a mid to maybe slightly high single digit sequential range. Is that reflective of the IBM opportunity that gets you into that higher seasonal pattern for the October quarter?

Michael Klayko

I think it’s reflective of a few things. We’ve got a brand new product set also and a lot of excitement around our whole growth Ethernet offerings not just with IBM just from a standpoint of bringing the Foundry product into our expanded distribution base and customer base so you have that. You’ve had a lot of folks out there that want an alternative and so there’s a lot of excitement there. You have partnerships that we’ve been pretty true to on our storage side and so we continue to see that business ramp.

It’s not just one area, there’s a whole variety of areas that even though in this tough macro environment we have still pretty good degree of confidence.

Aaron Rakers – Stifel Nicolaus

Any update on the HBA OEM expansion?

Michael Klayko

We announced a couple so far, watch for some more this quarter.

Operator

Your next question comes from Jeff Evanson - Sanford Bernstein

Jeff Evanson - Sanford Bernstein

I was wondering if you could give us a bit more color on the $12.6 million in sales of IP equipment that you made to Data Storage customers who were not previously IP customers, in particular I’m wondering have you trained the Data Storage people to sell or your channel partners to sell the IP equipment or are you bringing in someone from the old Foundry relationship?

If you could talk a little bit about what the customers buy, is it closet switch to try things out or are they buying core switches or is this one or two big customers or hundreds of very small customers?

Michael Klayko

When you take a look at last quarter we really did still have, we didn’t have an integrated sales team as we do now. The sales team is now integrated. What we’ve done is we have specialists around the SC side to help with some of the sales opportunities. When you take a look at last quarter where we have this revenue, this was measured out of our database that said customers who have never bought any Foundry at all but yet had bought Brocade SAN products how much revenue did we generate?

It’s a variety of products all the way from edge switches to MLX products which is the core products. It wasn’t just one it was all and therefore production use. Relatively short sales cycle when you think about it because we started talking about the opportunity Q1 and actually implemented in Q2 but this was revenue not just a few customers it was many customers there.

As that word got out now we have literally hundreds of opportunities where we are calling on our current Brocade SAN base and bringing in the IP set. We’re now having an opportunity to look at our full portfolio of products. Part of this adjustment that Richard talked about earlier what we’ve done is we have gone through the cross training where you’ll have one person will represent both product lines but he’ll have technical specialists help him with the correct implementation of these products whether they be SAN or IP Ethernet.

Jeff Evanson - Sanford Bernstein

You talked about normal seasonality going into your third quarter is typically flat to down 2%. Some moving parts in this transition however; one is you just finished a 14 week quarter, next quarter is 13 weeks. Second, there’s some purchase accounting transitions that are being made that should benefit you next quarter. Does it just all wash out to the 0% to 2% or do you want to make any clarifying remarks on those?

Richard Deranleau

The clarification is you have to almost take a look at it from a high level where we’ve given you color around how you should shape your models. What then we do is give you a lot of detail. We’ve given you detail in all the purchase accounting adjustments so we’re trying to provide for you enough information and guidance for you to take a view and drive your models forward.

I did want to make the point from a 14 week versus 13 weeks so yes we had a 14 week quarter. Basically that just gives the sales people an extra week to try to close the deals. I’m not sure, I don’t subscribe to the fact that you actually get a weeks worth of revenue, I wish it was. I just don’t really believe that.

Jeff Evanson - Sanford Bernstein

It looked to us, at least from what we had understood about your purchasing accounting guidance that the $6 million that you had in purchase accounting on the global services was about double what we had understood before. Is that correct that it was double and what was the source of that?

Richard Deranleau

I don’t believe that’s correct. I think we’re pretty consistent between what we showed in our last slide on purchase accounting and what we actually have in. I get with you offline and we can try to go through what questions you have but I think it’s pretty consistent.

Operator

Your next question comes from Munjal Shah – Jefferies

Munjal Shah – Jefferies

Do you expect a higher revenue synergies from the OEM model then what you laid out in the past?

Michael Klayko

I think it’s pretty consistent what we laid out. It’s a pretty big opportunity that we have there and so if you take a look at that. Frankly we just got out of the gate April 28th and so we’re pretty excited. We don’t have enough history yet. We’re less than a month into this. The opportunity is there now it’s just a matter we’ve got to do some execution and so forth. Everybody in the company both here and right now with IBM is very, very excited about this opportunity. Hard to go ahead and quantify it one month into a long term strategic relationship.

Munjal Shah – Jefferies

Your competitors are also trying to work with IBM, could you share as to how that competitive dynamic could potentially work going forward?

Michael Klayko

The nature of an OEM relationship that’s who we are, that’s our being, that’s a fabric of our soul. For the last 13 years that’s what we’ve done very, very well. We have 23 different OEMs that we work with around the world and we know how to work that model very, very well and we know how to provide differentiation whether it be around product sets, go to market, marketing programs and so forth. It’s not just putting a label on a product and moving it through a channel, that is not what makes an OEM model successful.

Because it is who we are and how we’ve done it for such a long period of time, we’re always about making it a winning situation for both us and the partner. I think we can continue that going forward.

Munjal Shah – Jefferies

You mentioned $12.6 million in IP products to traditional Brocade customers. Was that all in the Federal segment or was it across the board? If it’s Federal, because Foundry used to do a lot of Federal business if you could explain what the dynamics are, what agencies they might not have penetrated that you had?

Michael Klayko

Enterprise segment.

Operator

Your next question comes from Brian Marshall – Broadpoint Amtech

Brian Marshall – Broadpoint Amtech

I think there’s a little bit of a misconception out there in the marketplace with regards to fiber channel over Ethernet or converts to enhanced Ethernet and how that relates to Brocade whether its an opportunity or threat over the long term. I was wondering if you could give your thoughts on that.

Marc Randall

I’m certain that it’s a misperception; I think it’s a lack of understanding of what’s happening in the market today. What’s happening is that there’s still quite a bit of demand for the SAN product line, the fiber channel product lines and growth to next generation, as well as continued growth in pure Ethernet IP. There is a move more from looking at synergies to move to fiber channel over Ethernet as bridge between your storage data and your IP data.

The way that the industry is moving is that it looks like its going to be technology that will be in the test phase for the next four to eight quarters before we start to see some adoption of the technology.

Brian Marshall – Broadpoint Amtech

With regards to your converged network adapters can you comment on the rough HBA differential between them and HBAs as well as gross margins?

Michael Klayko

I think they’re going to be relatively the same in terms of gross margin model going forward. I think it’s pretty benign isn’t it.

Richard Deranleau

Yes.

Brian Marshall – Broadpoint Amtech

The service revenues, I was wondering if you could give us a little bit more granularity with regards to the mix from your data storage products versus the Ethernet products.

Michael Klayko

On the support it’s at a high level just think about mixing the companies together from the revenue that we showed you in the press release that’ll show you the revenue percentages between IP and data center and you can kind of get the same ratio if you will when you think about support revenue.

Operator

Your next question comes from Scott Craig – Bank of America-Merrill Lynch

Scott Craig – Bank of America-Merrill Lynch

I was wondering if you could talk a little bit about the relationship from an OEM standpoint, how much does the OEM actually influence the customers buying decision from your product versus the competitors product and whether or not it’s a more customer driven decision process. On the cash flow side of things, as you think about longer term cash flow obviously there seems to be an opportunity to grow the operating margin and hence the net margin and then grow cash flow that way. What about from a working capital side longer term how do you think the opportunities for cash flow enhancement?

Michael Klayko

An OEM means it’s their product, it’s their solution, and it’s their go to market. Frankly it’s our job to assist them to be successful with their overall solution. I never want to say that many others have said the OEM is just a distribution channel, that couldn’t be father from the truth. The fact of the matter is that they do drive the overall solution and then we assist in that sale of that product with the OEM.

If you’re going to make a very successful OEM model work on a long term basis, I mentioned before, we’ve been doing this for more then a dozen years you have to make sure you fit within that sales process. Yes, the OEM does drive the solution.

Richard Deranleau

On the working capital there are two areas really that I think about. One is DSOs and as we move DSOs from high 40s to mid 40s that’s going to true up some cash that would up side to what we’ve shown in the past. The second area which is actually a bigger area is on inventories. As we go through the transition over the next couple of quarters what you’re going to see is our inventory levels are going to come down and that’s obviously going to generate cash. I think there’s a lot of opportunity there.

Operator

Your last question comes from Keith Bachman – Bank of Montreal

Keith Bachman – Bank of Montreal

What would your estimate be on the amount of the Ethernet side that is Greenfield, that is to say new installs where there isn’t an existing product line either from your experience at Foundry or feedback from IBM?

Michael Klayko

Unless you live in some rural area you’re probably connected in some fashion to some type of Ethernet device. I think a better way to look at it and how we’ve looked at it is we’ve actually went out and did some very detailed surveys of customers and how they’ve implemented their IP environment. What’s interesting is very, very high percentage of our customer base the last real architectural change they made in their IP networking was Y2K which is a decade ago when you think about it.

When you go from a Y2K perspective and you say what’s happened, basically folks just continued to buy. They had architected once and because it was a plug and play architecture for the most part you could just continue to add switching products to it and so what started out as a core network may be three, four layers even five layers deep sometimes.

Because of our technology and the density of the technology and the performance levels, we can actually come in and help with that re-architecture and re-design, eliminate layers, improve the performance and take radical cost out. For us, any large enterprise is a Greenfield opportunity is how I have to go ahead and look at it because you have to then, customers are willing to take a look at change to take cost out but you need the products to do it. That’s a different definition of a Greenfield opportunity but its one that’s really resonating well with us.

Keith Bachman – Bank of Montreal

I’m trying to scope what the opportunity may be with IBM because even according to some of the folks we talked to at IBM if there’s an incumbent there its much more difficult for IBM/Brocade to influence or gain share at that account. Maybe try to ask the question a different way. Any kind of scoping you can give us on or how you come to that conclusion on how much share you’ll be able to pick up because clearly IBM is still going to be doing business with Cisco and Juniper and the rest of the crowd.

Michael Klayko

Yes they will but I think the fact is when you look at the customer base right now that is actually the ones writing the check that are out there, they’re all trying to figure out how to handle the massive growth in data and network traffic yet take costs out of their environment not add costs in and with that provides an opportunity that will be OEMs are going to go ahead and participate in. I think our product that bodes well for us to be specked into the solution.

Keith Bachman – Bank of Montreal

Could you add a little more color then on how you see gross margin trends through the balance of the next couple quarters?

Richard Deranleau

What I would look to see is that you’re going to see incremental improvement. Q3 is probably a little bit more flattish because of the seasonality but you’re going to get some benefit as some of these cost synergies come online. Then in Q4 you’re going to get an incremental to that. Then that’s going to set us up for being in model in 2010 if not, exiting 2009 in our fourth quarter. Generally speaking, you’re going to be seeing the improvements in gross margins.

The other point I would make to your earlier question too is I wouldn’t underestimate the difference between with an OEM selling their own branded product versus selling a non-branded product from somebody who is now also selling a competitive product. I wouldn’t underestimate that.

John Patun

Thank you everyone for joining us and we look forward to seeing you at our Technology Day in Mountain View, June 2nd.

Operator

Thank you for your participation in today’s conference. This concludes the presentation, you may now disconnect.

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Source: Brocade Communications Systems, Inc. F2Q09 (Qtr End 05/02/09) Earnings Call Transcript
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