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Aruba Networks (NASDAQ:ARUN)

Q3 2013 Earnings Call

May 16, 2013 4:30 pm ET

Executives

Maria Riley - Director

Dominic P. Orr - Chairman, Chief Executive Officer and President

Keerti Melkote - Co-Founder, Chief Technology Officer and Director

Michael M. Galvin - Chief Financial Officer and Principal Accounting Officer

Analysts

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

Sanjiv R. Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Mark Sue - RBC Capital Markets, LLC, Research Division

Kent Schofield - Goldman Sachs Group Inc., Research Division

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

William H. Choi - Janney Montgomery Scott LLC, Research Division

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

Roderick B. Hall - JP Morgan Chase & Co, Research Division

Ehud A. Gelblum - Morgan Stanley, Research Division

Benjamin A. Reitzes - Barclays Capital, Research Division

Operator

Good afternoon, ladies and gentlemen, thank you for standing by. Welcome to Aruba Networks' Third Quarter 2013 Earnings Conference Call. [Operator Instructions] This conference is being recorded today, Thursday, May 16, 2013. At this time, I'd like to turn the conference over to Maria Riley, Investor Relations. Please go ahead, ma'am.

Maria Riley

Good afternoon, and thank you for joining us on today's conference call to discuss Aruba Networks' Fiscal Third Quarter 2013 Financial Results. This call is also being broadcast live over the web and can be accessed in the Investor Relations section of Aruba Networks' website at www.arubanetworks.com.

With me on today's call are Dominic Orr, Aruba's President and Chief Executive Officer; Keerti Melkote, Aruba's cofounder and Chief Technology Officer; and Mike Galvin, Aruba's Chief Financial Officer.

After the market closed today, Aruba Networks issued a press release announcing the results for its third fiscal quarter ended April 30, 2013. If you would like a copy of the release, you can access it online at the company's website or you can call The BlueShirt Group at (415) 217-7722, and we will send you a copy.

We would like to remind you that during today's call, management will make forward-looking statements within the meaning of the Safe Harbor Provision of Federal Securities Laws regarding the company's anticipated future revenue, gross margin, operating expenses and other financial and business-related information. These forward-looking statements involve a number of risks and uncertainties, some of which are beyond our control, which could cause the actual results to differ materially from those anticipated by these statements. These forward-looking statements apply as of today and you should not rely on them as representing our views in the future and we undertake no obligation to update these statements after this call.

For a more detailed description of these risks and uncertainties, please refer to our most recent report on Form 10-K and 10-Q filed with the U.S. Securities and Exchange Commission, or SEC, on October 11, 2012 and March 7, 2013, respectively, as well as our earnings release posted a few minutes ago on our website. Copies of these documents may be obtained from the SEC or by visiting the Investor Relations section of our website.

Also, please note that unless otherwise specifically noted, all the financial measures we use on this call are expressed on a non-GAAP basis and have been adjusted to exclude certain charges. We have provided reconciliations of these non-GAAP financial measures to GAAP financial measures in the Investor Relations section of our website located at www.arubanetworks.com and in our earnings press release.

Before I turn the call over to Dominic, I would like to announce Aruba we will attend the Barclays TMT Conference in New York City on Wednesday, May 22; and the RBC conference in Boston on June 4.

Now I'd like to introduce Dominic Orr, President and Chief Executive Officer for Aruba network. Dominic?

Dominic P. Orr

Thank you. Good afternoon, and thank you, all, for joining us. On today's conference call, I would like to spend a few minutes discussing our third quarter performance. I would then turn the call to Keerti to discuss our acquisition of a mobile software company, Meridian, that strengthens our location-aware platform. Mike will then provide you with additional details on our results and our outlook for Q4.

In the third quarter, revenue was below our expectations at $147.1 million, up 12% from the prior year but down 5% sequentially. In April, we saw large call enterprise wireless LAN deals in both North America and Europe push out or, in some cases, get redefined to smaller projects. This slowdown was across the general enterprise, while our government, health-care and education verticals performed well in the quarter. Secondly, service provider across Asia significantly reduced spending.

A tougher economy also make these more competitive. A situation that was further compounded by our allocation of few resources. A couple of quarters ago, we intentionally directed a significant portion of our go-to-market resources on building outbound activities for our ClearPass platform. While we believe this will drive future growth, it nevertheless hindered our ability to respond at the end of the quarter to our core wireless LAN business as quickly as we would have wanted.

The growth of the ClearPass pipeline remains very robust and we believe that ClearPass can help drive growth across our full product portfolio. Our win rate with ClearPass continues to be very high, which gives us reassurance that we have the right strategy in place despite the challenging results in the third quarter. We do not believe that projects have been delayed indefinitely as we have already closed some of these deals in the fourth quarter.

At the same time, as the macro environment remains uncertain, we expect to see a heightened level of competition and bundling strategy from our largest competitor. We believe that it is essential to enhance and continue to differentiate our technology as the way to grow and compete in this environment. We are very encouraged by customer feedback on our direction and are therefore continuing to execute on our long-term growth strategy while sharpening our focus on near-term opportunities.

In our core wireless LAN business, our account teams are working diligently with major customers on planning the next wireless LAN expansion, which includes readiness for 11ac and unified communication on mobile devices. Additionally, we are expanding our presence in the distributed enterprise with Aruba Instant, which exceeded our sales expectations in Q3.

We continue to build momentum for our MOVE architecture, which redefines and unifies the access network. Let me share examples of recent customer projects. Most of these deployments are using our new 7200 controllers. A very large technology company globally deployed Aruba Instant Enterprise for remote access. A large private university in the Midwest adopting all elements of our MOVE platform, including our mobility access switch and ClearPass. A retailer in Asia selected Aruba Instant for corporate and guest access, as well as delivering media content to its customers in the stores. Two leading global manufacturers and 2 leading global professional services firm deploying various elements of ClearPass. And a large Midwest school district deploying ClearPass for policy management and replacing its legacy wireless LAN with Aruba products.

We have previously discussed our plan for the public-facing enterprise, leveraging our unique Layer 4-7 capabilities. We have seen momentum and interest for our solutions in this area of the market. Today, we strengthened our position in this segment with our acquisition of Meridian, a mobile software company that helps enterprise deliver indoor GPS for mobile applications that take advantage of location aware Wi-Fi networks. Keerti will we walk you through the details of the technology, but first, I would like to note that Meridian is a key application that our largest competitor has integrated with its mobility platform. And now, Aruba owns this technology.

With that, I would like to turn the call over to Keerti.

Keerti Melkote

Thank you, Dom. Public-facing enterprises are increasingly looking at location-based services as a way to increase their engagement with their guests. They're interested in enhancing the overall experience at their venues with mobile apps that deliver conceptual location-based information in realtime. Meridian's Wi-Fi base and the location services platform for smartphones and tablets helps guests navigate large indoor facilities such as shopping malls, airports, resorts, hospitals and campuses. The platform delivers location-specific mobile application that provides indoor GPS functions such as turn-by-turn directions, highlights points of interest along the way, delivers context-aware notifications and offers detailed analytics about user's travel patterns and preferences.

Meridian's platform enhances Aruba's MOVE architecture by tightly integrating with MOVE's context engine which grants network access based on realtime context such as you user device application, location, and time update. The addition of Meridian will enable enterprises to tap into all their information so that they can better engage with customers with personalization and realtime analytics.

This is a clear opportunity for Wi-Fi to become not only an enabling platform for BYOD but now across industries, a revenue-producing, customer engagement platform for the business. We are excited to have the Meridian team join the Aruba family and we look forward to bringing unique location-based services and engagement models to our public-facing enterprise customers.

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

Dominic P. Orr

Thank you, Keerti. While we are disappointed with our third quarter financial results, the secular trends driving our markets are strong. The proliferation of devices, BYOD and the need to manage mobile data and personal devices are all growing challenges for CIOs. We are confident in Aruba's long-term strategy and the power of our platform to transform access networking. We will sharpen our focus on the core wireless LAN and continue to invest in our core differentiation and product developments.

Our MOVE platform is well ahead of the competition. Aruba is the only provider today with a full range of products that are fully based on the Layer 4-7, application-aware software platform designed from the outset with a mobile edge. We're expanding our capabilities with the Meridian acquisition, which will tightly integrate with MOVE's context-aware capability. And our ClearPass platform brings it all together with dynamic policy and access management.

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

Michael M. Galvin

Thank you, Dom. In Q3 2013, total revenue was $147.1 million, representing a 5% sequential decline and 12% year-over-year growth. Product revenue of $121.2 million decreased 7% sequentially and grew 10% year-over-year. Professional services and support revenue of $25.9 million grew 6% sequentially and 21% year-over-year. U.S. revenue grew 17% year-over-year, representing 62% of total Q3 revenue. EMEA revenue grew 15% year-over-year, representing 19% of total revenue. And Asia Pacific/Japan revenue declined 11% year-over-year representing 15% of total revenue.

In the month of April, North America and EMEA were impacted by slower conversion of our pipeline in enterprise accounts. The Asia Pacific/Japan region showed strong enterprise growth in the quarter but was significantly impacted by a decrease in service provider sales.

Total non-GAAP gross margin in Q3 was within our target range at 72.3%. This compares with gross margin of 72.4% in Q3 '12 and 73.4% in Q2 '13. Q3 non-GAAP product gross margin was 71.5%, an increase from 71.2% in Q3 '12, and a decrease from 73% in Q2 '13. The sequential decrease in product gross margin was due primarily to normal fluctuations in product mix. Q3 non-GAAP services gross margin was 76%, up from 75.4% in the prior quarter and a decrease from 78.5% in the same period a year ago. We continue to invest in the infrastructure of our services business, including both people and systems. We expect total gross margin to continue to perform within our near-term target range of 71% to 73%.

Non-GAAP research and development expense was $25.1 million. As a percentage of revenue, R&D was 17% compared with 15.7% in Q2 '13. Our R&D spending levels are affected by the timing of headcount additions and programmatic spend related to our product roadmap. While we see a challenging near-term environment, we will continue to invest in R&D for further product innovation and differentiation.

Non-GAAP sales and marketing expense was $47.2 million in Q3. As a percentage of revenue, Q3 sales and marketing expense was 32.1% compared to 30.1% in Q2 '13. We will continue to invest in our go-to-market engine, including optimizing our sales force for all facets of the Aruba platform.

Non-GAAP G&A expense increased to $9.9 million in Q3 from $8.2 million in Q2 '13. As a percentage of revenue, G&A expense in Q3 was 6.7% compared to 5.3% in Q2 '13. The primary drivers of the sequential increase in G&A spend was further investment in headcount and infrastructure. Total headcount at the end of Q3 was 1,460, an increase of 53 from the prior quarter. In total, Q3 non-GAAP operating expenses were $82.1 million or 55.8% of revenue compared to $79.4 million or 51.1% of revenue in Q2 '13. Our non-GAAP operating profit in Q3 was $24.2 million or 16.5% of revenue compared with 22.3% in Q2 '13, and 20.6% in Q3 '12.

Our non-GAAP tax rate in Q3 was 43%, above our prior guidance range. As we have previously discussed, our overall tax rate is subject to change, including from the projected geographic mix of the company's revenue, as well as changes resulting from any new U.S. or international regulations or interpretations. Our tax rate in Q3 was impacted by our drop in overall profitability. And importantly, the mix between the U.S. and international profitability also shifted towards the U.S. We expect our full year fiscal year 2013 non-GAAP tax rate now to be in the range of 30% to 32%. To be clear, the FY '13 rate of 30% to 32% implies a Q4 modeled non-GAAP tax rate of 37% to 39%.

Non-GAAP net income for the quarter was $14 million or $0.11 per diluted share. This compares to $27.3 million or $0.22 per diluted share in Q2 '13 and $19.4 million or $0.16 per share in Q3 '12. The weighted average shares outstanding were 125.8 million on a diluted basis. On a GAAP basis, net loss was $20.2 million or $0.18 per diluted share compared with Q2 '13 net income of $5 million or $0.04 per diluted share and a Q3 '12 net income of $6 million or $0.05 on a per diluted share basis. Our GAAP net income results were negatively impacted by $17.9 million provision for income taxes.

As you have seen in prior quarters, our GAAP tax rate and provision is very sensitive to changes in profitability. This is primarily due to fixed tax amortizations resulting from our international structure we entered into almost 2 years ago. These fixed amortizations are in place for the first 3 years of the international structure through the end of FY '14. A full reconciliation of GAAP and non-GAAP information is contained in our financial results' press release issued this afternoon.

Turning to the balance sheet. During the quarter, we continue to manage our working capital very well, which is reflected in our key balance sheet metrics. We finished Q3 with cash and short-term investments of $440.9 million, an increase of $38.6 million over the prior quarter. Cash flow from operations in Q3 was $25.3 million.

During the quarter, we did not purchase stock under our stock repurchase plan. We currently have approximately $50 million remaining in our stock repurchase program. We ended Q3 with $71 million of accounts receivable, an increase from the Q2 '13 balance of $70.1 million. Days sales outstanding were 44 days compared with 41 days in Q2 '13 and 57 days in Q3 '12. Our target range for DSO remains 50 to 55 days.

Total deferred revenue of $118.4 million increased 30% year-over-year and $0.3 million from Q2 '13. Short-term deferred revenue of $89.3 million increased 26% year-over-year and declined 1% sequentially. Aruba's inventory totaled $27.9 million at the end of Q3, a decrease of $1.6 million from the end of Q2.

Before reviewing guidance, let me remind you that guidance consists of forward-looking statements, and please keep in mind our earlier comments regarding such statements.

As Dom mentioned, we see a challenging near-term economic environment, including potentially some impact to our federal business. And we are entering Q4 cautiously from a top line perspective. At the same time, we are continuing to invest in our product differentiation and go-to-market optimization, which we believe will lead us to longer-term growth. Balancing all these factors, we expect Q4 '13 revenue to be in the range of $148 million to $150 million, an increase of 6% to 8% year-over-year and 1% to 2% sequentially. We expect non-GAAP EPS to be approximately $0.10 to $0.12 per share using 127 million shares on a diluted basis.

With that, let me turn the call over to the operator to take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from the line of Jason Ader with William Blair.

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

So Dominic, when you talk about a heightened level of competition and bundling from your largest competitor, I imagine this is baked into the guidance. But do you think this is going to affect win rates and discounting both, or just a heightened level of discounting and more kind of sales cycle delays based on your competitor?

Dominic P. Orr

Thank you, Jason. I see that win rate continued to be the same, without change. But what we see in April in North America and in Europe is the across-the-board action from our main competitor on large deals in enterprise account of very expensive extensive price action as well as bundling. In the past, we only see bundling between wireless and wired, but now we are seeing bundling including the router upgrade core as well. And this is the most significant development bundling into data center projects. Everything's linking in. And that, in the end, in vast, vast majority of the case, we still prevail but it definitely caused a lot of the deals slipping out of April. And we expect that the extended duration, extra sales cycle will continue. In fact, I have a recent information from our field leaders that this activity, this behavior has extended now to the Middle East and part of Asia, so that is really a part of our plannings and it's into our guidance.

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

Just such one follow-up on that, so as you face that, looking forward, Dominic, I mean, how do you respond? I mean, it just seems like -- I mean it's kind of a dire picture in terms of thinking about their ability to wield all that muscle in the market. How do you respond?

Dominic P. Orr

Okay. Okay. So first is, I've been in this industry long enough to see bundling financial level will give you some transient kind of actions. But over time, technology and total cost of ownership prevail. And I don't expect this to be different. Secondly, our pipeline for current quarter has never been better. It's such that given the thickness and given the very dramatic kind of delaying of sales cycle and price reaction and so on from our competitor, we have baked in a lower conversion rate primarily because we are now expecting we have to win some of the major project 2 times, 3 times, but we will win.

Operator

Our next question is from the line of Sanjiv Wadhwani with Stifel, Nicolaus.

Sanjiv R. Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

Dom, just wanted to figure out post the pre-announcement last week, wondering if you guys have time to do any analysis. And the reason why I bring that up is if you look at Cisco's results yesterday, and I know there are some moving parts in that because it's a service provider Wi-Fi business, but they actually had a pretty good wireless number. Ruckus, which sort of competes in the small and midsized enterprise market, also sort of said they had decent stuff on enterprise side. So I'm trying to figure out what caused your miss versus what Cisco and Aruba -- Cisco and Ruckus were seeing. Wondering if there some sales execution stuff that you might have picked up or anything else that you might be able to point us to?

Dominic P. Orr

Sure, Sanjiv. First one, if you peel back Cisco's numbers, the enterprise growth is, I believe, 17%. And you have to add in, that is the Meraki component that was not existent year-over-year. And then there's an element I do not know how they count the 38, 50 switches that had the wireless enablement inside. So if you peel back those elements, we are looking at roughly in the same range. Our -- like I said, our growth in the government health care, the education, is actually very good. Our growth enterprise business and Asia Pacific/Japan was very good. And our distributor enterprises for Aruba Instant exceeded our expectations. And it is really in the core large deals, in the core enterprise space that we believe there is extensive pricing action and bundling action in the month of April that preclude us from achieving our number and making those projects selling cycle quite a bit extended. We do not believe that, that would affect our long-term competitiveness. In fact, some of the lengthened sales cycles that we were not able to close in April, already have -- some of them have coming in, in the beginning of May. So what we really need to do is to build a bigger pipe in that space and adjust our go-to-market model for longer sales cycle. And in our sales force, emphasize the rightsize network aspect and the total cost of ownership aspect. As noted in our competitor's earnings call, they have finally, finally acknowledged that the world is changing from wireline to wireless. And I think they are threatened by our superior architectural and technology position in the marketplace and then afraid that we might bring our successes from our core vertical and high-tech enterprises into the mainstream enterprises, hence this reactive movement, which I expect them to continue.

Sanjiv R. Wadhwani - Stifel, Nicolaus & Co., Inc., Research Division

So Dom, just a quick follow-up, just trying to figure out kind of what changed, let's say, in the month of April versus the month of Jan, Feb and March in terms of this sort of increased pricing and bundling action. I think it's something that you've seen pretty much in the past but looks like it's sort of increasing in the month of April. Any thoughts of what might have changed in the month of April versus 3 months ago?

Dominic P. Orr

I believe that the change of action actually happened promptly after our Analyst Day as we articulate not only our current offering but our roadmap in using Layer 4-7 and the software defined network architecture, redefining the next generation access network. I think that, that was the first time we clearly articulated our long-term ambition in the enterprise space, in access layer in general. As I mentioned early on, earlier bundling that we see in the previous year and quarters are more mixing the wired line and the wireless bundle, but now we're seeing programatically, seemingly bundling across a major segment, including data center and core. And which makes it more formidable at the financial level because the numbers are now a lot bigger and the financial incentive a lot bigger. A lot of the IT management now have to further justify to the financial management part of the house why this is apples and oranges.

Operator

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

Mark Sue - RBC Capital Markets, LLC, Research Division

If I look at the comparisons of [indiscernible] from Cisco, because we don't know exactly what they include or don't include. And I look at your revenue growth, it's steadily decreased on a year-over-year basis as we move -- progress through the year. Now we're looking at a company that used to grow at 44%, now to 12% to potentially single digits. Do you think some of that is penetration-related? Do you think some of that is related to scaling your large numbers? Or do you think it's just something that's temporary and would you kind of see some re-acceleration? And what would drive that re-acceleration to double-digit supply growth going into fourth, maybe beyond?

Dominic P. Orr

Good question, Mark. I think there's a combination of factors here. I think the reaction of this -- a quarter ago, I mentioned in our call, that looks like our largest competitor has given up fighting us head-on technologically. But rather than fighting back, they're fighting us by financial means. It seems like that they decided that to increase that approach. And particularly, in light of the macro environment, that makes that approach temporarily more sensitive, more effective in delaying the sales cycle. That, coupled with the fact that from an absolute pound-for-pound of our field resources selling Capstone wireless LAN, like I mentioned in my prepared script, we have, starting 2 quarters ago, significantly invested in our go-to-market resources on developing the ClearPass pipeline, which by the way continue to impress me in terms of the growth, quarter-to-quarter growth of the pipeline and quarter-to-quarter growth of our customers and as well as number of new customers that have ClearPass component as part of the architecture, so all this is investment. We were counting on some of this investments funded by strong tailwinds in our core wireless LAN business. So when that tailwind did not show up, we feel a little stressed on our core funding model. But we believe that strategically, that is absolutely right thing to do, so we just need to go through the next couple of quarters until we get back to the growth that you mentioned, basically in the -- starting to exceed the 20% year-over-year growth within multiple quarters.

Mark Sue - RBC Capital Markets, LLC, Research Division

Okay. And as your competitor is relying on bundling, tactically, what you do? Do you find the bundling partner yourself? And if you do now need to allocate more sales and marketing resources. Mike, what does this entail for your long-term financial model? Are we at a point where we need to kind of reboot the long-term expectations for operating margins?

Dominic P. Orr

So we do -- first of all, let me answer the bundling aspect. We have wireline partners and we have other IT partners but I think our value proposition in our go-to-market approach for that company's existence really has been accentuated in innovation and solving mobility and security problem for enterprise that value them. And now we're moving the value proposition very, very slowly in the Layer 4-7 area. So I think we just need to do increasingly good job in articulating those value and articulating those tough customer problems that are uniquely solved by our solutions that -- and all of those situations, bundling caused disruption of the sales cycle, the lengthening of the sales cycle but ultimately and potentially, admittedly some the discount pressure but ultimately, statistic shows that we don't lose the deal after all.

Michael M. Galvin

Yes, Mark. So with regards to the operating model and sales and marketing, clearly the operating margin took a hit this quarter. You can see by our guidance that we are continuing the investment path. We've had a hit on revenue but it by no means derails us from the focus and the strategy that company's on. So with regards to sales and marketing, that optimization of the go-to-market, Dom talked a little bit about some of the rotation we did towards ClearPass versus W-LAN, et cetera. We're going to continue that investment and that optimization, and that shows in the Q4 guidance. Really, the operating model overall, we still believe absolutely in the market we're playing in the growth that it can achieve and what that operating model can do. But really, I guess not surprisingly, the math there on the op model is heavily dependent on the revenue growth and that's our focus. And we believe in that model, including the sales and marketing investment and the key to that will be bringing the revenue back to the growth parameters we were going after.

Dominic P. Orr

And the focus is bringing a go-to-market model that encompass this lengthened sales cycle in the full enterprise with looking for unique differentiations across the board.

Operator

[Operator Instructions] Our next question comes from the line of Kent Schofield from Goldman Sachs.

Kent Schofield - Goldman Sachs Group Inc., Research Division

First off, it sounds like tactically, you're going to continue with investments in ClearPass. So can you just give us a sense as to what kind of sales resources are you putting at this opportunity like in the grand scheme of things? And then I wonder if you can talk to us a little bit about how we should think about the revenue coming from that opportunity. And if there are any parallels to maybe what you've seen in the past when you went after the hardware switch opportunity.

Dominic P. Orr

Okay. So obviously, we -- I'm not breaking down product line but I can tell you that a significant portion of our sales, but more importantly, our system engineering resources and our partner development resources have been directed to the ClearPass activity. And this is the -- we have multiple discussion within the company about whether rotating back some of the resources. And in the end, I think the momentum of the growth in the ClearPass customer base, as I mentioned, that we're picking up double-digit quarter-over-quarter growth now and also as a point of statistics, for all main new accounts that we gained the last quarter, close to half of the customers now have integrated ClearPass as part of the initial -- part of portfolio that they accept from Aruba. So we believe even though a short-term reaction might be to kind of rotate back to take down core wireless LAN opportunities, that in the long term is still the right thing to invest -- using ClearPass as a leading tool to get into the core enterprise, so we are going to stick to the course of that. And I believe within a couple more quarters, we will see even more dramatic return of our investment.

Operator

Your next question is from the line of Rohit Chopra with Wedbush Securities.

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

Dom, I was wondering if you could go over the issue with your field resources that you put into ClearPass, and I think you used that to blame part of the issues in the quarter. What are you going to do with those resources? Are you going to put them back on the original core product? Are they going to stay with ClearPass? What you do to fix that execution issue?

Dominic P. Orr

I think what we will do is actually -- there are 2 -- several prompt. So the core wireless LAN business, we are going to focus on enhancing our Layer 4-7 capability. We will actually apply extra resources in what we call a public-facing enterprises particularly with the Meridian acquisition. And we sharpen our focus in building the big deal pipelines for the core wireless LAN to and adjust for a more conservative conversion ratio because of the delaying tactic of our largest competitor using financial bundling means. But in terms of -- and in terms of system engineering activity, we are -- we think we're doing the right thing to continue to work with our install base to prepare them for 2 major reasons for upgrading the wireless LAN in the next -- say, in the coming quarter which is readiness to accept 11ac devices and access point and ability to support unified communications over the various form of mobile devices. So those are really the area that we're going to cover our focus that would help our wireless LAN business. One thing that our biggest competitor has admitted with this shift, a pretty big shift of wireline to wireless in the enterprise that we also believe it is time to reactivate and refocus the network rightsizing exercise, which is a financial exercise, in conjunction with 11ac introduction. Because with 11ac, for the first time in the network access industry, wireless is faster than wired now and that really is bringing the wireline to wireless transition to a point of no return, so we will be investing our resources in there. Other than that, I think we are doing everything that we should be doing right for the ClearPass channel and partners and technical enablement and we will be sticking pretty much along on the same course.

Operator

Next question's from the line of Bill Choi, Janney Capital Markets.

William H. Choi - Janney Montgomery Scott LLC, Research Division

I guess I'm still confused as to exactly how effective this new bundling strategy from Cisco is. I mean, you talk about it but you said that, let's say, of the $13 million that you missed a quarter by, some of these deals have already been closed. And you said win rates are not being affected, it's largely dragging it out. What are you assuming that you ultimately lose? I mean, what is the newest bundling strategies' effect on your business?

Dominic P. Orr

Sure. You're pipeline is starting in the quarter and you use your historical analytics to devise a conversion rate for each of the geography, which one of the vertical. So you assume a certain ratio and then that's how you set your target. If suddenly for big section of the vertical, which is the core enterprise in this case, that a lot of the deals that are in the pipeline that you feel can be committed in the quarter that you have won. Technically you won the RFP. Then suddenly there's 2 level more signatures of examinations, so on. Suddenly your pipeline conversion ratio get lower and you need a bigger pipeline. And it would normally take you 2, 3 quarters to rebuild that pipeline to be appropriate for you new conversion ratio to achieve your new target. So while we, in terms of -- if you define win rate, from a new startup project to you win the proposal then that rate has not changed. But if you define when ultimately when the order comes in, that rate, that win rate has not changed significantly. But if you define if it has to close within the certain timeframe, that is what caught us a bit off-guard in April about how many of these larger projects in the core enterprise were in those situations.

William H. Choi - Janney Montgomery Scott LLC, Research Division

I get the explanation. I'm asking if there were any deals you specifically lost because of this new bundling strategies that involve data centers and so forth?

Dominic P. Orr

I understand. Okay. So I think, it is -- I can say to my knowledge, a small single-digit number of deals that we lost and we actually have access all the way to the CIO level and the explanation to us is now at this kind of bundling level with this kind of number and tying in the data center and so on, it is no longer a CIO decision, it's a CFO decision. And at that point in time, we cannot compete.

Operator

[Operator Instructions] Our next questioner is Jess Lubert with Wells Fargo Securities.

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

I wanted to understand the decision not to buy stock in the quarter and how you're thinking about the buyback going forward. And then, Mike, if you can offer any thoughts on tax rate for 2014, that would be helpful.

Michael M. Galvin

Jess, so the buyback in the quarter, as I said, we did not buy back any stock in the quarter. On a regular basis, obviously, we look at different -- our different capital needs, et cetera. We make certain decisions. For instance, the Meridian acquisition is an all-cash acquisition. You take into account things like that. But also, we have a set of parameters and if you want to call them restrictions, if you will, in our plan they're not publicly disclosed. There's a set of variables in the plan. And when any of those restrictions trigger, you're prevented from purchasing the stock. We did have some of those triggers in the quarter and as we go into Q4, our plan, as it has been in the other quarter so far, if triggers don't trigger, we plan to be active in Q4 if none of the restrictions hit. So that's the dynamic behind the buyback. We've got $50 million left on it. We absolutely view it as a valuable tool and are going to continue to pursue it within the realm of the parameters of the plan. And I think your question was on tax for FY '14, is that what you.

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

Yes.

Michael M. Galvin

So I think the right marker, I talked about the profitability drop. I mean, there's no question overall in the tax structure. Increasing profitability and, importantly the balance of that profitability, is what ultimately drive, between international and U.S., is what drives that lower. Those things both hit us. You can see in Q4 that we're continuing on kind of the margin level or you could say the lower margin performance then we were previously on the track for. So that hits us and I think the right marker for now for FY '14 is to keep that 30% to 32% that I talked about for the balance of FY '13. And obviously, as we get into FY '14 in Q1 and with the different variables, I'll revisit that every quarter, but I think that's the right marker right now.

Operator

Our next question is from the line of Roderick Hall, JPMorgan.

Roderick B. Hall - JP Morgan Chase & Co, Research Division

Just a couple of quick questions. Back to the sales force, I wonder -- can you talk a little bit about your incentive plan. It sounds like you made some big changes to your FT base this core sales of ClearPass, but did you make changes to your incentive program? And are you thinking of potentially switching those back to refocus for the carrying sales people on the core wireless business? Can you talk through that? And then it would be great if -- could you just describe again the fixed amortizations, Mike, that you mentioned that affected the adjustments between non-GAAP and non-GAAP, just again clarify that, if you would, what those are for.

Dominic P. Orr

This is Dom. We have not made any change in our comp plan. But the change 2 quarters ago was really allocation of resources with certain concentration and focus, so we have nothing to reverse back to. We did not change the company.

Roderick B. Hall - JP Morgan Chase & Co, Research Division

Yes. And on the GAAP tax side. And in particular, a note that these fixed amortizations apply to the GAAP rate and not the non-GAAP rate. And then I'll try not to go too far here. But when you set up the international structure, basically, the U.S. entity or the international entity pays the U.S. for the transfer of intellectual property, et cetera, over. And it's called the buy in, it's the buy in of the structure. And what you have is those buy-in costs are amortization straight-line and over the first 3 years of the program. And so what happens in the GAAP tax line is you've got these fixed costs, which are amortizing, and that's effectively your numerator. So regardless of profitability going up and down, you've got this relatively fixed expense stream going through. And then if you go to the denominator, we have relatively modest GAAP either income or loss. We're fairly close around breakeven depending on the quarter. So you've got a very small denominator, a relatively fixed numerator and so when the numbers change, you get these frankly outrageous tax rate and some of these outrageous movements that you see. The non-GAAP rate is really the rate that is the most reflective rate of our cash tax impact of the company. Frankly, the GAAP stuff is a lot of accounting that is going to swing here in the first 3 years. The non-GAAP rate is the more accurate way to look at the real cash, ultimate long-term cash impact of the company.

Operator

Our next question is from the line of Ehud Gelblum with Morgan Stanley.

Ehud A. Gelblum - Morgan Stanley, Research Division

You have a 72% gross margin that's staying amazingly high and strong, it's terrific. I'm still try to understand what happened and what Cisco's doing? And if they're bundling is that just kind of code for they lowered prices. And if you're still getting 72% gross margins, maybe your prices are just too high. Is it just as simple as that? You should be getting 65% gross margin and you'd be more competitive?

Dominic P. Orr

No, no. I think basically, when you're starting to take -- the concept here is I think is wallet share. If your competitor has a much bigger wallet share of the IT budget and they move around and they are now trying to use their whole -- their total portfolio, independent of the campus network, used to be, like I say, the bundling is just squishing around between wired and wireless. But now the wireless component is getting bigger, the wire part is getting smaller, there's not a lot as much room to play with, so you have to look into the core, you have to look in the data center. Now that data center project is normally are much bigger. So if they are tied into an incentive, certainly, it gets the attention of finance and operations executive that had nothing to do with the campus project but they would just say, hey, suddenly there is an incentive. Basically, used to be we say that for some situation, wireless for the customer is free. Now it's more than free because if you're now leveraging a much, much bigger procurement budget outside of the campus, and then certainly all kinds of questions being asked.

Ehud A. Gelblum - Morgan Stanley, Research Division

But that's been true for a year, couple of years.

Dominic P. Orr

We have not seen bundling of the data center projects together with wireless project.

Ehud A. Gelblum - Morgan Stanley, Research Division

Until April 1st? Has it really happened in the last 4, 5 weeks?

Dominic P. Orr

I would say the uniformity and ubiquity of the happening in enterprise sector, deal of large-size, was rather dramatic.

Operator

Your final question comes from the line of Ben Reitzes with Barclays Capital.

Benjamin A. Reitzes - Barclays Capital, Research Division

Can you talk a little bit about how things are going in federal into October? I guess I'm trying to see if you think the revenue is going to improve or not in October quarter after flattish in the July quarter? Or is the Cisco pressure just too much? You're going to be flat sequentially over the next 2 quarters. Can you talk about maybe the ramp in the back half that maybe give us some hope of optimism?

Michael M. Galvin

Yes, Ben, so just on one context overall from that is what we do -- fed is part of -- when you look at our guidance for Q4, it is part of that guidance and the metrics that we built up. We do show in the pipeline, et cetera, a softer fed Q4 than we had in Q3. And with regards to October, it's interesting for Aruba because traditionally, we've been in the larger programmatic programs, if you will, in business that we've won. So we've had some less sensitivity to that October budget flush in the Fed because of the multiyear programs that we've been in. And that applies -- when the Fed's doing well, we tend to not get as much of the flush and when the Fed's is not doing well, we tend to take as much pain. We don't have a clear picture for that yet for Q1 but that is -- that has been the makeup of the business.

Dominic P. Orr

And so you're looking over some of the -- a couple of dynamics here. First is in light of this -- from a planning perspective, we are going to expect our largest competitor to continue to exert this pressure through bundling through the strength of their entire business on this pretty large vertical for the large deals. So the only way we could overcome that is to building a bigger pipeline. And the bigger pipeline is going to be driven by a couple of factors. That is a strong trend of this large enterprises going to deploy Unified Communications and mobile devices that need a significant infrastructure upgrade and that is where our Layer 4-7 differentiation showed the sharpest. And then the general 11ac upgrade is going to be pushing a strong pipe. And I think that -- and then the service part of the business in Asia Pacific, we expect this quarter to be still relatively weak. We believe that it will come back, the spending will come back. So those all will be some of the drivers that will be bringing us back to that set of environment that you're looking for. I think it's going to take a couple of quarters, but it will -- we're confident that, as far as we can see, the growth will resume at our previous rate.

Benjamin A. Reitzes - Barclays Capital, Research Division

Okay. And just to sneak in one thing, if Cisco's getting the power of bundling from having the whole data center offering, is there anything that's making you reevaluate your decision to stay an independent company?

Dominic P. Orr

Absolutely. We are as determined as -- if ever, like I mentioned earlier on, bundling is a transient tactic. We are having a very comfortable -- commanding a largely roadmap position to our continued build up of Layer 4-7, coupled with the ClearPass offering is giving us a very, very strong position to drive the next generation software defined network at the edge. I think the bundling transient effort is just a very frightened reaction when they really see our roadmap and then heard from the customer base that they are actually going to go wireline to wireless. That is a very -- they feel very threatened and we have -- we can deal with that kind of transient reactions.

Michael M. Galvin

And just to clarify there, Dom, that we are absolutely not evaluating ourselves as an independent company as opposed to -- absolutely. Absolutely not.

Dominic P. Orr

As a matter of fact, as we continue to look at what for technology acquisition to build up our strength. And building up on the fact that the Cisco 3850, because of the ASIC implementation, is permanently limited, I would say, for a long time to add Layer 4-7 capability at all. So we feel very good to hear that actually the 3850 is taking traction that is guaranteeing the near future of the new customers that they acquire will not be able to execute Layer 4-7 capability. And that is going to be a significant disadvantage going forward.

Operator

Ladies and gentlemen, that does conclude our question-and-answer session. At this time, I would like to turn the conference back over to Dominic Orr for closing remarks.

Dominic P. Orr

Again, we thank you for being on the call today. I'd like to take a moment to thank all of you for your support, our very employees for their excellent execution through a challenging quarter and our customer partners for their dedication, commitment and hard work. We look forward to updating you in our next quarterly earnings call.

Operator

Thank you, sir. Ladies and gentlemen, if you would like to listen to a replay of today's conference, please dial 1 (800) 406-7325 or (303) 590-3030 using the access code of 4614156 followed by the pound key. This does conclude the Aruba Networks Third Quarter 2013 Earnings Conference Call. Thank you for your participation. Have a good day.

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