Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Brocade Communications Systems, Inc.

F3Q09 Earnings Call

August 20, 2009 5:00 pm ET

Executives

Peter Ausnit – Senior Director, Investor Relations

Michael Klayko – Chief Executive Officer

Richard Deranleau – VP of Finance and Chief Financial Officer

Dave Stevens – Chief Technical Officer

Analysts

Mark Moskowitz – J.P. Morgan

Paul Mansky – Canaccord Adams

Brent Bracelin – Pacific Crest

Kaushik Roy – Wedbush Morgan

Mark Sue – RBC Capital Markets

Aaron Rakers– Stifel Nicolaus

Katy Huberty – Morgan Stanley

Min Park – Goldman Sachs

Jeff Evanson – Sanford Bernstein

Nikos Theodosopoulos - UBS

Operator

Welcome to the Brocade third quarter 2009 financial results conference call. My name is Louisa, and I will be your coordinator for today. (Operator instructions) As a reminder, this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today’s call, Mr. Peter Ausnit, Senior Director of Investor Relations.

Peter Ausnit

Joining me today from Brocade are Michael Klayko, Chief Executive Officer; Richard Deranleau, Chief Financial Officer; and Dave Stevens, Chief Technical Officer.

Before we begin, let me cover some housekeeping items. Brocade issued a press release today detailing its third quarter financial results via Business Wire and First Call. The press release is available on our web site at www.brcd.com. In addition, a copy of this slide presentation has been posted to our web site. This conference call is being webcast and will be archived on our web site 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 May 2, 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 web site.

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

Michael Klayko

Thank you for joining us. I will start by providing some highlights of our quarterly performance. Then, I’ll review our product and technology innovation, our leading position in storage, and our opportunities in the ethernet space. After that, I’d like to spend some time discussing our expanded reach and success in our partnership model, selected customer wins, customer feedback, and current market conditions. After that, Richard will review our financial results in detail along with our financial outlook.

I’m pleased to report another strong quarter as Brocade achieved record Q3 revenues of $493.3 million, growing 35% year over year. We exceeded our EPS goals, thanks to expanding gross margins and effective cost controls. Brocade continues to grow due to the Foundry acquisition and to the fact that customers need our products and services and look to us as a true business partner.

While current economic conditions challenge the budget and timing of technology spend, out ability to drive down our customers’ IT costs continues to resonate well with our customers. Looking at our last five quarters, it’s clear that we’ve been on a sustained revenue growth ramp, and we expect our growth to continue as we execute on our playbook, expanding our routes to market, innovating to build the products our customers need, and closely working with our OEM and channel partners.

Let’s look at why Brocade leads the storage market and why we are well positioned to grow our market share in IP networking. The primary reason is because of our sole focus on developing and delivering extraordinary networks. We believe this focus will pay off because there is an explosive demand for networking and storage capacity driven by the exponential growth of data and traffic. Just a few data points: In May, YouTube added 20 hours of content every minute of the day, up by a third from over 15 hours per minute in January. Mobile broadband users are expected to quintuple from over 200 million last year to over 1 billion in 2013. In just a few months, mobile data is expected to exceed voice traffic.

Clearly, the need for networking is growing fast and with it the need for new, faster, more efficient communications infrastructure. We have spent $300 million in the last 12 months alone on networking innovation to support our market leadership and enable our long record of superior product performance and support. This is why our partners and customers expect Brocade to be typically first to market with the best performing, most reliable networking products.

We were first to market with 4 and 6 gigabyte fiber channel as well as 1 and 10 gigabyte Ethernet. Now our broad portfolio of end to end solutions is sold via a balanced set of channels including a range of tier 1 vendors. We’re committed to helping customers preserve their IT investments and enabling them to choose on their own timeline the best solutions for their specific business needs, whether that’s in a data center, a campus LAN, or the service provider markets.

Our continuing investments led to multiple new IP and ADC products in the third quarter and to solid progress with partners like IBM which recently chose Brocade for its first FCoE switch. We’re pleased with our Q3 products and are looking forward to announcing more new storage and IP products in the fall. Our new products are proof points in our record of continuing innovation.

In the third quarter, we introduced new TurboIron 10-Gigabit top of rack switches, ServerIron application delivery controlling, and FastIron Edge switches. Our new products improve the customer experience through increased performance, reliability, and a focus on power, cooling, and space efficiency, while reducing complexity and cost. These products are designed for customers who are now spending up to 25% of their total IT budgets on energy and operations and yet still need high performance.

We continue to lead the storage networking market as we have for years. We’ve leveraged our longstanding position to expand our strong relationships with OEMs, enhance our partner ecosystem, and broaden our worldwide sales and support infrastructure. We believe that these assets coupled with our leading technology and reputation for quality will allow us to continue to do well in the storage networking market and position us to gain share in the IP Ethernet market.

The IP Ethernet market is large, with the total addressable market depth comfortably exceeds 30 billion. In a market this size, if we gain a single point of share, we grow our business by more than $300 million. This is a compelling opportunity. In addition, customers are open to new vendors who can significantly reduce their overall IT spend without having to completely tear out their existing infrastructure. Brocade continues to actively demonstrate how we can reduce IT costs by a target of 30% or more with improved operational performance.

We see many openings in IP networking as go to market relationships among our partners and other IP vendors which have been established for more than a decade are now under review in light of changing market dynamics.

Scaling our distribution is a key element of our corporate strategy. Today, our distribution is balanced. Our large OEMs drove 46% of our revenue in the last quarter, other OEMs drove 17%, and direct sales from channels contributed 37%. Prior to the Foundry merger, our distribution lacked this balance, and historically, our OEM and direct channels tended to carry our storage or IP Ethernet products. Our go-forward strategy is to scale our distribution by leveraging our end to end portfolio into all our channels which now have global reach along with longstanding relationships at every customer level.

Our model requires partnering expertise, how to support the partner in the field, and how to help our partners make money. Out long-term commitment to our partners has helped establish trusted relationships. In fact, along with our partners, we have invested over $1 billion in co-marketing and co-development funds, and in the last quarter, we have been expanding and deepening our channel relationships.

Earlier this week, we announced our partnership with NetOne Systems, the largest independent Japanese network integrator. Our agreement with NetOne positions us to substantially expand our reach into the $110 billion Japanese IT market and serves as a cornerstone of our Asia Pacific presence. During the quarter, we also launched our technology alliance partner program, which tests interoperability and performance to provide choice and proven end to end solutions from a single source. We also established strategic distribution partnerships with Avnet and Tech Data.

At the product level, we announced that all our major OEMs and tier 1 vendors now sell our HBAs and CNAs. Our FCoE switches are now being sold by HP, IBM, and NetApp. We’re excited about our IBM partnership on both the storage and IP networking sides. Brocade and IBM are both committee to an open approach, and we’ve seen a pickup in our pipeline, which we expect to continue into Q4 and next year.

Brocade reduces total cost of ownership while providing choice, reliability, performance, and a future proof roadmap that respect the customer’s timeline. This explains why our existing datacenter customers including nearly all of the Global 2000 along with numerous service providers are eager to work with us. Since Q1, 442 customers who had not previously purchased Foundry networking products have now purchased IP networking equipment and services from Brocade. Our reputation for performance, value, and quality along with our pragmatic approach to implementation makes us an attractive alternative supplier of networking solutions, and in the third quarter we announced that service providers including over 90 independent operating companies that provide converged video, voice, and internet access are using Brocade IP solutions.

In the enterprise, we announced that Inside Investments, a UK asset manager, with over 119 billion pounds under management chose Brocade for an end to end networking and storage solution. Mizuno USA also selected Brocade IP products for its network including our new FastIron Campus Edge switches and ServerIron application delivery controllers which we introduced in the quarter. We continue to make customers around the world who are grappling with the realities we’ve been addressing for years.

First, data and network traffic continue to grow fast. Almost 500 new exabytes of content were created year to date. That’s a pace that more than quadruples the roughly 160 exabytes created in all of 2006. Also a single high definition video conference consumes at least 3 and possibly 4 orders of magnitude more bandwidth than typical desktop productivity application, and is at the same time far less tolerant of congestion and dropped frames.

Second, network performance requirements are increasing. Analysts expect 600 million new internet users in the next 4 years and 850 million people selling on the internet with pictures and voice. Yet, IT budgets are flat or even down. Customers need performance that meets specific business requirements—interoperability with existing systems and a development roadmap that delivers the simplified, secure, standard space infrastructure they demand. They are looking for alternate vendors that can help them achieve today’s cost reduction mandates while positioning them to meet tomorrow’s needs.

Brocade’s focus on networking in standard space choice is endorsed by customers. As others move in different directions, this creates a need for new supplier relationships, both in the channel and among customers. Brocade is positioned with the right technologies, products, and playbook to make the most of this opportunity.

Before Richard goes over the results and outlook in detail, it’s important to remember that data growth and rising network performance requirements require a wholesale re-architecting and rebuilding of the world’s networks. Neither we nor our customers see an endpoint to the trends driving demand for our products and services, so we’re very excited about the future.

Brocade is executing to its playbook, with strong revenue growth and margins and with EPS ahead of expectations. As we build on our storage leadership and global reach to grow our IP networking share with our OEMs and channel partners, we think we have the right strategy, products, and partners to succeed and to build the world’s extraordinary networks.

I would like to now turn the call over to Richard to provide more details on our Q3 results. Then I will return for a few concluding remarks.

Richard Deranleau

As Mike said, Brocade turned in a strong quarter with revenues in line with our seasonal expectations with higher than expected gross margins and earnings. Revenues were driven by strength in North America, directors, and in our global services business. The Foundry integration is complete, and in just the second full quarter of combined operations, our margins are back within the long-term model, thanks to the cost synergies we’ve achieved to date, a favorable product mix, and cost reductions in our IP business unit as we consolidate our IP and ADC supply chain.

Synergy realization and effective cost controls produced Q3 non-GAAP EPS of $0.12, which was ahead of expectations. From a balance sheet perspective, we continue to execute on our long-term debt reduction plan, continue to generate strong EBITDA, and our financial covenants remain well below thresholds.

Gross term debt fell below $1 billion for the first time since acquiring Foundry. On our key financial metrics slide, you can see the continued improvement in both non-GAAP gross margins and non-GAAP EPS.

Turning to revenues by business unit, our mix remain consistent with Q2, but with a modest increase in global services as a percentage of total revenues. Total revenues decreased sequentially by $13 million, driven primarily by slightly higher than expected seasonality in storage and IP product revenues, which was partially offset by a small sequential increase in our ADC product line and a 3% sequential increase in global services revenue.

Reported revenue within our global services business unit tends to increase with the growth of our installed base. Within storage, we saw strength in directors. Our server product group consisting HBAs, CNAs, embedded switches, and mezzanine cards generated over $31.5 million in the quarter, up from $30.5 million in Q2. As Mike touched on earlier and as the chart on slide 20 illustrates, Brocade has assembled a balanced mix of larger and smaller OEM partners and a significant direct and channel sales capability. We continue to make progress towards selling our full product line through all of our channels.

Turning to geography, the US represented 64% of reported revenues, down from 69% in Q2 ’09 and 65% in Q3 ’08. However, on an estimated end user basis, adjusting for those OEMs who take deliver for internationally bound products within the US, the US strengthened to 52% of total revenues, up from 51% in Q2 ’09. The increase reflects Foundry’s relatively larger US presence and the relative strength of our US market.

In the quarter, AMEA was weaker thane expected, reflecting a tougher IT spending environment than we saw in the US. We believe that average European deal sizes were smaller and some deals were deferred, but have not necessarily been lost. Gross margin on a non-GAAP basis increased to 58.2%, up sequentially from 56.2% in Q2 and consistent with our long-term target model.

Again this improvement was driven by the realization of cost synergies as well as lower purchase price accounting adjustments. In addition, service margins improved to 52.2%, up from 50.5% in Q2, as we scaled that business against a base of relatively fixed costs. From a pricing perspective, we saw a slight increase in pricing pressure in our ASEAN business, with sequential ASP decline in the mid single digits. We did not experience any significant ASP declines in either our IP or ADC segments.

Non-GAAP operating margins improved sequentially as lower cost of revenue more than offset operating expenses which increased as a result of our investments in sales and R&D resources. Non-GAAP operating margins improved sequentially as lower cost of revenues more than offset operating expenses which increased as a result of our additional investments in sales and R&D resources.

As a result in Q3 ’09, non-GAAP operating margins were 20.3%, a 150 basis point increase versus the prior quarter’s non-GAAP operating margin of 18.8%. Mindful of the current economic environment, we continue to work to control operating expenses which were 37.8% of revenue versus 37.4% in Q2 on a non-GAAP basis. Operating expenses were slightly better than our long-term target model of 38-40% of revenues.

Our Q3 non-GAAP tax rate was 29.2%, down from 32.1% in Q2. These factors combined with improved gross margins contributed to a 190 basis point improvement in non-GAAP net margins. Q3 non-GAAP net income was $55.4 million, up 18% sequentially, and equates non-GAAP diluted EPS of $0.12.

Turning to our balance sheet, at the end of the quarter as of August 1, 2009, cash and equivalents were $250 million, up $13 million from the prior quarter. Total gross term debt before the debt discount of $38 million was $992 million, reflecting payments in the quarter of $33 million which was $20 million in excess of required payments.

Q3 adjusted EBITDA was again a healthy $120 million, consistent with Q2. Trailing 4-quarter consolidated adjusted EBITDA was $519 million which yields a senior secured leverage ration of 1.94, well below the 2.3 financial covenant.

Q3 capex was $44.8 million with $24.8 million for the new San Jose campus and $20 million for operations. As of the end of Q3, total cumulative campus capex was $155 million representing approximately 50% of the total planned campus capital spend. In addition, Brocade’s legal expense or indemnification obligations was an approximately $0.5 million benefit after netting expenses and the receipt of settlements related to those indemnification obligations.

Days sales outstanding were 56 days, up from the 49 days in Q2 and reflecting a less linear quarter than we typically have, reflecting the tougher economic climate. The net impact of this increase in accounts receivable was approximately $52 million and led to a lower than typical cash from operations of $16.6 million in what is normally a seasonally weaker cash flow quarter.

We would expect DSO and cash from operations to improve in Q4, which is typically a seasonally strong cash flow quarter for us. Inventories turned 17 times, up from 15 times in Q2, reflecting continued supply chain improvements. During the quarter, GAAP weighted shares outstanding averaged 407 million shares, and we exited the quarter with approximately 418 million shares outstanding.

Turning to post merger gross and operating margins, we found it useful to compare the trend lines we’re seeing from the Foundry acquisition to those of our McData acquisition. As you can see, the trajectory of our gross and operating margins is following similar trends to those achieved following the McData integration.

Turning to our prior commitments, we have currently realized approximately $20 million in annualized savings in cost of goods sold. We expect to realize a total of between $35 and $40 million in annualized savings in cost of goods sold by the end of Q1 2010, or approximately 17% more and nearly one full quarter earlier than our original commitment. From an operating expense perspective, we have realized approximately $12 million in synergies as of the end of Q3, nearly two full quarters earlier than our original commitment.

As to potential revenue synergies, we shared with you on our last earnings call, we are pleased with the continued progress we have made in this area, and we believe we remain on plan. In Q3, our margins returned to or target model, just two full quarters after the close of the Foundry acquisition. We’re on plan to achieve our revenue synergies, and we’re delivering cost synergies ahead of plan. The company continues to drive strong cash flow and is repaying debt ahead of schedule.

Lastly, we are executing well despite current economic conditions, and we’re committed to our long-term financial model. Now as we look to the remainder of the year, here are some things to consider in developing your financial models. Our planning assumption is that current IT spending environment will remain the same through the balance of calendar 2009 due to the uncertain macroeconomic environment. We expect IT spending in general and the storage and IP market specifically to improve during 2010 and to return to normal historical growth rates by the second half of 2010. While not factored into our current fiscal 2009 forecast, continued improvement in the macroeconomic environment in AMEA and additional strength in the US federal season could drive additional upside.

WE expect to see a more subdued seasonal pattern in our Q4 ’09 revenues than the typical Q4 seasonally which is normal up 6 to 8% sequentially. While our core markets remain competitive, we believe that product advantages and momentum, our strong OEM partnerships, and our installed based advantage keeps us in a strong competitive position. We believe we will maintain market share in our core SAN market. We believe directors and embedded switches will grow faster than fixed port switches in the overall SAN market, and we expect to be a leading supplier of HBAs and CNAs.

Within the IP Ethernet market, we expect to begin to see the benefits from our IBM OEM partnership in Q4 ’09 with an increase in traction in fiscal 2010. From a pricing perspective, while we have seen some additional pricing pressures resulting from the macroeconomic environment, we expect quarterly ASP declines to remain in the low to mid single digits through the end of our fiscal 2009.

Given these considerations, our outlook for fiscal 2009 is as follows. Consistent with the fiscal 2009 outlook we provided in February, we expect revenues to be in the range from $1.9 to $2.0 billion. We will be providing a mid quarter update at our analysts’ days in Boston on September 22, 2009, to provide additional details. We expect non-GAAP gross margins, operating expenses, and operating margins in model. We expect our annual non-GAAP tax rate to be approximately 30.5%. We expect our annual diluted shares outstanding to be in a range of 450 to 460 million shares. We expect non-GAAP EPS to be in a range from $0.48 to $0.52 which is up from $0.40 to $0.50 range given on the February call. We expect cash flows to be in a range of $120 to $150 million in fiscal Q4 which is typically a seasonally strong cash flow quarter.

Before I turn the call back to Mike, I’d again like to invite all of you to join us for the Brocade analysts’ day in Boston on September 22, 2009. In addition to the mid quarter update and details for Q4, we plan to provide the underlying assumptions around our fiscal 2010 financial forecast. Please visit our investor web site for additional information regarding these events and contact our investor relations department if you would like to attend.

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

Michael Klayko

Before we open the call to questions, I’d like to reiterate why I’m so excited about the opportunities ahead. With unprecedented data growth and rising network performance requirements, we foresee a demand for the wholesale re-architecture and buildout of the world’s networks on the storage and IP Ethernet sides. Brocade has the right strategy, products, and partners to execute in our core markets and we’re growing and profitable in whish is a historically challenging environment.

With our success and the rapid integration of the foundry business, our expansion of routes to market for all our business segments and continued delivery of industry leading product and technology innovation, we believe brocade is extremely well positioned to continue its market leadership in storage and gain market share in the Ethernet space. While other companies have chosen to hunker down in this economy, our long-term model and shareholder value call for growth, and that is exactly what we’re doing.

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). The first question comes from the line of Mark Moskowitz with J.P. Morgan.

Mark Moskowitz – J.P. Morgan

With respect to the guidance, Richard, could you give us a little more context around the wide range on revenues, how much of that is related to potential IBM ramp on the ethernet side versus concerns around AMEA or other factors?

Richard Deranleau

When we looked at our Q4, we had expected typical seasonality. Typical seasonality would have been flat to down 2%. We ended up with our actuals down more than that about 2.5%. When we look forward to the guidance, I think if you look at where we are and the guidance that we gave and what it means relative to other players in the market and what other players saying around the town, then I think that’s going to get you a good understanding of what we are trying to look at. It is a tougher environment out there. It’s hard to have visibility, I think everybody has agreed in our ecosystem that visibility out there is still tough in this condition, so we thought the right play for us is really to go back and compare our guidance this quarter on an annualized basis to what we gave you back on the Q1 earnings call.

Mark Moskowitz – J.P. Morgan

Can you put some context around the linearity you talked about with respect to your DSOs and your cash flow? How did that play out in the third quarter and had you seen any sort of improvements or degradation on that linearity in the first part of this current quarter?

Richard Deranleau

Sure. As you know, based on our business model, one of the things that’s very good about our business model is we typically are very linear which helps us generate strong cash flows. This quarter, really driven by the macroeconomic condition, customers were holding onto their cash longer which extended the sales cycle, so that’s really the aspect of it. Some of that had to do on the IP side. We’re expecting to be able to get back to more typical linearity for us, and so actually not too worried about it, but it was a factor in Q3.

Mark Moskowitz – J.P. Morgan

Mike, could you talk a little bit about the government vertical as it relates to the ethernet or the IP business? That was always historically one of Foundry’s wheelhouse. Have you seen any increasing traction there just because of the Brocade stamp and your OEM model, where you’re actually even getting a greater thrust if you will in terms sales velocity, and could that continue going forward?

Mike Klayko

The government spends a couple of times a year in bulk, and we’re hoping that bulk comes up in September, which is a typical buying season. Good pipeline, nothing alarming in that space. We actually have a very good federal team because in the IP space, our Foundry team is very good in the military and the intelligence agencies. From the classic Brocade, we had some strong strength in intelligence and civilian, you put it altogether, now that we put the sales team together also, we’re able to leverage both organizations, so I’ve got good promise and hope, but again, it’s unpredictable what’s going on in the U.S. government, but if it’s typically seasonal on how they will spend money, September should be pretty good.

Operator

The next question comes from the line of Paul Mansky with Canaccord Adams.

Paul Mansky – Canaccord Adams

I wanted to shift gears just a touch to the service provider side. Obviously historically, that had been a major source of growth for you and for Foundry certainly in the trailing 12 months prior to the acquisition. It looks like it was relative at least in my model the primary source of the product weakness in the quarter, down fairly materially on a sequentially basis. I know that’s a choppy business, but we have seen others showing a bit of a rebound on the service provider side. Can you just remind us your strategy to maintain that foundry momentum on the service provider side, how we’re thinking about order flows from that customer sets over the next few quarters?

Mike Klayko

We are focused on enterprise-based campus environments in the service provider space, and frankly that service provider market is very large. You’ve got backlog carriers, you have tier one providers, and you have literally thousands of others providing services in that market space. I think right now, we added 90 plus, in what I’ll call it the smaller tier environment where our products did very nicely. We focused on very specifics around internet exchanges, around some of the rural areas that I think are going to see an uptake in the market, but you’re right, they are kind of choppy, but when they buy, they buy in larger quantities, and they may go dark for a little bit, so we’re pretty much on plan I think we thought we would be in this market place. In fact, in some areas in some of the outside U.S. areas, we’re kind of ahead of plan. From a product perspective, Dave, you might want to comment what we’re doing in that space.

Dave Stevens

I think as Mike said, we focus in three primary areas—datacenter infrastructure, the campus, and service provider market. I don’t think we’ve taken our foot off the gas at all in the development side. On the service provider market, we’re happy with the products that are there. We continue to make good progress. As Mike said, we focus on particular areas within the service provider sphere. As you pointed out, it is a lumpy business, but we don’t feel like we have become any less competitive there, and we’re continuing to make great traction with people. One area where we are working, as you know the last quarter, we introduced a new application delivery controller product, and we’re making great progress with that in some early trials with that product as well, so we haven’t seen really any slowdown in the spending or interest level that we would expect to see there.

Paul Mansky – Canaccord Adams

If I can shift gears again over to the HBA side, I know you’re probably collectively tired of answering the question, but can we revisit our commitment relative to that 10% market share of the HBA, how do we feel like we are tracking relative to that? Do you think this is a fiber channel opportunity or shifting more towards a CNA opportunity?

Mike Klayko

What’s happening is, it’s kind of blurred the lines where we originally started off a while back just looking at fiber channel HBAs. It’s really broader than that because now you have to look at the embedded opportunities, the mezzanine opportunities, the CNA opportunities, and that’s how we are going to start reporting it. I think we’re up $1 million quarter on quarter in that market space, and so we’re seeing some large interest in the CNA space, only because we have an end to end solution all the way from top of rack to all the way to the edge, and so one of the things we plan on doing Paul at our analyst day is revisiting the metric and giving you a target what we think now based on a new way of looking at that market space. It’s a fair way to look at it now.

Paul Mansky – Canaccord Adams

Did you happen to say what the purchase accounting adjustment on the foundry service revenue was in the quarter?

Richard Deranleau

I don’t believe I said it. It’s in the slides in the backup, Paul. It’s $4.9 million in Q3.

Operator

The next question comes from the line of Brent Bracelin with Pacific Crest.

Brent Bracelin – Pacific Crest

Richard, you thought Q3 here would be typical seasonality flat to down 2%. You’re actually down a little bit more than that. What proved to be more challenging than you thought in the quarter? Clearly the IP products are down 6% looked like certainly weaker than we would have thought, international down 10% sequentially, weaker than we thought. What would you attribute to having a little bit more seasonal decline here than you thought going into this quarter?

Richard Deranleau

The biggest and what took us by surprise was we have gotten used to Europe really producing very strong. We have a big exposure internationally as you know, and if you go back over the last multiple quarters, AMEA has been a big driver of our growth, and we were expecting that in Q3. I think if you look at what’s going on in the ecosystem, you’ll see that a lot of people have mentioned that they have struggled in the AMEA region. The IP spending there was really off the charts, and that was the biggest driver. On the IP side, feeling really good. We have only had Foundry now for two full quarters. We’re getting an opportunity to go in and place bids. There’s a lot of quoting activity. I’m actually very encouraged and actually excited about the IP space. It’s the summer, it’s a little lumpy, but all things considered, the IP side is feeling pretty good about it. Europe, we’re hoping that Europe can get some economic recovery which would drive IP spend going forward. Is it going to happen in Q4? Don’t know, but that’s really the surprise in Q3.

Mike Klayko

We actually put the sales forces together. I think we mentioned that last quarter. If we didn’t, I’ll mention it. Beginning of the quarter, we integrated all the sales forces together, and that piece of work is behind us, but one of the other things we asked them to do is really go establish new footprints, and that’s why we’re very excited about the number of new accounts. We have added over 440 new accounts since the acquisition, and I will tell you those accounts are, I call them the classic sell-one-buy-many, and so we wanted a crack, we wanted a chance, and so it takes some energy to go ahead and have these accounts, let us in with people who have never bought Foundry product before, and so now we are in those accounts, and so that gives us a chance. Again, we’re anticipating that that will continue to buy from us going forward, so again not huge transactions, but we have a lot of footprint out there that we never had before.

Brent Bracelin – Pacific Crest

One quick followup on the IP side, as you think about your guidance and what you’re factoring into your guidance, you assume that the IP business could be up more than the typical 6 to 8% seasonality given federal or are you making the assumption that you’re going to continue to have muted demand on the IP side?

Richard Deranleau

I think what we said in the prepared remarks is and Mike alluded to federal, we would expect federal to be typically seasonally strong. If it is stronger than normal for Foundry, then that’s potentially upside. Other than that, we would stick with the guidance framework that we gave.

Operator

The next question comes from the line of Kaushik Roy with Wedbush Morgan.

Kaushik Roy – Wedbush Morgan

Going back to the revenue line, I understand the demand wasn’t that great, but can you comment if you saw a little bit more competition from Cisco because seems like pricing was slightly worse on the SAN side?

Richard Deranleau

If you segregate things, on the SAN side, in terms of competition, no, it wasn’t driven by any of our competitors. We did note that the pricing was a little higher than normal, but we attribute that to where the economy is. From a competitive position, we feel very confident in our ability to compete on the SAN space. When you look at the IP space, we’re a market attacker, we are driving to build market share, and yet, you didn’t see any significant price reflect itself in our financials, so a little bit counterintuitive.

Kaushik Roy – Wedbush Morgan

I understand you’re reiterating the full-year guidance for revenues, but the street estimate for October is $546 million which is up 11% sequentially, and considering the current environment, that seems like a little too high. Would you agree?

Richard Deranleau

Going back again, we come along in the earnings season a little bit later than most, and I think if you look at the guidance that we gave and you put that in the context what other major players are saying, I think you’ll see that we’re kind of right in with everybody else.

Operator

The next question comes from the line of Mark Sue with RBC Capital Markets.

Mark Sue – RBC Capital Markets

Richard, the low end of your guidance implies a sequential decline of minus 5%. Is that even a possible scenario? Are you suggesting that is mostly going to be flat to up in October, but it’s backend loaded which is why you are declining to give specific guidance at this time, and then Mike a question for you, why do you think IBM is moving on their own timeline if the intent is there and the pipeline is improving? Are there certain problems such as limited customer pull?

Richard Deranleau

The approach that we are taking, and I announced last analyst day really going to annual guidance, so if you look at us effectively reiterating the guidance that we gave back in February and that would explain the wide range, and I guess I’d leave it at that. I think we’ve explained to you what some of the issues were relative to Q3. We’ve explained that we’re trying to be with what the rest of the ecosystem is doing, and I think that’s a reasonable approach for us to take at this point.

Mark Sue – RBC Capital Markets

Does that mean, Richard, that from now, we should not expect quarterly guidance?

Richard Deranleau

Really, all of this year, we’ve gone to annual guidance, and we always are looking at what other people are doing, but that’s the path we’ve set ourselves down to try to give you the full because we don’t want to people so hyperfocused on each particular quarter and lose the sight of the tremendous strides the company has and will be making year over year.

Mike Klayko

Mark, to answer your question about IBM, I’m very pleased. I look at this way. Last quarter, I think we said we don’t think anything will be material in Q3. It’ll start ramping in Q4 and then I’ll say really ramping in 2010, and that’s kind of the path we’re on. A company with 300,000 to 400,000, I don’t know how many people they have, and as many places as they are, it takes a while. It’s like getting the train going down the tracks and so forth, but what we’re really good at is managing the OEM process, managing how we go ahead and create programs and deliverables that create revenue. And again, we’re starting from a dead stop in this space as IBM was I should say, and we’re right on the mile markers we said we’re going to go ahead and be on. We didn’t have a whole lot of revenue plan this quarter, Mark.

Mark Sue – RBC Capital Markets

But then, why did you last quarter say that you would exceed the $1.9 to $2.0?

Richard Deranleau

On that one, Mark, we frankly were expecting a lot better performance in AMEA, outside of IBM. So the driver in terms of our guidance now being less than not being able to exceed the February versus now being reiterating it is really a function of the economy in AMEA. It’s really not a reflection of the performance on IBM.

Mark Sue – RBC Capital Markets

OEM inventory—anything that we should read into that? Are we still at very lean levels?

Richard Deranleau

We really are. We’re still below two weeks of inventory. As you recall for the last several years, it was 2-1/2 weeks. The OEM shut it down to 1-1/2 weeks back in Q1. Over the last couple of quarters, there has been a small increase. I really can’t control what the OEMs do on the inventory side. Will it go back up to the 2-1/2 weeks? I don’t know. Am I happy with the fact that I’m under two weeks? Yes.

Operator

The next question comes from the line of Aaron Rakers– Stifel Nicolaus.

Aaron Rakers– Stifel Nicolaus

I think last quarter you had talked about incremental flow through revenue into Brocade accounts for foundry, and I think the metric you threw out there was $12.6 million. I understand that you gave the number of customer opportunities that you’ve won, but as a basis of tracking that trend going forward, can you share that with us again?

Mike Klayko

We’re going to do that. We’re going go pretty much detail it, but we’re not going to do it till analysts’ day.

Aaron Rakers– Stifel Nicolaus

I’m trying to understand the message with regard to the October quarter. If I look at the guidance range you’ve given for the full year, it’s going to imply anywhere from down 5% sequentially to up 15% sequentially, and your typical seasonal sequential growth rate is 6-8%. Are you trying to send a message that you expect a seasonal…it just seems like a wide range, any help on that would be appreciated.

Richard Deranleau

If you look at the EPS guidance in conjunction with the revenue guidance and you do your typical modeling, I think that’s going to get you where you need to be, and then what I also said in my prepared remarks. The guidance in February was $0.40 to $0.50, we got it now between $0.48 and $0.52, so that’s going to help you triangulate, and I think what I said in the prepared remarks was that typical seasonality would be up 6-8%. I believe I said we expected to see a more muted seasonal pattern.

Aaron Rakers – Stifel Nicolaus

You gave some interesting charts around overlaying the McData gross margin trend relative to the Foundry integration trend that we have seen on gross margin right now. In that, we saw an acceleration into a 60 plus percent gross margin level really in this next quarter or so, is that the message you’re trying to send that we see that type of appreciation in this gross margin trend here over the next quarter or so?

Richard Deranleau

Yes. One of the things we are very happy with this quarter is the performance on cost of goods sold. It’s just a little over two quarters and back into our model, and again I think what the message we’re sending is we’ve done this before, we have a world class supply chain, we know how to wring out cost, and a picture is worth a thousand words, right? We were explaining it would be a similar type of a situation, but I think those graphics bring it into focus.

Aaron Rakers – Stifel Nicolaus

There have been a lot of investor questions I have gotten about the debt structure of the company, the 7% senior secured facility. Any thought Richard on your thinking about easing that expense, i.e., any possible converter, any type of changes to the capital structure?

Richard Deranleau

The good news is I don’t feel I have to do anything. I’ve got very good cash flows. I’ve got a strong quarter coming up ahead of me. I’ve got working capital that’s probably going to go my way, so the good news is I don’t have to do anything, but on the other hand, I’ve said even back when I did my YouTube, I said we would be always opportunistic, and I would say that’s where we are right now. We don’t have to do anything. Would we be opportunistic if the numbers makes sense? Yes, we would.

Operator

The next question comes from the line of Katy Huberty with Morgan Stanley.

Katy Huberty – Morgan Stanley

As a follow-on to that last question, is it fair to assume that you expect free cash flow to head back into positive territory over the next few quarters?

Richard Deranleau

Certainly in Q4, absolutely. Yes, I believe so.

Katy Huberty – Morgan Stanley

Can you guys give any view that you may have gotten from the customer base around the expected adoption rate of the new servers over the next couple of quarters? Will that be a significant driver or is it something that you have to wait until 2010 as it relates to the HBA/CNA business?

Dave Stevens

Certainly the adoption of the server is something that’s ongoing in the customer base. We’ll see a shift over to 10 gig as the adoption happens, but candidly we’re are not seeing widespread take-up on it right now. It’s gradual. It’s on a project by project basis. I think we like everybody else are sitting and waiting for an ongoing refresh cycle on the server business.

Operator

The next question comes from the line of Min Park with Goldman Sachs.

Min Park – Goldman Sachs

Richard, just with respect to your deferred revenues in the quarter, can you just help us understand why they declined on a sequential basis?

Richard Deranleau

Some of our biggest OEMs have gone to a quarterly billing of our service revenue outside. In the past, we had annualized billings, so what happens is instead of having twelve months worth of deferred, effectively you have three months. It doesn’t affect our P&L because we’re still selling the same amount of money, but that’s the answer.

Min Park – Goldman Sachs

Just going back to the question on the capital structure, can you give us an update on your plans for the McData convert, whether you expect to pay it down or refinance it, and to what extent would a paydown actually benefit your EPS in calendar 2010 due to a lower share account?

Richard Deranleau

Expanding on what we said just a question ago, but the plan of record is we’d pay it off with cash. As you can see, we have been building cash up over the last couple of quarters. We’ll continue to build cash as well as continue to make some payments down on the term debt, so the plan of record is to pay off the McData covert. If we pay it off currently, the diluted impact on a non-GAAP basis or if we’re generating profitability on a GAAP basis, it’s roughly 12.1 million shares, so that would come out of the diluted shares outstanding or diluted share calculation.

Operator

The next question comes from the line of Jeff Evanson with Sanford Bernstein.

Jeff Evanson – Sanford Bernstein

I was wondering if you could give us any insight into how your deal closing times have been changing over the last couple of quarters, and also any metrics that you look at in thinking about your future sales, like book to bill, etc.?

Mike Klayko

From a closing perspective, it’s been relative benign quarter to quarter. The book to bill ratio I don’t think has changed much. We’re trying to look the number up right now.

Richard Deranleau

The book to bill to us really is not a meaningful measure. The contract manufacturing model that we have is very efficient, and we basically take delivery and ship nearly immediately or put into hubs, so backlog to us has never been material and is likely to be never material because of that model.

Peter Ausnit

Operator, we have time for one more question.

Operator

Your last question comes from the line of Nikos Theodosopoulos – UBS.

Nikos Theodosopoulos - UBS

You mentioned the pricing was a little bit more severe this quarter in the SAN market and you’re expecting it to improve next quarter. Can you give your rationale and why you expect it to improve?

Richard Deranleau

Basically, we’ve ran specific programs in Q3 relative to our SAN business, and we’re not expecting to have to renew those programs in Q4.

Peter Ausnit

This concludes our call. Thank you for your interest in Brocade.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Brocade Communications Systems, Inc., F3Q09 (Qtr End 08/01/09) Earnings Call Transcript
This Transcript
All Transcripts