Brocade Communications Systems Inc. F4Q09 (Qtr End 31/10/09) Earnings Call Transcript

Brocade Communications Systems Inc. (BRCD)

F4Q09 Earnings Call

November 24, 2009; 08:00 am ET

Executives

Michael Klayko - Chief Executive Officer

Richard Deranleau - Vice President of Finance & Chief Financial Officer

Dave Stevens - Chief Technical Officer

Peter Ausnit - Senior Director of Investor Relations

Analysts

Brian Marshall - Broadpoint AmTech Research

Nikos Theodosopoulos - UBS

Mark Sue - RBC

Paul Silverstein - Credit Suisse

Kaushik Roy - Webush

Munjal Shah - Jefferies

Kathryn Huberty - Morgan Stanley

Jason Ader - William Blair

John Slack - Citi

Aaron Rakers - Stifel Nicolaus

Katy Huberty - Morgan Stanley

Glenn Hanus - Needham

Jason Ader - William Blair

Munjal Shah - Jefferies

Paul Silverstein - Credit Suisse

Ittai Kidron - Oppenheimer & Co

Keith Bachman - Bank of Montreal

Min Park - Goldman Sachs Research

Mark Moskowitz - JP Morgan

Bill Fearnley - FTN Equity Capital Markets

Presentation

Operator

Good day ladies and gentlemen, and welcome to the fourth quarter 2009 Brocade Communications Systems Incorporated earnings conference call. My name is Ann, and I will be your coordinator for today’s call. (Operator Instructions)

At this time, all participants are in listen-only mode. We will be facilitating a question and answer session following a presentation. (Operator Instructions)

I would now like to turn the presentation over to Mr. Peter Ausnit, Senior Director of Investor Relations. Please proceed sir.

Peter Ausnit

Thank you Ann and good morning. And welcome to Brocade’s Q4 earnings question and answer conference call. By now you should have seen our press release and prepared comments which are available on www.brcd.com.

The press release is also distributed by Fist Call and Business Wire. Before we take questions, investors should note our comments, they may include forward-looking statements including without limitation, statements about Brocade’s financial results, plans and business outlook.

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 on Brocade’s Form 10-K for the fiscal year ended October 25, 2008, and the 10-Q for the quarter ended October 1, 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.

In addition, we may discuss various third-party estimates regarding total available market and other measurements which do not necessarily reflect the view of the company. Further, Brocade does not guarantee the accuracy or the liability of any such information or forecast.

We may discuss certain financial information on non-GAAP basis. The most directly comparable GAAP information and a reconciliation between the non-GAAP and GAAP figures are provided in the accompanying press release, which we issued yesterday and I referenced earlier, which has been furnished to the SEC on Form 8-K and is on our website.

Okay, we have been accepting questions via email and have assembled a queue; we have organized them logically; the flow will be, we will talk first about, M&A rumors, recent M&A activity in the market, our partners channels and cross-selling, and then we will - that will be the first 30 minutes. Then we will have 30 minutes of traditional Q&A.

So, with that I will start and hand it over to Mike.

Michael Klayko

Thanks Peter. I appreciate that. Welcome to our Q&A call. With me this morning are Richard Deranleau, our CFO; Marc Randall, our Senior Vice President of Products and Offerings; Dave Stevens, our CTO; and Ian Whiting, who is our Senior Vice President of Sales and Marketing. I hope you are going to find this format more informative and efficient.

We sent the prepared comments out in our outlook and what we believe is a more accessible format. We expect to cover more questions in the time we have available and as time permits, as Peter mentioned, we are going to answer as many questions as possible that we don’t handle and some of the questions that have come in via email already.

So, with that, I would like to go ahead and get started immediately. Peter, what do we got?

Question-And-Answer Session

Peter Ausnit

Thanks Mike. The first question is from Brian Marshall of Broadpoint AmTech, who asked for comments on the M&A rumors?

Michael Klayko

Yes, well actually as mentioned in the past, we don’t like to comment on rumors in fact, we have never commented on rumors, and we don’t, and we will continue that going forward that practice of not, we are very, very focused on what we are doing as a company, and the long term vision; but I really do want to address some misinformation that was out in the marketplace right now.

Now that a lot of these rumors have died and that has to do that we were shopping ourself; and the fact of the matter is, that is just false. We have not, we never did, we got a very bright future. The fact that we spent the last five years planning and putting all the different pieces in place to execute on a very, very large infrastructure build out opportunity going forward. It just doesn’t making a lot of sense and so, I want to put that one to bed right upfront.

Peter Ausnit

Okay, following up, Nikos Theodosopoulos from UBS and Mark Sue of RBC asked, if the rumors impacted our business?

Michael Klayko

Actually no, apart from the fact we got a lot of publicity out of this whole thing.

Peter Ausnit

Okay, Mark Sue followed up with a question about partnering and saying, networking is influx. Who, who will Brocade be friend and what does that mean today? And what is Brocade’s future a midsize company among giants?

Michael Klayko

Well actually, I think we got a great future; going forward, when you look at the fact that customers are demanding choice and more open systems and it’s the largest. I mean, by a long percentage part of the market of customers who like to build the most efficient solutions available. Those customers are looking for value and choice and I think we stand to be in business for a very long time because we do satisfy a very broad ecosystem of not only partners and customers but it’s going to continue for a long period.

Peter Ausnit

Okay, turning to a recent M&A. A lot of people had questions about HP3Com; in fact, Mark Sue of RBC; Paul Silverstein of Credit Suisse; Kaushik Roy of Webush; Munjal Shah of Jefferies; and Katy Huberty of Morgan Stanley have asked how does the HP3Com merger impact Brocade?

Marc Randall

Okay, this is Marc Randall speaking. So, we had a long partnership with HP in the storage area, OEM, there have been OEM in our directors and switches and we built embedded blades for them and Host BUS Adapter cards. And we believe that that’s going to continue as a strong partnership going forward.

On the IT side, we’ve been competing against HP in the ProCurve line ever since the two companies came together and Foundry competed against them as a standalone company. And we are looking at their portfolio but we do some areas that we believe that they are still going to continue to be weaken in the major areas in datacenter applications. One of the areas that we’ve had a large initiative is our convergence, and that’s the convergence of IP data storage together.

That’s the technology that’s missing from their portfolio; and currently we don’t see any presence in the datacenter space with their product lines. So, we believe that we’ve got a real strong product from a density and performance point of view. So we feel that we’re in relatively good shape.

Peter Ausnit

Okay terrific. There are other questions around that acquisition as well, such as how does HP3Com chains Brocade Ethernet sales strategy and execution? Does it impact your fiscal year 2010 revenue expectations or your blade switch opportunity?

Ian Whiting

Well, this is Ian Whiting. Let me take that one. So, first of, it doesn’t change our strategy at all, I mean, we are still competing primarily with Cisco in the datacenter. We didn’t have any revenue associated with HP in our plan for 2010. So, there has really no impact to the revenue or to our current outlook.

There is a different ecosystem in the Ethernet world. There are different partners outside of the traditional server storage vendors as well that we are intent to work with to expand our opportunity and expand our coverage. So, as far as HP is concerned, they continue to be a strong and important partner for us in the storage space; both in the blade switch and in the broader storage marketplace and we expect that to continue.

Peter Ausnit

Terrific. Nikos Theodosopoulos of UBS asks for question, excuse me, asked for answers relating to HP’s claims of 3Com’s Ethernet product Testbest?

Dave Stevens

I can take that. Good morning, this is Dave Stevens. So, I don’t think it’s any surprise that’s what they would say when you are sponsoring the test. I think we’ve taken a pretty close look at the product lines and we’re very, very comfortable that the products that we have in the marketplace today have very good advantages in terms of power and density and cooling.

And the other thing I would say is that, the products that we have in the marketplace today have been there for quite some time and they’ve been tested in some of the toughest environments of the world for the better part of a decade, and that’s a lot things that tend to not show up on tests when you hook the systems up to aspiring testers and just test raw through put.

I think if you sort of compared the two product lines, the product lines that they are just getting ready to ship were roughly 2x density in performance with our last generation products relative to the products that they are just getting ready to ship. So, I think we are in good shape; I think we’ll maintain that lead going forward. We are very comfortable competing against that product line.

Peter Ausnit

Okay thanks. Nikos followed up with a question, why didn’t HP buy Brocade?

Michael Klayko

This is Mike. Again, that’s just a rumor and that’s one of the things we don’t comment on. So there are no comments on rumors again.

Peter Ausnit

Okay, Jason Ader of William Blair asked, if we expect to sign HP as an OEM partner for FCoE switches?

Dave Stevens

This is Dave again. I can take that. The answer there is that there are already customer for FCoE switches. They are already OEM, our Brocade 8000 top-of-rack switch that runs FCoE. The OEM, the blade, the FCoE Blade for the DCX Director; the OEM, the HBAs and CNAs to-date. So, you know, we’ve already got those products in our HP portfolio and 3Com doesn’t bring us the OE technology to that. So, my expectation would be that we would continue to have that relationship going forward.

Peter Ausnit

Okay, turning partner channels and cross selling. John Slack of Citi asked about other Ethernet OEM deals since HP appears off the table?

Ian Whiting

Yes, this is Ian. Let me take that one. So, I think as I’ve mentioned earlier the Ethernet market really opens up a lot of additional partners outside of the traditional storage and server OEM ecosystem, and it’s reasonable to assume that Brocade is working with a number of those companies and we would anticipate announcements and more activity with some of those non-traditional servers storage OEMs in the future.

It’s fundamentally a different marketplace and we intend to expand our reach to expand our coverage through a whole range of new partnerships as we go forward and as we outlined in our Analyst Day back in September.

Peter Ausnit

Okay. John Slack of Citi, Mark Sue of RBC, Nikos Theodosopoulos of UBS, and Jason Ader of William Blair asked for update and others as well since results but these were the early questions, asked for updates on IBM and Dell during the quarter, specifically related to Ethernet product sales through each of these channels; and with a follow up, was there an impact on Ethernet product margins?

Ian Whiting

Let me take the first part of that. This is Ian again. So, as far as Dell and IBM are concerned, we are on track with our plan. As we outlined back in September, in Analyst Day, there is a tried and tested process for successfully bringing products to market through an OEM channel and this is an area that Brocade excels at. And we outlined the timeline, when we expect to see a ramp in revenue which is 2010 and we are certainly on track to meet those expectations and we are comfortable with the progress that we have made to-date, specifically with regards to IBM and Dell.

Richard Deranleau

This is Richard Deranleau. Good morning everybody. In terms of the impact and margins, our gross margins, as you can see, have increased as we bring additional costing agents online from the supply chain management and reduce our cost structure of our products. So, what you are seeing is the same gross margins grow up in Ethernet space.

Peter Ausnit

Okay, following up again, Nikos of UBS say that his context say the IBM feel as happy selling Cisco and ask why sales at IBM are not materializing for Brocade and Aaron Rakers asked for a, asked Brocade to update comments made in Q3 regarding the pipeline at IBM.

Ian Whiting

Yes, this is Ian. So, I will just really repeat some of my earlier comments. We are on track with IBM. We are very comfortable with the progress that we are making. You would have to ask IBM about how comfortable they are with Cisco these days given the competitive dynamics.

But overall, you know the pipeline is growing with IBM daily, both in the product and in the services group. So overall, our investments are beginning to bear fruit and we are very confident that the plan we have in 2010 is on track and will begin to ramp in accordance with the timeline we outlined back in September.

Peter Ausnit

Okay, Aaron Rakers of Stifel Nicolaus and Mark Sue of RBC asked about the Dell Ethernet OEM relationship, revenue timing, the impact of Juniper at Dell and how Dell and Brocade work together, excuse me, how Dell, how Brocade is working with Dell as Dell integrated pro systems.

Ian Whiting

Well, I’ll begin to answer that one perhaps. This is Ian again. So, Brocade is certainly a central part of Dell’s efficient enterprise plans. Dell is working with Brocade to provide integrated solutions for their customers around the virtual data center and cloud computing. And we are extremely aligned with them on the issues surrounding open systems and providing choice to our customers. So, we are right in the middle of Dell’s strategy for efficient enterprise and very confident that we will be able to support that initiative.

Peter Ausnit

Okay, Mark Sue of RBC asked how will we work with Oracle as they integrate Sun?

Ian Whiting

So, we’ve had a long and very fruitful partnership with Sun for many years and we certainly expect that to continue after the acquisition closes with Oracle subject to all of the regulatory approvals, etc. We’ve also had a very strong alliance with Oracle themselves and a lot of activity in their joint test and development.

In particular, we are fully baked into one of Oracle’s key solutions around data warehousing on the IP networking so the house, something which we announced in the form of a press release recently. So, whether it’s Oracle or Sun, there is an existing very tight partnership and alliance and we fully intend to continue to partner with Oracle after the acquisition.

Peter Ausnit

Okay. Brian Marshall of Broadpoint Amtech asked storage area networking switching is an OEM business for Brocade, how does Brocade envision the importance of OEM Partners to Ethernet switching over time ago. Can OEM revenue be 50% plus of Ethernet revenues in three to five years?

Ian Whiting

Well, I would like to, same again, I would like to refer back to some of the comments that we went through an analyst day again when we went into some detail about how we plan our routes to market and storage.

One of the key differentiators for Brocade and one of the reasons why we have maintained the position we have and why we are growing in the Ethernet space is because we have this unique blend of paths to market, OEM, distributor, VA, global systems integrator, and direct sales. And each one of those is growing in, at different rates.

One of the keys to our success is, it’s been our ability to leverage those different markets and to balance them based on the product segments and the market segments that we are pursuing. Compared to our competitors in this space, we have considerably more paths to market than they do. And we’re very comfortable with that strategy because we are less dependent on one specific path being successful. So, it’s balance and it’s the blend of those different paths to market that I think is a unique asset to Brocade.

Peter Ausnit

Okay, Aaron Rakers of Stifel Nicolaus asked how many incremental customers have purchased Ethernet from Brocade as of the close of Q4?

Ian Whiting

This is Ian, our prepared comments that we referenced with this update talked about over 500 new Ethernet customers in 2009. So, that is a statement of fact. More importantly, I think part of our strategy was to leverage the strength that Brocade has in the data center from our traditional SAN perspective. And we are happy to announce that we more than doubled our penetration amongst our largest, the top 100 storage customers in 2009 and we have some very strong metrics and plans to continue that clip rate in 2010.

Peter Ausnit

Okay, Katy Huberty of Morgan Stanley asked if there was downside revenue risk at current OEM Partners as they broaden their partnership strategies?

Ian Whiting

Well, you know, there is always risks and we always ultimately have to execute against our plan to mitigate those risks. So, we remain extremely vigilant, we have contingencies in place and as I said earlier on, one of the real advantages we have is that we are not dependent on particular class of market for revenue, we have a unique blend of OEM distributors, system integrators, and Direct ChAnnls, all of which are very active and fully integrated with our sales teams to ensure that we can pursue all of those markets successfully. And that gives us the contingency that enable us to mitigate against risk in any one part of our go-to-market strategy.

Peter Ausnit

Glenn Hanus of Needham asked about sales force integration. Were the integration has been completed but how effective has it been and what work remains to be done to improve productivity?

Ian Whiting

Well, we are delighted with this, the sales integration. We actually completed it ahead of schedule as we referenced in prior conference calls. We integrated the sales organizations of the Foundry Classic and Brocade Classic teams in May of 2009. We have already started to see some great results, one phase to the customers yielding much greater productivity for us.

We have retained specialist skills in our technical teams so we still have the defects, which is in both the SAN and LAN space. But having one phase to the customers be it an OEM, a channel partner or an end-user customer, that certainly given us a lot of leverage in our sales model; and while we will continue with training and continue with process and productivity improvements, we are well on track to yielding some of the productivity that we outlined earlier on in the year.

Peter Ausnit

Okay. Turning to questions about competitors. Mark Sue of RBC asked about Juniper’s EX Series. Is this having the impact on Brocade?

Ian Whiting

Well, certainly not in the datacenter because we don’t see Juniper and the EX product line being a datacenter a class product. EX is a campus product and to the extent, we compete in the campus LAN marketplace along with a number of other companies; that’s where we would encounter the EX; but it’s an early product; it’s not been out for long; and I think it’s still yet to be proven in the campus LAN marketplace.

So, we see it like any other product in that space. It’s a competitor and we have tactics and strategies to compete successfully against that product line but not in the datacenter where we don’t see it.

Peter Ausnit

Okay. Jason Ader of William Blair and Brian Marshall of Broadpoint asked about EMC; they were is your largest channel. How does EMC-Cisco Alliance impact Brocade?

Michael Klayko

I will give Ian break here. I’ll take this is Mike. Actually, we’ve had a relationship with EMC for 10 plus years, and it’s been a very good relationship; and in fact that relationship, I would anticipate continuing for a long period of time. A couple of things that have happened, one of them is that customers are really demanding Brocade by name in the largest enterprises.

When you look at it, EMC is a very, very good company delivering best of breed solutions. And so, we match up very well from a competitive features and functions standpoint against anybody in the marketplace. And when you look at the customer base right now, a recent survey said that 95%, about 95% of all the customers want best of breed solutions versus close proprietary vertically integrated solution, which is only about a 5% of the marketplace.

So, there’s a very small market, it’s actually asking for that complete further integration. But, I like the fact that, we and EMC together are going to participate in the 95% marketplace.

Peter Ausnit

Okay. Munjal Shah of Jefferies asked about thoughts about the blade networks in Juniper partnership.

Dave Stevens

I can take that one. This is Dave. We don’t seem them a lot as Ian said before. They obviously feel like to have a whole new product portfolio that needs to be clear; it’s not clear to me. They don’t just build up themselves to be perfectly honest. It seems like a fairly complex relationship for an embedded Ethernet switch when, you know, as a company, you are in the business of building Ethernet switches. So, as Ian said before the positioning between that and the 4200 is a little confusing and we don’t see it very much.

Peter Ausnit

Okay. Turning to TAM’s technologies and products. Paul Silverstein of Credit Suisse asked about the outlook for the fiber channel market?

Dave Stevens

From a fiber channel perspective, I guess, I would turn back to what we looked at, at Analyst Day back in September. The growth drivers we talked about consistently, the growth and data, the number of devices that are being attached, and the traffic that’s going to the network, all of these are robust and growing exponentially.

When we prepared for Analyst Day, we were again, wary as analysts, we always sanitize that against our internal folks here, and we are comfortable. We talked about an 8.4% [Inaudible] through 2012. We feel very comfortable with that as particularly, two months later as we finished off Q4 and look into Q1, we are very comfortable with our forecast.

Peter Ausnit

Okay. Glenn Hanus of Needham asked a macro question to that. Asked us for a comment on budgets, datacenter refresh activity, and MEA?

Michael Klayko

I will take that I guess. From a budget standpoint, it’s all over the map. We got customers that are down, we’ve customers so to say that are up; I should say that the market survey and the research work we’ve done. However, in a couple of areas, one in storage purchases as well as network infrastructure, those are both positive, which is a very good indicator for us.

Frankly, no one knows how to get to a handle on this incredible growth in digital data as well as the demand for network traffic continues to grow and so those two line items have been actually carved out and look very positive from a budget standpoint. But there’s no real pattern. It’s kind of a scatter map in terms of all the budgets depending upon geography, customer, different verticals, and so forth; but there is a couple of unique characteristics and that happens to be around storage and networking.

We are actually seeing it around datacenter refresh activities, more and more increased RFPs, RFQs, as well as early pilot and test. In fact, a tremendous number of new increase compared to say the last 12 months, and so that refresh activity is clearly underway. And from MEA it’s spotty again, in terms of geography right now which you were saying is, you are saying, different countries in different sectors in the MEA marketplace, growing at different rate.

Some of the emerging opportunities in some of the central European countries are still doing quite well but some of the larger ones are still more flattish; but not down but more flattish at this point.

Ian Whiting

Yes, I will just add to Mike’s comments. So, I think what we are starting to see now is some of the pent up demand and slowing down that we saw in new datacenter build-outs in 2009 is starting to be released. And what’s interesting is from the storage perspective, it’s still all fiber channel, there is no fiber channel over Ethernet installations, or implantations in any of the large new datacenters builds that we are seeing.

The message that resonates particularly well, I think, with customers is that we have build fiber channel over Internet readiness into our current generation of the products, which is ensuring that graceful migration capability that customers always look for in those next generation platforms that they are putting into their, their new datacenters.

Peter Ausnit

Okay. Staying with the TAMs here. Munjal Shah of Jefferies, Aaron Rakers of Stifel Nicolaus, Paul Silverstein of Credit Suisse all asked is there anything besides Dell’Oro that you can show us that will convince industry that storage growth could be higher than the single digit range and how are we positioned for FCoE?

Richard Deranleau

This is Richard. I will jump in on the first part of it. Besides Dell’Oro, obviously, we talked about the other folks that we look at, whether it would be Synergy or IDC, Gartner, or a host of others; but I guess beyond that, just looking at the strength that we saw in fiber channel in Q4, are visibility as we move in to the new year gives us confidence in where we are and then I would just reiterate what Ian talked about, which is the customers are talking about datacenter builds. We see that, we have the pipeline, that is confirmed, given us comfort into our forecast.

Dave Stevens

I will probably take the second half of that. This is Dave. With respect to the FCoE, and we talked a little about this at the Analyst Day, the thing I remember about FCoE is it’s really all about preserving the fiber channel stack and carrying it over enhanced Ethernet.

The hard part of that is the FCoE part, right. The hard part is the storage part, not the Ethernet part. And it’s important to be able to take those FCoE solutions to be able to connect and back in their existing infrastructure, right. So, today we are shipping an FCoE top-of-rack switch, we are shipping an FCoE blade for the DCX, director and the SANs base and we have outlined plans to add CEE interfaces into the MLX platform.

So, we have got that migration path for customers that Ian talked about and we are, you know, we’re shipping products today and as I think Mike has said much times in the past we are experts in the storage base, which is one of the critical criteria for making that successful. So, I think we are in a great shape on it.

Yes, and just to add onto that, its new data center build out, that’s been a longer obviously, just having the conversation around the storage network, our sales model, our product offering enables us to have a much deeper and broader conversation around the whole network and particularly, in Greenfield new data center opportunities, there isn’t about legacy installed base, that has to be taken into consideration.

So, we are being invited to the table and many large customers to talk about the whole network now, not just the storage network where we are obviously the dominant player. So, that’s a great opportunity for us and our sales model is enabling us to really take advantage of that opportunity.

Peter Ausnit

Okay, Aaron Rakers of Stifel Nicolaus has asked how does HP3Com pertain to HP’s efforts around building a proprietary position for FCoE.

Dave Stevens

So, this is Dave. I will take that one again. I would just say, you know, unequivocally, there is no such thing as proprietary FCoE, right. The FCoE standard was just ratified few months ago. Cisco was there, we were there, other large players were there. And you know, the whole point of FCoE is to preserve the entire standardized fiber channel stack, right. The T11 committee standardized FCoE in the FC-BB-5 standard and you either support it or you don’t. And if you don’t adhere to that standard, you know, it doesn’t work. So, I am not sure what proprietary FCoE anybody is talking about.

Peter Ausnit

Okay, Nikos Theodosopoulos of UBS asked when will Brocade refresh traditional boundary products.

Dave Stevens

I guess I will take that one again. The thing, I think, is we have been refreshing the boundary products since the acquisition closed earlier in the year. I think, Mike talked about, we introduced 62 new products in 2009.

A lot of those were Ethernet products. We introduced new 10 Gigabit top-of-rack switches, we introduced stackables for the enterprise campus; we introduced a new line of high performance application delivery controllers; last week, we introduced a compact MPLS router for the Carrier Ethernet space. We’ve done blades for the MLX router. So, there’s lots of those programs in progress.

You’re not going to see a wholesale overhaul in one of those product lines because we don’t need to do it. Those product lines have lot of life left in them and will continue to enhance them going forward.

Marc Randall

Just to expand a little bit on what Dave was saying, this is Marc Randall. We’ve been very clear on what are product development strategy was going to be this year. And we’ve been concentrating on three major areas of development.

As Dave mentioned, a lot of activity in the Ethernet side where we have continued to grow that portfolio, but we’re also investing on the SAN side and this year we completed our transition of product from 4 to 8 gigabit fiber channel. We released new chassis, we have an encryption cards, and host bus adapter extension products. So, a real broad portfolio, we are going to continue to invest in that space with higher density 8 gig and then ultimately moving to higher performance 16 gig.

And then the other area of focus is around convergence technology and that goes really, we have been talking about fiber channel over Ethernet and Convergence Enhanced Ethernet where we delivered top-of-rack products; we delivered blades for the DCX; we delivered Converged Network Adapter for servers; and we are also building embedded cards for our server partners.

So we’ve got a three-prong approach for our development that covers all of the three market service providers, LAN, campus, and datacenter in those three technology portfolios.

Peter Ausnit

Okay. We are halfway through the hour-long Q-and-A call. Now we are going go to traditional Q-and-A over the telephone.

Operator

Your first question comes from Aaron Rakers - Stifel Nicolaus.

Aaron Rakers - Stifel Nicolaus

I’ve got actually two questions. The first question, it looks like the stocks are going to come under a little bit of pressure today, and I think what a lot of people are going to grapple with here, is obviously taking your guidance of below seasonal trend in the fiscal first quarter, I think it’s going to leave a lot people to ask the question about what gives you comfort in the flat sequential trend going into the fiscal second quarter relative to what you said at the Analyst Day, which are normal seasonal trends, down about 4 to 6% I think sequentially, and I do have a follow-up.

Richard Deranleau

Sure. This is Richard Deranleau. Actually, we are feeling pretty good-looking at the year. As you know, we reiterated guidance from Analyst Day. There has been, when you look at where the economy in IT spending is, IT spending is improving; it will continue to improve throughout the year; we will continue to bring our initiatives online.

Ian spent a lot of time talking about the channel work, the direct sales, new products, the OEM ramp, and as the economy in IT continue to improve in second half year, gives a very good confidence. Going into this quarter, we are just basically following around. We are looking at what our peers and partners are saying and so, we’re not troubled at all. Again, we feel very good and what we gave in terms of guidance for the year.

Aaron Rakers - Stifel Nicolaus

Yes. But Richard, if I could push back, I mean, there’s got to be something in that fiscal second quarter you know expectation as you sit here right now, causing you to be comfortable that you will be, you know, a decent amount above what a typical seasonal sequential pattern is?

Richard Deranleau

Well, I think Mike has it.

Michael Klayko

There’s a couple of other things here without going too far into it but there’s a whole series of things we talked about in the past. We talked, where we laid a lot of foundation with new partners and new products and so forth.

They are starting to ramp up and so, what you are saying is, you are saying is to change our business model which has been in the past traditionally SAN oriented, which at, kind of a very definable seasonal pattern to, not so definable pattern anymore because as we layer our new products and new relationships and so forth, they don’t fit in compartmentalized into some of the quarters that we have had in the past; and so what you are getting here is just a blunted effect; they are just in fact, new products have come out, new partnerships that we have either announced or they are in play.

Aaron Rakers - Stifel Nicolaus

Okay. And then the other question that I have is that it looks like given the stuff you disclosed last night, it look like you are actually raising your free cash flow assumptions relative to what you’d laid out at the Analyst Day and I am trying to understand our bridge that differential and in particular in this as you see your campus spending come off after fiscal third quarter. It looks like its implied or the operating CapEx goes up quite a bit in fiscal ‘10. I guess to summarize, can you just help me bridge the gap of why the change in the free cash flow assumptions?

Richard Deranleau

Sure, and this is Richard again. By the way, just on that last question; go back to 2006 and look at what happened when you have a year where we have consistent new products, and that was driven by the 2 to 4 gig. If you look at what was going on, that’s how we are looking at this year.

From a cash flow perspective, you are correct, we did increase the cash projections and that really has to do with as we finished up our Q4. Frankly, just more comfort around our working capital and also with the stock rate as we are getting more cash exercises. So, those are, that’s really to bridge their confidence level based on continued demand to the working capital.

From a CapEx perspective, when we go up beyond 10, we would look to potentially as we continue to grow, we are going to have to have more capital and it’s basically around laboratories but that, you know, once we go beyond 10, we’re giving you color but I am sure those numbers may chance. But as a bigger company, we are going to have bigger CapEx.

Peter Ausnit

Ann, can you give us the next question?

Operator

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

Mark Sue - RBC Capital Markets

Thank you. Maybe just a more granulate but where the incremental 10 to 20 million would be otherwise in the January quarter and additionally, do you have some bottoms-up analysis and data to support the large double digit ramp in the fourth quarter or, we are just kind of hoping that somebody’s large other deals going to kick in during that time because the, if I were to look at your high-end of 2010 fiscal year guidance, then we are looking at a very meaningful double digit sequential growth in October. So any bottoms-up analysis will be great.

Richard Deranleau

Sure, this is Richard again. I guess Ian may have some colors well but I think, again from our perspective, we share with you where we are at Analyst Day. We are confirming the deal that we get with the exception of the improvement in cash. We are confirming what we talk to at Analyst Day.

So really, there is not a whole lot of news here other than we had a strong quarter in Q4 and again, I think validated some of the assumptions that we talked about and obviously, we have a better visibility into earlier part of the year, and we gave some general shaping in terms of our guidance at Analyst Day that’s pretty much how the Street has made its assumptions. If you look at first call, in terms of where the Street are and we are basically reaffirming what we said at Analyst Day.

Ian Whiting

Yes and maybe if I could add some color to that. I think the other reason why we have confidence is that the experience of the last 12 months has been that we are winning and we are winning consistently against our competition, our message around the delivering an alternative to the incumbent, with our complete end-to-end networking story is resonating.

We are first to market the new technologies and some of the new partnerships which were referenced have been baked now for 6 to 12 months and as we outlined, we are expecting to see the benefits of that. And those expectations are built on joint predictions and outlooks from us and our partners. So, that’s what’s giving us some of the confidence but overall, the message is that we are wining in the segments that we choose to participate and compete in.

Mark Sue - RBC Capital Markets

So the little softness that you’re seeing in January, it’s not really related to a particular OEM. And we shouldn’t really see it as federal sales not repeating, it’s just kind of broad seasonality, do you think?

Richard Deranleau

Yes, I mean if you look at what other people are saying around Q1, I think we’re just matching everybody else. And, I think what you’re looking at is enterprise has traditionally been very strong in our Q1, which is the calendar Q4 we’re expecting that to happen again. So, I wouldn’t necessarily represent it as softness in Q1 but more looking at, you know, where is the ecosystem at and providing a little bit of color around that.

Mark Sue - RBC Capital Markets

Okay, and just lastly Richard, 2.25 to 2.45 as we stand here today, how should we kind of be thinking about that in a range midpoint, low end?

Richard Deranleau

I would say it’s just again right at, we haven’t changed from Analyst Day and if you took a view at Analyst Day, you probably want to keep that view.

Mark Sue - RBC Capital Markets

Okay, so midpoint?

Peter Ausnit

Okay thank you. Ann, can we take the next question please?

Operator

The next question from the line of Nikos Theodosopoulos with UBS. Please proceed.

Nikos Theodosopoulos - UBS

Yes, thank you. A couple of quick ones, hopefully. The tax rate was kind of lower than expected this quarter, can you just comment on that and what should we think about the tax rate going forward?

Richard Deranleau

We’ve given you, we are reaffirming the guidance on that. The drivers to that was essentially R&D tax credits or some technical reasons why the R&D tax credit was a little bit better than we expected. And we’re reaffirming guidance we gave on the tax rate.

Nikos Theodosopoulos - UBS

Okay. And in terms of the IP business this quarter, how, if you were to look at the business in two parts, namely US federal and non-US federal, can you comment on how those two pieces did sequentially? I am just trying get a sense of the non-federal IP business, has it started to show a steady sequential increase now that after a difficult prior quarter or was this sequential increase purely driven by the federal exposure?

Richard Deranleau

I think it did below the numbers and Ian can give some more color the, which he’s got to something add. But I would look at it as if you look at non-federal business within United States, you saw sequential growth. If you think about the ADC business that Dave had talked about, you look at sequential growth there as well. So, you know actually it’s a very nice quarter from a long perspective.

Ian Whiting

Yes, I would reiterate that. I think there is a different concentration of business now since our acquisition of Foundry and there is more US base than it was historically although our presence in Europe is expanding. The European market has been under pressures as we’ve have seen from most of the companies and the macro economic indicators.

So, they are continuing to struggle in certain sectors but overall, our position in Europe is stable and is now set for growth but in Americas in particular, we’ve got considerable market coverage and we’re planning in a lot more places so as Richard said we grew in the Americas, non-federal and that’s definitely an engine of growth as we go into 2010.

Peter Ausnit

Ann, can we have the next question?

Operator

And the next question comes from the line of Brian Marshall of Broadpoint Amtech. Please proceed.

Brian Marshall - Broadpoint Amtech

Hi. Good morning. Thanks. I got a question on the sequential growth for the January quarter at 45%. I guess, you know, was wondering it seems like some of your larger OEM customers are actually forecasting. You know, it’s kind a more or less normal seasonal trends and obviously we’re a little bit below that so, I was wondering if you could comment a little bit more on that element?

Richard Deranleau

Yes, I think from our perspective again, if you look at the situation of the economy and IT spending, specifically improving throughout the year. We’re just providing for that in our guidance.

Brian Marshall - Broadpoint Amtech

Okay. And Richard what kind of budget, IT growth budget assumptions are using for the current guidance that we have in place right now?

Richard Deranleau

You know, just go back to what we said at Analyst Day. We are assuming that there will be a budget plus, there typically has been a budget plus in IT spending or assuming that it will be consistent with prior years.

Brian Marshall - Broadpoint Amtech

But, you are talking about kind of a sort of recovery mode over the next couple of quarters and then, sort of return to normalcy in the back half of next year I guess. Would you assume normalcy for the entire IT industry at around 5%?

Richard Deranleau

Yes, I am not sure I am the best, whether from an IT growth perspective but just there seem to be a lot of questions to take a little step back or just a minute. So, we gave you a growth for the year at Analyst Day, we’re referring that.

When we talked at the Analyst Day, if you remember typically, what you would see with Brocade as a storage area networking company by itself, as you would see a strong Q4 sequential growth in Q1, and then a meaningful decline in Q2 and flat to down again in Q3 and then back to Q4. What we’re looking at, as I said before, is something more akin to 2006 where you have a growth in each quarter.

Now, we’re saying in Q2 and Q3, probably they are not huge growth, probably some growth there. So, I think when people think that there’s a big growth in Q4, they are probably over, are underestimating we believe will be continued growth throughout the year.

Brian Marshall - Broadpoint Amtech

Okay thanks. Final question, with regards to the service revenue being down almost 2% sequentially, do you talk about some of trends that you have there and maybe some potential seasonality that impacts your October quarter there?

Michael Klayko

Yes, I think, you know services can be a little bit lumpy. I don’t think there is anything more than that as a little bit lumpier on the professional services side but it’s a good business. The main insight of the business is fairly predictable. It’s got some good margins to it. We’ve little bit an adverse mix, perfect gross margin, our professional services versus the maintenance services. But, it’s a good quarter.

Brian Marshall - Broadpoint Amtech

And can you talk about the difference between the gross margins between those two different services around the revenue lines?

Michael Klayko

Yes, you can imagine when you are selling professional services, you get a, you know much lower gross margin than when you are really selling a maintenance stream. The maintenance stream has very-very high gross margins, product margins and then obviously, you know, you are going to get a substantially lower gross margin when you’re working at basically, adding the markup to a person.

Operator

Your next question comes from Katy Huberty - Morgan Stanley.

Kathryn Huberty - Morgan Stanley

Initially, you had talked about some non-traditional partners potentially coming on line. Can you just go into more detail on what those partnerships may look like and then, on a comparison basis. What was the size of those partnerships look like versus some of the larger that we aim to sign on this year?

Michael Klayko

Katy, this is Mike. I would prefer just because it is really competitive out there, that I wait until I announce them before we discuss on, don’t want to kind of tip the hand on some of the things we are working on at this point in time. But when you start looking at the Ethernet space, there is a tremendously different ecosystem that exists today, just in the server or the storage space, and so over time we will start announcing these on a periodic basis. I am going to hold that part or drive for a while until we get in to announcement, okay?

Kathryn Huberty - Morgan Stanley

Okay, but as we look for not, you know, specific on names or even types, that we think about the incremental partnerships being many smaller partnerships versus few large partnerships in the first half of the year. There is still some large ones out there to bring on line.

Michael Klayko

Well, there is a lot out there. Yes, it really depends Katy on how you classify small versus large. Like, for example, we did a partnership I don’t know four months ago, three-four months ago, actually three months ago with a company called Net One Systems in Japan.

Now, that’s a non-traditional type of partnership yet they do a billion dollar a year of Ethernet spent on Japanese market alone, which frankly with our largest competitor and so that partnership you established on September 1st and it’s starting to now you will see results in next year and you will see a lot of other different partnerships of that nature as well as some non-traditional may be you wouldn’t have excepted from us dealing with just traditional server and storage vendors.

Operator

Your next question comes from Min Park - Goldman Sachs.

Min Park - Goldman Sachs Research

Just a couple of questions, first just on the cash flow. Can you just remind us where what the minimum cash level you would be comfortable having and why you actually practically build the cash up to $500 million level, given the low rate of return environment and why not pay down your debt more aggressively?

Richard Deranleau

My name is Richard, I guess we have shown you kind of base case where our cash build is and we certainly reserve the right to pay down our debt faster. There is a lot of leverage on that, and our state of case has been to pay down debt as fast as possible, but we would like to keep our options open. So we have shown you our base case if you look at what we have done this year we have paid down almost 15% of our initial term debt over $160 million in less then 12 months, so it’s been very good I think, at demonstrating paying down the debt and we certainly with hold that option to us.

In terms of cash what I have talked about historically is some thing around $200 million level. Keep in mind that we have over $110 million liquidity line of credit available to us.

Min Park - Goldman Sachs Research

You did raise your cash flow from operations target from 400 to 460 but you kept revenue margin and earnings target unchanged can you help us understand where that extra cash is coming from.

Richard Deranleau

Yes, it’s really coming from, principally through working capital improvements as well as some expectations about, from a free cash flow perspective, cash from stock options exercises.

Min Park - Goldman Sachs Research

Okay and then just lastly, is a quarter going to be a twelve-week quarter for you guys?

Richard Deranleau

Every thing is a 13-week quarter for us, and will be for the next five years.

Operator

Your next question comes from Mark Moskowitz - JP Morgan.

Mark Moskowitz - JP Morgan

Two quick questions here; I heard Ian’s comments earlier in terms of how you are working with the IBM and Dell and seem pretty constructive about that ramp in longer term but my question really is just will Brocade have to employ any sort of incremental incentive and/or education programs for either IBM and Dell to really overcome from the organizational inertia at those organizations as I saw you used to working on Cisco.

Ian Whiting

Yes, this is Ian. So, we already have baked into our plan our investments required to realize to ramp that we have to outline for both Dell and IBM. So we are comfortable, we have the resources in place to the extent that the business ramps faster, clearly that is an opportunity for us to pile on and reallocate resources or go back and request more resources but at this point based on our and our partners projections for revenue and what it’s going to take us to realize those opportunities.

Mark Moskowitz - JP Morgan

Then Richard, you talked earlier in the prepared remarks about the growth margin improvements in the quarter and some of it was because of supply chain efficiency is realized and the Ethernet part of the business.

I just want to get a sense you can comment a little more about how much the supply-chain verses what could be, maybe some surprises on the customer mix for the quarter and if there is any customer mix how sustainable is that just given as you ramp more OEM partners there will be some downward pressure kind of we talked about back at the Analyst meeting, is there any change there?

Richard Deranleau

Yes, and not a whole lot of change, I think you see we continue to drive cost cut of our product and cost cut of supply chain and that has provided a lot of left on the gross margin side.

When you think of going forward I think we talked about at analyst day, is that as we move to more indirect channels and as we beef up the OEM channel, there is going to be some pressure on margins we are comfortable through we continue drive cost out. We can fund that and stay in our targeted gross margin range, but it is really two things going on different directions. Taking cost out but going to a less reached channel.

Operator

Your next question comes from Ittai Kidron - Oppenheimer.

Ittai Kidron - Oppenheimer & Co.

Thank you. I’d like to get a little bit understanding as to what will - can you talk a little bit more about your operating expenses plans and how do you plan to ramp those up through the year.

It looks like just by looking at this quarter you are at the low end of your long term gross margin range that said already at the high end of your operating margin long term opportunity, I am trying to understand why for 2010 you are not going to be in the position, you do not see yourselves already at this point in the position to raise your operating margin range for the year?

Michael Klayko

Yes, I think the way I look at it is when we talk about all the initiatives that Ian has put in place in his driving, when you think about what Mark is doing on the product side. There is a certain amount of investment necessary in sales, sales engineering, R&D and global services and we are going to be putting resources in place to drive that additional revenue, and having said that, we typically are within or below our targeted amount of OpEx .

So you know, we have been very cautious about spending money in this environment. This quarter we made some investments in head count in the areas I spoke specifically and will continue to do that. We feel comfortable we will be able to operate in a range on, probably even the low end on the OpEx.

Ittai Kidron - Oppenheimer & Co.

Can you give us an update on what is your headcount right now and you know for my headcount stand point sort of, what is the run rate you expect to hire through the year on a quarterly basis?

Ian Whiting

Well, we actually have the number of employees that is 4070 as exited the quarter and we do not really put out how many people we are going to hire. I think you can probable get there from an OpEx perspective.

Michael Klayko

And again, where you would look for us to be putting resource principally or in sales, sales engineering, Research and development, global services.

Operator

Your next question comes from Keith Bachman - Bank of Montreal.

Keith Bachman - Bank of Montreal

I was wondering if you could update us on your HBA aspirations, either in terms of share or revenues or any metrics that you give us and what you think the key impediments have been over the past couple of quarters and I have a follow-up please.

Richard Deranleau

Sure, may be I can start off and then somebody else may jump in. I think Mike has been pretty clear that we intend to be a significant, a material player, leading supplier of HBAs and CNAs in a converge network. I am not sure you can segregate between being an HBAs and CNAs. I think we expect to be a player there, and I think the world is moving more from 4 to 8 Gig as well that plays to our strength.

Dave Stevens

This is Dave, I could make a couple of comments there as well, I think from a strategic stand point we believe that the embedded switches and the edge products, HBAs and CNAs are an important component of being able to deliver an end-to-end solution, both on the FCoE and CEE side and in the fiber.

On the fiber channels space as well. So, we are continuing to invest there, continue in to push those, I think is a group of products, adapters, switches, mezzanine cards all those things together that businesses continue into to ramp nicely, we are continuing to get design wings there, we are continuing to push on there you know it’s a tough business to break into, it takes some time to go do it I think we are mostly over the hop and turns of qualification but there is always more you know that you can do there but that business is in a whole continuing to grow.

Keith Bachman - Bank of Montreal

In the past, you have talked about 10% share, is that still what you are seeking to obtain?

Richard Deranleau

I think you are correct we had put at a 10% as a threshold. I think our aspirations are actually larger than that, we are not putting time frame around it. And I think if you look at the way we represent the business as HBAs, CNAs, embedded blades we are pretty significant player today but we haven’t put out a new number for say.

Keith Bachman - Bank of Montreal

Okay fair enough. Then my follow up Richard for you I think is just an add on to the initial question, if I look at Q2, you mentioned that there would be several factors that help in your efforts I think ‘06, when you went from 4-Gig to 8-Gig, I just want to parse it a little bit differently in that. You see it more as being a partnership led activity or product led activity that would enable you to have a better than historic norms in terms of sequential growth for Q2?

Richard Deranleau

Yes, I think it’s both. I think from a products perspective we have a lot of products we would be delivering, I think from a partner and channel perspective we have more and more channels coming online. People were focused on IBM and Dell but there is also we talked a little about Net One, there are number of other partners. Our channel business by the way is doing very well.

So, I think that tells us that again its not somehow you are taken up bunch of money and stick in it from Q1 into Q4, I think you are sprinkling it relatively along each quarter and gets us right back to the confidence that we showed at the Analyst day and now with two months more behind us finishing up what is I think a pretty good Q4 looking at the visible in Q1, we feel very-very confident.

Operator

Your next question comes from Bill Fearnley - FTN Equity Capital Markets.

Bill Fearnley - FTN Equity Capital Markets

A quick question here on gross margins, there is lot of talk about component pricing and more talk about potential capacity constraints of pinch points at ODMs and in the supply chain. What you guys hearing near and could component pricing or supply chain constraints affect on what you see in FY’10 and if so when might you see it?

Ian Whiting

I think Mike has a comment, I would just say that based on the way we do our forward-looking planning, we always make sure we have capacity in the system; we look at 12-18 months horizon and so, if we make sure we have the supply, we make sure that if there is short-term disruption that does not typically affect us because we are forward-planning organization.

Operator

Yes and it is from Glenn Hanus with Needham & Company. Please proceed.

Glenn Hanus - Needham & Company

Quick question on the service provider side, looks like that you know sort of trended down either percent of business again this quarter such as lumpiness or may be you could comment more broadly on the initiative there?

Ian Whiting

Yes this is Ian. Let me make couple of comments. So first of our service provider business actually grew, I think that was a data classification issue here because what has happened is we have moved some of our service provider reporting into enterprise, say for example, what we classify as the regional telecommunications companies or IOC’s in domestic U.S. that’s now been moved into our enterprise sales organization showing up in enterprise sales.

Similarly, some of the service provider business that we have historically done direct is now being transacted through selected specialist channel partners, so there is been a mix or a shift in the revenue but certainly when we analyze it at the next level of detail, our service provider business as defined by service providers where we compete over segments of the market where we compete is strong and has grown in fact sequentially by something in the region of 8% possibly 9% when we are all set and done.

Michael Klayko

Yes, just to add, when you are a direct company only it is really easy to get classifications but as you move to more indirect you loose some of that visibility. So not exactly apples to apples but we will continue to work on, been able to track that better as we go forward.

Ian Whiting

Okay, thank you. Now, I am going to turn the call to Mike for some final comments.

Michael Klayko

Yes that’s all the time we have this morning, I really hope you found the new format more efficient and informative, we are going to keep the Q&A e-mail line open, so if you have any other questions and so forth we can follow up not only today, but throughout the quarter.

Couple of thoughts, we executed very, very well in Q4, I think is indicative at our numbers, we grew faster than our competitors, we are gaining share in both storage and the Ethernet market. One of the only two guys in the world, two companies in the world, networking companies that have innovative products that can go end-to-end, and so that is our differentiation that sets us apart going forward and I think we are the best positioned to execute in 2010 and beyond.

So, with that I am going to thank you for joining us today and ask the operator to conclude the conference.

Operator

Ladies and gentlemen, we thank you for your participation in today’s conference. This concludes the presentation and you may now disconnect. Have a wonderful day.

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