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Gigamon, Inc. (NYSE:GIMO)

Q3 2013 Earnings Conference Call

November 4, 2013 5:00 p.m. ET

Executives

Cynthia Hiponia – IR

Paul Hooper – CEO

Duston Williams – CFO

Analysts

Tal Liani – Bank of America-Merrill Lynch

Kent Schofield – Goldman Sachs

[Giorgio Skerkopoulos] – Raymond James

Ben Reitzes – Barclays Capital

Jason Ader – William Blair

Josh Beck – Pacific Crest

Operator

Good day, ladies and gentlemen, and thank you for standing by. Welcome to Gigamon's Third Quarter 2013 Earnings Conference Call.

(Operator Instructions). This conference is being recorded today, November 4th, 2013.

I would now like to turn the conference over to Cynthia Hiponia with Gigamon Investor Relations. Please go ahead, ma'am.

Cynthia Hiponia

Thank you, [Chad]. This is Cynthia Hiponia, Gigamon Investor Relations, and I'm pleased to welcome you to Gigamon's conference call to discuss its third quarter fiscal year 2013 earnings results.

After the market closed today, Gigamon issued a press release through PRNewswire. The release is also available on the company's website at gigamon.com. This call is being webcast live on the Investor Relations page of the Gigamon website and will be available for a period one year.

During the course of today's presentations, our executives will make forward-looking statements within the meaning of the federal securities laws. Forward-looking statements generally relate to future events or our future financial or operating performance. Forward-looking statements in this presentation include but are not limited to statements related to our business and financial performance and expectations and guidance for future periods, our expectations regarding our continued focus on our current strategy, our expectations regarding macro trends in the market and our expectations for our products. Our expectations and beliefs regarding these matters may not materialize and actual results in future periods are subject to risks and uncertainties that could cause actual results to differ materially from those projected.

These risks, including those set forth in the press release that we issued earlier, as well as those more fully described in our filings with the Securities and Exchange Commission. The forward-looking statements in this presentation are based on information available to us as of the date hereof and we disclaim any obligation to update any forward-looking statements except as required by law.

Please note that other than revenue, the financial measures to be discussed on this call will be on a non-GAAP basis. The non-GAAP financial measures are not intended to be considered in isolation or as a substitute for results prepared in accordance with GAAP. A discussion of why we present non-GAAP financial measures and a reconciliation of the non-GAAP financial measures discussed in this call to the most directly comparable GAAP financial measures are included in our earnings press release that is available on our website.

On this call we will give guidance for the fourth quarter fiscal 2013 on a non-GAAP basis. We do not make available reconciliation of non-GAAP guidance measures to corresponding GAAP measures on a forward-looking basis due to the high variability and the low visibility with respect to the charges which are excluded from these non-GAAP measures.

Let me now turn the call over to Paul Hooper, Gigamon's CEO.

Paul Hooper

Thank you, Cynthia. Good afternoon and thank you for joining us for our third quarter 2013 earnings call. I have Duston Williams, our Chief Financial Officer, joining me on the call today.

This is our second quarter as a public company and we're pleased to report solid results. Record revenue of $39 million, up 20% sequentially and up 52% year over year. Gross margins at 81%. And an EPS of $0.18 per diluted share in this third quarter. I would like to take this opportunity to acknowledge the efforts and commitment of the complete Gigamon team to achieve these results.

In our last earnings call I provided some background and detail regarding our market, our solution and technology, and today, before highlighting some of the accomplishments of this exciting quarter, I want to build upon the discussion of the last call and examine the forces that are driving greater demand and interest from our Visibility Fabric solution.

Communications are increasing in every aspect of our lives, and this is causing the underlying network infrastructure to rapidly scale to the next level. Service providers are moving from 3G to 4G with many exploring LTE deployments, serving both voice and data. In the residential market, cable providers are delivering richer, broader and faster communication services. And within the enterprise, network architects are looking at the next wave of upgrades, including 10 gigabit, 40 gigabit, and the emergence of next generation of wireless technologies.

The industry describes this as big data, and with it comes big challenges. In parallel with the growth in communications traffic, the need to monitor, manage and secure infrastructure has never been more acute. The delivery of high-quality, valuable and differentiated services to service provider subscribers and enterprise users is dependent upon a pervasive, detailed and accurate understanding of the status, availability and performance of infrastructure and the communications that it carries.

Therein lies the big challenges caused by big data. To ensure service quality and performance, infrastructure owners need to watch the right traffic. However, the definition of right will change based upon a multitude of dynamic factors. It may be the traffic from a specific location, a specific application, a subset of a group of offices or as granular as a specific user. Infrastructure owners are increasingly aware that they can no longer watch everything. And so the solution and technology that allows for powerful, agile and pervasive selection of the right traffic is moving from a nice-to-have consideration to a need-to-have component of infrastructure.

Delivering the right traffic to the right destination started on what is referred as [tap and aggregation]. In fact, this simplistic approach, without meaningful control, can be counterproductive as it can and will lose a significant and relevant traffic within the larger mass.

Our Visibility Fabric is the leading solution that allows our customers to identify the right traffic and forward only that traffic to the relevant monitoring, management and security systems. Our continued differentiation is around the scale, control and intelligence of our solution through, at one of the scale, our Flow Mapping technology, that far outperforms competitive aggregation solutions, and at the other end, our GigaSMART traffic inspection and modification technology which serves some of the most demanding and complex networks on the planet.

Our Visibility Fabric empowers our customers to uniquely find, filter and forward only the right traffic, and then applies powerful inspection and transformation logic to deliver it in the right format. The inspection and transformation technology, GigaSMART, is significantly more powerful and capable than competitive offerings and is a leading indicator of where this market is heading.

As a tangible proof point of this market adoption, approximately 40% of the GigaVUE HB1 products shipped this quarter, the product's first full quarter since launch, shipped with GigaSMART applications. And by way of comparison, it took over three quarters for our HD series to reach a similar attach rate of GigaSMART applications.

In the coming months and quarters ahead, we will continue to build upon the power and versatility of the GigaSMART solution as we enable our customers to deploy the most powerful and intelligent traffic characterization logic, or [MAPS] as we refer to them, creating even greater differentiation to the Gigamon Visibility Fabric.

And now turning to the customers that are already benefiting from the power and flexibility that our Visibility Fabric offers. We have continued to increase our installed base this quarter through the addition of 86 new customers, building upon the additional 72 new customers in Q2. And within the new customers in Q3, we saw an additional 19 of the Fortune100, a record number of additions in one quarter for the company.

In the quarter we also received our largest single purchase order in the company's history. The order from the U.S. Army is significant as they are a new customer and follow a similar largest order milestone in Q2. Looking back a few years, new customers would normally purchase a small system to evaluate and explore the capabilities of our technology and then follow up with a larger more widespread deployment of our solution. However, with the milestone of the largest orders in sequential quarters, we believe we may be seeing the early signs of a market that is crossing the chasm, and as I've mentioned previously, moving from nice-to-have to the need-to-have component of infrastructure.

Not only are we increasing our new customer count, we also continue to extend our relationship and deployments with our customers, and most notably, with our top 25 customers. In the quarter we saw the multiple of repeat purchases rise to 43 for the same group of customers that we highlighted in June during our IPO roadshow. To set context for this metric, this group of customers have purchased 35 times the value of their first purchase by the year-ago quarter and 38 times in Q2. This indicates that we've still not achieved full penetration in our largest customers and bodes well for the new customers that we added this quarter and for the customers outside of the top 25.

The market awareness and business momentum we're experiencing in North America region was also evidenced in our international markets during the third quarter. In Russia, a large broadband provider deployed our Visibility Fabric solution to provide differentiated services including content inspection, rental control, and to support their needs to manage the huge volume of traffic traversing their environment. A large mobile operator in Europe purchased several GigaVUE HD4 fabric nodes for deployment across multiple locations throughout the region. These nodes will intelligently forward traffic to a variety of customer monitoring tools, and in doing so, extend the life of their existing tools, mitigate the need for additional tool purchases, and provide more intelligent control of the traffic being delivered.

Turning to the Asia Pacific region, our Visibility Fabric was deployed by the NICT, Japan's national research institute for information and communications. NICT is conducting research work on real traffic transactions to establish the architecture and technology of the future cyber security framework of the Japanese government and other related public entities. This framework will include real-time security monitoring, threat analysis, detection and prevention technologies of malware. NICT chose the Gigamon Visibility Fabric because of its ability to reach into the virtual environment and deploy the GigaSMART deduplication application due to its high accuracy across multiple segments of the network.

While we believe our year-over-year growth pace of customer additions and repeat purchase multiple lead the market, we continue to invest and drive awareness for the solution and our brand to gain greater access to the market. By way of a proof point of the yet-to-be-accessed market opportunity, we undertook a survey of visitors to our booth at VMworld event in August, with 85% of the respondents believing that visibility to traffic in the virtual world is important and 70% not having heard of our Visibility Fabric that addresses this need. We remain confident that investing in awareness is a tangible driver to accelerate future growth.

Looking at the vehicles that will help drive increased awareness and reach of the Gigamon solution, we have specific successes with our [research] community and notable new products and our technology [partners]. In Bangkok, we hosted our first Asia Pacific Partner Conference in Bangkok, Thailand, which was attended by over 80 regional resellers. While the attendees included many existing partners, it also did include new partners to Gigamon that have been disillusioned by some of our competitors aligning themselves to specific tools. They believe in the value of a heterogeneous solution supporting multiple tools with the single Visibility Fabric. And hence, many are exploring relationships with us.

As we discussed on the prior call, we purpose-built a product, the GigaVUE HB1, to open up new markets for our solution, specifically the midsize enterprise and larger branch office locations of the Fortune enterprises. The HB1 has been our fastest-ramping product since launch. And while some sales were into larger enterprise, approximately 90% were into organizations outside of the Fortune1000.

We're pleased with the number of sales into the midsize enterprise as we believe this product provides platform for cost-effective tooling in the markets that previously have not been actively addressed.

And lastly, a word about our Visibility Fabric Ecosystem Partners, the VFEP program as we refer to it. In the quarter we saw continuing expansion of this community through the addition of two new partners -- LogRhythm, a specialist in cyber threat defense, and [Velisense] that focuses on instrumenting mobile data and services including voice over LTE. Both highlighted are unbiased support of tool vendors such as themselves as a key attraction of the Gigamon program.

In the quarter we continued to deepen our relationships with longstanding members of the VFEP community, including Compuware and Sourcefire who co-sponsored our Asia Pacific Partner Conference. We developed joint selling initiatives with the [Mail Factory], [FireI] and Riverbed, and worked with [Spirant], [Imperix] and JDSU to provide joint solutions to service providers in North America, Asia and the Middle East. Further, to our announcement in late June of Corvil's integration of our time stamping capability into their CorvilNet Operational Performance Monitoring, JDSU is currently integrating the same capability into their acceSS7 offering and other partners are actively engaged in similar efforts.

In summary, a successful quarter with continued positive momentum of four major metrics, clear evidence of ongoing market expansion, strong growth from new products, and increased depth and breadth of both customers and partner relationships.

Let me now turn the call over to our CFO, Duston, who will review the third quarter in detail and provide our outlook for the fourth quarter. Duston.

Duston Williams

Thank you, Paul. I'll review our Q3 actual results and then follow that up with our outlook for Q4.

The following analysis of Q3 results is based on non-GAAP and all references exclude non-GAAP stock-based compensation and any related income taxes. And please refer to our press release available on our Investor Relations website for the comparable GAAP results along with our reconciliation to the non-GAAP figures.

Total revenue in Q3 was a record $39 million. Our product revenues in Q3 were $29.2 million, representing a very strong sequential and year-over-year growth rate of 25% and 56%. Our services revenue in Q3 were $9.8 million, representing sequential year-over-year growth rate of 9% and 41%.

We had no 10% end-user customers in Q3 as our business continues to be very well diversified. Although on a non-end-user basis, our long-term distributor Interlink did account for 55% of the revenue. And as we've mentioned in the past, we have been focused on diversifying this relationship when we added Arrow Electronics as a North American distributor in April of 2013. We're pleased with the progress of this new relationship, with Arrow accounting for about 10% of Q3 revenue on a non-end-user basis. Revenue derived from both of these relationships represents products sold through to hundreds of end-user customers.

Our top 10 end-user customers accounted for 27% of revenue in Q3 compared to 28% in Q3 of 2012, which continues to highlight strong diversity of our business. From a geographic perspective, in Q3, North America accounted for 80% of revenue, AMEA was 13%, and APEC was 7% -- all similar to the year-ago period. On a year-over-year basis, North America grew 52%, AMEA 57%, and APEC is 39%. We continue to believe there is significant leverage in the international markets.

Looking at the vertical markets, enterprise accounted for 58% of bookings in Q3 versus 66% in Q3 of 2012. Service providers accounted for 18% versus 18%, and the government vertical accounted for 24% versus 16%. The government vertical performance for the quarter was aided by the government's September 30th yearend as well as booking our largest order in the company's history within this vertical as Paul mentioned. On a year-over-year basis, the enterprise vertical grew at 48%, service providers 68%, and government at 155%.

Gross margins in Q3 were 81% versus 81% in Q3 of 2012. Product gross margins was 77% versus 76%. And service margins were 92% versus 93%. The gross margin performance for the quarter was aided by a favorable customer mix within the service provider vertical.

Now turning to expenses -- operating expenses for Q3 were $22.4 million versus $21.9 million in Q2 of 2013 and $16.9 million in Q3 of 2012, reflecting sequential and year-over-year growth rates of 2% and 32%. The expenses for the quarter came in much lower than our expectation as headcount growth was below plan and some prototype and other miscellaneous expenses related to -- other miscellaneous expenses rolled into Q4. We expect the Q4 operating expenses to revert to a more normal growth [trend]. The ending headcount for the quarter was 335, that's versus 327 in Q2, reflecting an increase of only eight heads in the quarter.

The operating profit for Q3 was $9.2 million or 24% of revenue, far exceeding our expectations, which was driven by higher revenues and gross margins, combined with lower operating expenses. Going forward, we will continue to invest significant amounts back into the business, with a focus on revenue growth, and therefore you'll see a much more modest operating profit in the future quarters. Net profit for Q3 was 3.4 -- after a $3.4 million non-GAAP provision and other miscellaneous expenses, was $5.8 million or $0.l8 per share on a weighted average diluted basis.

Looking at the balance sheet for a few minutes, cash, cash equivalents and investments ended the quarter at $105.4 million. That's versus $121.5 million in Q2. We used $13.9 million of cash from operations in Q3 versus a positive $4.8 million generated in Q2, with the decrease primarily related to the previously communicated $20.4 million performance unit plan, or PUP payment, that occurred during the quarter in connection with our IPO in June.

DSOs were 63 days versus 50 days in Q2. Inventory turns were 22 versus 6 in Q2, reflecting the full transfer of the manufacturing operations over to [Jabil]. Capital expenditures were $0.6 million versus $1.3 million in Q2. The total preferred revenue balance was $40.9 million versus $36.3 million in Q2. Service deferred revenue in Q3 was $34 million versus $30.2 million in Q2 of 2013 and $21.3 million in Q3 of 2012, for a sequential and year-over-year growth rate of 13% and 60%.

Now for the outlook for Q4. Q4 started off with reasonable bookings, combined with modest but above-average backlog entering the quarter. Our Q4 operating outlook calls for record revenue, slightly reduced gross margins, and significant operating expense growth, reflecting the previously planned headcount additions, combined with the rollover of the prototype and other miscellaneous expenses that did not occur in Q3.

The following guidance in Q4 is based on non-GAAP results and excludes the non-cash stock-based compensation. Revenues of $40.5 million to $42.5 million. Gross margins of 78%. Operating expenses of $26 million to $26.5 million. A non-GAAP tax rate of approximately 40%. And based on an estimated average diluted weighted shares outstanding of approximately $34 million, this would lead to an EPS of approximately $0.10 to $0.12.

Two closing comments before we open up the call for questions. First, just a quick factual reminder as we approach Q1.

As we previously discussed in the past, our Q1, which is the March quarter, over the last four years have consistently experienced significant seasonality and has historically declined between 17% and 26% on a sequential basis from Q4. At this point in time, we see no reason to assume that this pattern of seasonality will show any significant deviation from past trends.

And lastly, I'd like to provide more color regarding my earlier comment that suggested more modest operating profit in future quarters. As a result of our out-performance to date, our Q4 guidance suggests operating profit for the full year 2013 to be 15%. Although we are very pleased by being able to demonstrate substantial leverage in the business, we continue to believe that focusing on top-line growth at this stage of our evolution will deliver greater long-term value to our shareholders, which could result in a more modest operating profit in future quarters. As we enter 2014, we remain committed to our ongoing strategy of being profitable on an annual basis while investing in our technology and market leadership to deliver top-line growth.

Operator, with that, if you could now please open up the call for questions. Thank you.

Question-and-Answer Session

Operator

Thank you, sir. We will now begin the question-and-answer session. (Operator Instructions).

And our first question comes from the line of Tal Liani with Bank of America-Merrill Lynch. Please go ahead.

Tal Liani – Bank of America-Merrill Lynch

Hi guys. Congrats on good quarter. I'd like to actually ask about the last comment and then go back to the fundamentals.

What -- so when you speak about more modest increase in operating margin, is it based on a higher growth in expenses versus what we've seen before or margin -- gross margin pressure? I mean, how do we take this and translate it into next year model? Where is the delta versus this year when it comes to the rate of increase of sales versus rate of increase of expenses? So that's question number one.

Question number two, you're performing exceptionally well in a tough environment. Most companies are worse than expected this quarter, not better than expected. And the question is, how long do you think you can continue and outperform the industry, the general spending environment, and what are the conditions where your -- the spending you see are going to more mimic the more negative environment or more -- kind of the greater pressure on spending that we see around you? Thanks.

Duston Williams

Yes, Tal. This is Duston. Maybe I'll take the first one and then Paul could follow up with the second one.

Yes. I said a more modest level of operating profit, not a more modest increase, but a more modest level of operating profit. And it's not -- it wasn't in context necessarily of gross margin pressure. That was in context of spending some more on the top-line growth and focusing on the top-line growth.

You know, in Q3 we just didn't add many heads and we weren't able quite honestly to spend to our plan that we thought we were going to spend to. And, you know, the delivery, you know, we're very proud of the 24% operating profit, but to deliver that kind of operating profit at our stage in life here two quarters out from an IPO, is probably a bit aggressive from this point of view and we'll focus on continuing the top-line growth and continuing to invest. And you'll see us adding more heads in Q4 -- probably significantly more heads in Q4 than we did in Q3.

Tal Liani – Bank of America-Merrill Lynch

Got it. So you're, just again to interpret what you're saying, you're expecting the consensus is calling on a fiscal basis and calendar basis, the consensus is calling for non-GAAP operating income to increase next year. And you're saying that your operating income can decline. How do I interpret what you say more modest operating profit?

Duston Williams

Yes. Well, certainly at 24%, nobody should expect 24%. And obviously we're not commenting on next year's guidance either. We typically guide one quarter at a time. We thought it was just important to give some generic comments about how we're going to focus more on spending a little bit more internally here. So there's really no comment relative to, you know, where those operating profits could go. But to deliver this level at this point is probably detrimental to potential further revenue growth.

Tal Liani – Bank of America-Merrill Lynch

Okay. We'll take it offline after because I need to understand something. But let's maybe, if you don't mind, let's go and focus on the second question which is, how long do you think you can deliver such great outperformance in a tough environment? And what are the drivers that are kind of go-beyond environment that enable you to do this and how sustainable are these drivers? Thanks.

Paul Hooper

So, hey, Tal, it's Paul. Firstly, thanks for the comments. And building upon what Duston said, this is a fast-moving market. When we look back at the way this market has moved, if you think back to, you know, 2006, 2007, this market really formed in its early days, and 2009, 2010, this was a tap and aggregation market. 2012 it moved to higher level intelligence. And we see this market, as I mentioned in my prepared comments, in 2013 and 2014, this market is moving to higher level of intelligence. And we believe that our portfolio is well-positioned to go and capture on this, which is one of the reasons why I think we are outperforming many of the indices and kind of many of the bellwethers in the industry.

The other two aspects, Tal, firstly, there's greater leverage inside this business today. We still haven't fully flexed the international muscle, but we are working hard and continue to develop the international muscle. Our North American organization still continues to grow. But Europe is -- Europe and Asia still represent additional opportunities for us in the coming years and year ahead.

But also I want to just -- your particular point is, how come we can continue to outperform? And if I put it down to one thing, Tal, it's ROI. When companies get pressured and when CIOs come under expense pressure or capital pressure, they really do need to do more with less, a well overused phrase, but the reality is true. And we truly help companies do that.

So, you know, I commented on a couple of the wins that we had this quarter in my prepared remarks. It's one of a flurry. And the repeating theme is I can't afford to go out and retool my implementation, I need to do something that's very different approach. We represent that different approach. So we truly extend the life of tools, we enable tools to be that much more successful inside of the environment. And therefore, customers are turning to us to say, there's got to be a cheaper way of doing it. And as you may have seen in our secondary presentation, Tal, we highlighted a couple of customer examples there where we say, anything between, if I recall, the south end, it was 26, 27, and the north end it was 52% savings for the customer. That's very real and very tangible and I think that's what's going to keep us on this momentum curve for the foreseeable future.

Tal Liani – Bank of America-Merrill Lynch

Thank you.

Operator

And our next question comes from the line of Kent Schofield with Goldman Sachs. Please go ahead.

Kent Schofield – Goldman Sachs

Great. Thank you. Paul, Duston, I was wondering, we've recently seen new consolidation in the market in terms of the competitive landscape. Can you just talk a little bit about what you've seen over the last year in terms of consolidation, what you've learned from it, and, you know, what you expect to see from a competitive change in terms of the recent consolidation?

And then second question would be around the service provider space. You obviously have a strong installed base there. Love to get just an update as to what you're seeing in terms of uptake and then what you're seeing in terms of new customer additions in that vertical.

Paul Hooper

Kent, thanks for the questions. Let me make sure I cover them. If I didn't, point me back.

Firstly, the consolidation inside of the market, we're not surprised by the acquisition announced by [Exia] recently. And we're seeing, you know, you're right, there's continued consolidation. It's really in two forms. Form number is where there's just kind of a horizontal consolidation. Form two is the more common one which where there's vertical integration where [Nexia] picked up [Ompa] by way of example. It's a tool vendor buying a fabric vendor.

And as I said in the prepared remarks, one of the things that we still remain committed to, because our partners see value, great value in it, is remaining heterogeneous. As an independent company we can bring great value to any tool. We're not polarized. We're not going to enforce or request one particular exists on top of that fabric. We are truly a Switzerland as we've said all along since we first met.

So we see that this consolidation may still continue. We are still very much focused on building the business organically that we have in place today.

Second question you had was service provider space. We're seeing an increasing interest. I think I could characterize it as, from the service providers, particularly as they move from 4G to LTE, the volume of traffic that they're facing is daunting. And so they're really looking for alternative approaches to instruments and manage their networks. And we are certainly well-positioned to be able to help them.

We announced at Mobile World Congress back here in February earlier this year the FlowVUE technology that's really purpose-built for service providers with the intention of helping the address this need. So we see this as being a very exciting interesting market opportunity. And we actively will continue to focus on that service provider market space as being an area of interest and growth for us.

Third -- what's the third question? Is that --

Kent Schofield – Goldman Sachs

No. That covers it, Paul. Maybe just as a follow-up to that, I mean where do you think -- where are we at given the rollout of LTE globally, being mature in some places, not really started in others, I mean what does that mean for your opportunity then?

Paul Hooper

Our perspective, I think we're at the early phases of what the LTE opportunity could represent to Gigamon both domestically but definitely internationally. And so I think we're at very early stages from our particular perspective.

Kent Schofield – Goldman Sachs

Thank you, Paul.

Paul Hooper

Okay.

Operator

And our next question comes from the line of Simon Leopold with Raymond James.

[Giorgio Skerkopoulos] – Raymond James

Hi guys. This is [Giorgio Skerkopoulos] for Simon. Paul, can you talk about [whether] verticals (inaudible) the upside in the December quarter guidance? And also if you expect service provider budget flush in Q4 and whether this comes from tangible orders or it's more about the typical seasonality for the quarter? And then with the 2013 coming to an end, how should we think about the [distribution] market in 2014? And I know you cannot comment on specific guidance for Gigamon for 2014, but how are you thinking about the market overall? How fast do you think it grows next year? And how Gigamon grows compared to the market growth overall.

Paul Hooper

Good questions, [Giorgio]. Thanks for them.

Firstly, as we -- if I got your first question correctly, saying what's driving the upside as we think about going into Q4, that's very much just the continued momentum that we've got. We are now -- the fourth quarter is always a reasonably good quarter for us, but we have obviously sales on a ramp. We have ended the year budget flushes. We have all of the opportunities that Q4 represents. And so we see upside being driven by the existing customers that we've got, the repeat buying as I mentioned on the call, now 43, is a significant metric. And so we see that continuing to drive our business going forward. In addition to the number of new customer adds, we've had 72 and 86 in sequential quarters here, obviously more upside and more opportunity for us to go and continue to build our penetration in those locations.

2013 in the Visibility Fabric, so as I said in my prepared remarks, we feel as though this market is just starting to cross the chasm. There is still a good deal of education, awareness and brand identity to be built in this market. But with some of our back-to-back quarters, in Q2 and Q3 we both had the largest orders in the company's history, and that's really atypical in the way that we've been seeing customers buy. As I said, it really has been buy one box, try it, try it, add to it, try it, add to it, and then do a full deployment.

And in the case of the U.S. Army, just that one case in point, they're not atypical here, but that's one case in point. This was a first time order, new customer, the biggest order in our history. And it's a massive rollout in the scheme of, you know, Gigamon normal deployments for a first-time customer.

So we're continuing to see more and more interest of building this component into our infrastructure. And so I believe that bodes very well for what 2014 can mean for the Visibility Fabric. You add to that the confluence of increasing traffic volumes, the confluence of, as Tal mentioned, you've got, you know, increasing economic pressure to some degree and you've got some challenges insofar as continued growth, you add to that the budgets coming under pressure, the increasing traffic and the opportunity the Visibility Fabric represents, and I think we've got some -- a potentially, you know, good set of years ahead of us here.

[Giorgio Skerkopoulos] – Raymond James

And basically you said that you added 86 customers this quarter from 72 last quarter and as you just mentioned, the largest order ever in company history came from a new customer. But can you comment on the average order size from these new customers as compared to last quarter and perhaps the year-ago quarter? And then as you increase your customer penetration, is it fair to say that new customer acquisition costs also increased?

Paul Hooper

So the way we kind of -- I'll defer to Duston on the first bit. The way we think about it is we capture the number of $100,000 orders in a quarter. Duston, can you kind of --

Duston Williams

Yes. I think that's probably the best metric, and this quarter was 117 I believe $100,000 orders and last quarter that was 88. That gives you a feel for the size of the orders. And, you know, clearly the first-time customer average purchase has picked up, specifically obviously with this new customer that we just won in the past quarter, which helped that metric.

[Giorgio Skerkopoulos] – Raymond James

Okay. So basically the average of the 86 is higher than the average of the 72 last quarter, correct?

Duston Williams

That's fair. Yes, absolutely.

[Giorgio Skerkopoulos] – Raymond James

Okay. And the last question for me, looking out to next year and especially after you mentioned about the virtual solution, what percentage of revenue do you expect roughly the virtual solution to be?

And also, how the economics work for Gigamon. Do you think customers might purchase software on solutions? And when compared to your existing hardware-based solution, how should we think about gross margin dollars?

Paul Hooper

So let me take that. The virtual solution, we don't break out the virtual component from the revenue booking stream. We expect it to be a year of growth, for sure, for the virtual component. It comes in, and really there's three components that make our virtual system, just to be clear, [Giorgio]. One is the VM component itself. The second is our Fabric Manager which is the device that really configures, manages and controls the multiple virtual machines. And finally and not to be under-looked, there's the termination point for all of the traffic, which is one of our appliances running our GigaVUE H-VUE software.

So there's three components that come together to form it. We believe that the VM deployments going out into the years ahead are going to become increasingly relevant. But we don't see this moving to a software-only solution anytime soon. There will certainly be more and more customers using our software elements, but they will be in conjunction with our hardware appliances and our technology to allow you to carry out some of the transformational, the modification, the inspection, the enhancement, all of that -- really silicon program, that programmability we have inside of our silicon that allows for us to be able to transform the traffic in-flight. That's an appliance-based technology. So it won't go to a software-only solution, but there could be more and more components of GigaVUE VM, the virtual machine element, that are capturing traffic and delivering it to our central appliance. That could certainly happen in years ahead.

[Giorgio Skerkopoulos] – Raymond James

Excellent. Thank you guys.

Operator

And our next question comes from the line of Ben Reitzes with Barclays.

Ben Reitzes – Barclays Capital

Thanks a lot. Wanted to ask a question about your commentary, Duston, around the first quarter. I know you were, you know, you were just saying you didn't see any reason to have normal seasonality unlike -- not to have a normal seasonality. And, you know, I was taking the midpoint of that and I got around 23% revenue growth year over year for the March quarter. And your long-term model obviously calls for 30. So I was just wondering if I should take that literally and we should model for next year. And I know you don't have guidance and whatnot, but, you know, given that comment was made, I would think that we should model 1Q the low point for growth and then have it accelerate throughout the year with thoughts behind that normal seasonality. I just wanted you to clarify if you don't mind.

Duston Williams

Yes. The comment, Ben, was specifically just to make sure that that was in front of everybody. We've been very consistent about talking about, you know, Q1 and the historical patterns of Q1. And, you know, there wasn't any other intention there. And you've got all the historical growth rates for the last three or four years, so I think you've got a pretty good history there that you could go model that.

Ben Reitzes – Barclays Capital

Okay. But is there something bigger on the macro front that would make you, you know, without necessarily guiding, it would seem to make sense that things would potentially accelerate throughout the year given your product lineup, or is there -- should I not read into that?

Duston Williams

Well, again you should into the historical facts that would suggest that, that Q1 is always our lowest quarter, and it accelerates from there.

Ben Reitzes – Barclays Capital

All right. And then with regard to the -- could you just talk a little bit more about, you know, the federal vertical and whatnot and you obviously bucked the trend there, you had a huge deal. What kind of trajectory, you know, heading into 2014 though should we expect? Is there a big fall-off, you know, as usual, and maybe more pronounced than usual given what you'd just done?

Duston Williams

Well, clearly from the 24%, absolutely. Right? It always comes down, if you look at the government vertical, it will always come down from Q4 -- from Q3. It did last year. You know, Q3 in '12 was 16%. It came down to 6%. The prior, in '11, it was 11%, came down to 7%. So, yes, you should absolutely expect that to fall off.

Ben Reitzes – Barclays Capital

Okay, great. Thanks a lot.

Operator

Thank you. And our next question comes from the line of Jason Ader with William Blair. Please go ahead.

Jason Ader – William Blair

Yes, thanks guys. Can you talk about [this option] for the HB1 appliance? I was wondering as to how that's gone in the channel and any customer win for that product? Thank you.

Paul Hooper

I certainly can, Jason. The HB1 has been up to a solid success. It's the fastest ramping product from launch in the company's history. The notes I made in my script is that over 40% of them have gone out with GigaSMART applications attached. And in many cases they've gone out with, on average, two GigaSMART applications attached to each book.

So the book seems to be absolutely hitting the sweets, but our intention was to come out with a low-cost, low configuration, low-complexity device that could be picked up by midsize enterprises or picked up by larger enterprises as a consideration for large deployments inside our distribution centers or other remote locations.

So we're seeing a good deal of traction. Going into the, you know, coming quarter, it's all in line with the guidance that Duston offered, but we're seeing we believe the HB1 is going to be a very interesting catalyst for us to be able to continue to pick up new customers but also to kind of grow into a smaller end of the market that we haven't been addressing and candidly nobody in this market address as well. So we've got a good opportunity to capture a good share in that space.

Jason Ader – William Blair

And then I -- did I miss the comment on the -- did you talk about the attach rate on the chassis for GigaSMART.

Paul Hooper

So we did actually in our Q2 earnings call, we mentioned specifically that the attach rate for GigaSMART into the H Series was 40% in that quarter. And that was nearly three quarters -- just over three quarters after launch of the chassis -- of the GigaSMART technology in that chassis. So it took three quarters to get the 40% attached in the HD that was in the Q2 period. And here we are in the Q3 period and the first quarter -- first full quarter of the HB1 being out and it's exactly the same attach rate.

Jason Ader – William Blair

Okay, thank you.

Operator

(Operator Instructions).

Our next question comes from the line of Josh Beck with Pacific Crest. Please go ahead.

Josh Beck – Pacific Crest

Hi there. Thank you. The Fortune1000 additions, I mean that was obviously very strong, I think certainly above what we had modeled. I'm just wondering, within that particular segment, was there a certain vertical that took off? Was it related to the HB1 which I know you classified as SMB, but I imagine also has a Fortune1000 type of component, just any other color you can provide, you know, I think behind that number which was ahead of our expectations?

Paul Hooper

Well, it was also -- it was good news for us, it's kind of ahead of our expectations as well, I'll be honest, Jason -- Josh. It was, you say, we picked up 19 in the Fortune1000, primarily enterprise. There was no particular vertical. As you know, we're a very horizontal company.

On the prepared remarks I mentioned that we had 90% of the HB1's that went into south of the Fortune, less -- smaller than Fortune1000. So we had approximately 10% of the HB1's go into the Fortune customers. And what we saw was a lot of one and two, one and two, rather than large purchase. There were a couple of reasonably sized purchases of nothing but HB1's, but there were -- the vast majority I would characterize as one-two, one-two, which to me bodes very well. It looks to be a kind of an evaluation unit going in to a location and a large Fortune account that could ultimately, we hope, turn into a pretty wide-scale deployment of that device.

So we're optimistic for what that represents and we're going to continue to watch closely. But the very specific answer is no, generic enterprise, no particular vertical.

Josh Beck – Pacific Crest

Okay. And then on the software attach rate, it sounds like 40%, that, you know, stood out to me as surprising in terms of how quickly you're able to ramp that up to 40%. So, any other color you could provide on why that maybe gained traction faster than the high-end chassis? And then the other question surrounding that is, what's the potential impact to deal size? I mean obviously there was a nice uptick there and greater than 100K orders. Is software a significant driver behind that? And is there any further way to kind of quantify what percentage of product the software over time? Any color there would be helpful.

Paul Hooper

So let me make sure I've got that straight. So, yes, 40% was a good attach rate straight out of the gate. We believe this is due to the fact that customers are looking to -- for more intelligent inspection and modification as close to the point of origin of traffic as possible. So rather than for example [back] all of the traffic across WAN, put it into a central data center before you start removing duplicates, or add time stamp that would be theoretically inaccurate by the time it arrives in the data center. We're looking at customers doing more of our inspection capability in and as close to the -- as close to the origination points of the traffic. Hence, that could be some of the reason for the attach. We still see dedup or deduplicate as being one of the most attractive licenses that goes -- that go out with our SMART technology. So we still think there's a good upside in what that can represent and we believe that's going to be a great, great point in the HB1 that enables customers to deduplicate traffic on that device just as effectively on some of our larger devices.

The other not to be under-looked kind of element of the HB1 is it is absolutely identical in user experience to a high-end chassis. So a customer that gets trained and educated on the HB1 can be migrated through our HD4 chassis and then onto our HD8 chassis with exactly the same user experience, just greater performance, greater scale, and greater capability in the high-end chassis.

Then your second question you asked was, is software a driver? As I said in my prepared remarks, this market is a fast-moving market and we're moving far beyond just basic tap and aggregation. This market is now moving into how you can modify, inspect and enhance traffic, and we are certainly, we believe, leading in that space. And you're going to hear from us over the coming, you know, quarter and quarters ahead, more and more focus around what you can do inside of the software inspection modification and enhancement in GigaSMART. So we are intensely focusing on this area as we believe that is where the greatest interest lies in this market going forward.

And I think -- was that the last point? Was there a final point of your question, Josh, that I've missed out here?

Josh Beck – Pacific Crest

Yes. In the tie in to the large orders, I mean is software a significant component? I know that I think it went up to 117 from, you know, I think was probably low 60s last year. So that seems like a big change. And I'm just wondering, was part of that change in large orders tied to the software attach rate you're seeing both on the low end and high-end products?

Duston Williams

Yes, probably not necessarily directly correlated to the increase and the order size.

Josh Beck – Pacific Crest

Okay. And then it sounded like there was a bit of a structural change or an emerging structural change in terms of customers' appetite to broadly deploy this without a lengthy testing period. I'm just wondering, is there any reasoning behind that? Is it because you now have such strong reference customers and case studies that they can look at and that people are just maybe less cautious and feel like they don't have to go through a long trial and there's a buying in directly? I'm just trying to understand any other color on this, what seems like a very important shift in buying patterns.

Paul Hooper

That's a great question. The -- as I said, we -- maybe this market is crossing the chasm, maybe we're starting to see the characterizations of people consider this as a has-to-have rather than a wants-to-have so to speak, in spite of their infrastructure.

It's, as we look into the quarters and years ahead, the drive for people to be able to do more with less is driving people to look to unique ways to be able to instrument their network. After that, the volume of traffic, and the need to be a different approach. And we believe we represent that different approach.

And so people are either approaching us where want to do proof of concepts of larger scale than we have to be in the past, or there can be just the reference case, the peer group pressure and, you know. So we deployed in x of y of this vertical market and they gain confidence and trust from that perspective and we become just the de facto in this space.

I'm never going to sit back on our laurels and expect that, you know, this is a market -- this market is ours, etcetera. There clearly are competitors in this market. But we do believe that there is definitely some uptake and interest in these markets, an awareness to this market, and that's driving more and more people to think about this as being a has-to-have rather than a let-me-understand-it-before-I-move-ahead. And so we see quite a few customers coming out with, as you say, larger, $100,000 orders, 117 in the quarter, is a milestone for the company. And so we continue to expect that to be the trend going forward.

Josh Beck – Pacific Crest

Okay. And then just last one for me, really a clarification on the op margins. You know, you described basically mid-teens I think for the year which is largely how it was modeled ahead of this quarter with upside. But the way that I took that is, yes, there will be probably a dip in operating margins, but don't necessarily expect a quick snapback to 23, but there's absolutely no change in the long-term target. Is that the right way to interpret the operating margin comments?

Duston Williams

There is absolutely no change to the long-term target of 23% to 28%.

Josh Beck – Pacific Crest

Okay. So it sounds like more of a you got ahead of probably your plan this quarter and so maybe a slight reversion, but no change to any of the long-term assumptions?

Duston Williams

Yes, we got ahead of our plan for this quarter, we got ahead of our plan for the year, and rather significantly on both ends there.

Josh Beck – Pacific Crest

Okay.

Duston Williams

But absolutely no change to that 23% to 28%. I mean we were there this quarter obviously, we were ahead of the plan, but we were there this quarter.

Josh Beck – Pacific Crest

Okay. Great. Thank you.

Duston Williams

Okay.

Operator

And there are no further questions at this time. I would like to turn the conference back to Cynthia Hiponia for closing remarks.

Cynthia Hiponia

Thank you everyone for joining us this afternoon and we look forward to updating you on our next call.

Operator

And ladies and gentlemen, that does conclude our conference for today. Thank you for your participation. You may now disconnect.

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