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Datalink (NASDAQ:DTLK)

Q4 2013 Earnings Call

February 20, 2014 5:00 pm ET

Executives

Paul F. Lidsky - Chief Executive Officer, President, Director and Chairman of Merger & Acquisition Committee

Gregory T. Barnum - Chief Financial Officer, Vice President of Finance and Secretary

Analysts

Chad M. Bennett - Craig-Hallum Capital Group LLC, Research Division

Glenn Hanus - Needham & Company, LLC, Research Division

Al Sullivan - Lake Street Capital Markets, LLC, Research Division

Prabhakar Gowrisankaran - Canaccord Genuity, Research Division

Alexander Renker - Sidoti & Company, LLC

Operator

Good day, ladies and gentlemen, and welcome to the 2013 Fourth Quarter and Year-End Datalink Corporation Earnings Conference Call. My name is Patrick, and I'll be your coordinator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to Mr. Paul Lidsky, President and CEO. Please proceed, sir.

Paul F. Lidsky

Thank you, operator, and good afternoon, everyone. I'd like to welcome you to today's call, and thank you for participating. With me today is Greg Barnum, our Vice President of Finance and our Chief Financial Officer. I'm going to turn the call over to Greg, so he can discuss the fourth quarter and year-end results, and then I will provide some additional perspectives on the quarter and our outlook for the first quarter of 2014.

Gregory T. Barnum

Okay. Thanks, Paul. Before we begin with the quarter's results, let me first remind everyone that in today's conference call, we will be discussing our views regarding future events and financial performance. These forward-looking statements are subject to certain risks and uncertainties. Actual future results and trends may differ materially from historical results or those anticipated, depending on a variety of factors. We undertake no obligation to publicly update any forward-looking statement, whether written or oral, that may be made from time to time, whether as a result of new information, future developments or otherwise. Please refer to our filings with the Securities and Exchange Commission for a full discussion of our company's risk factors.

Now before we get started, too, let me also remind everyone that the results for the quarter and the 12 months ended December 31, 2013, include the results of operations from the acquisition of StraTech, which was completed on October 4, 2012. The results also include the effect of the 3.8 million new shares, or approximately $0.04 and $0.05 per share for Q4 and the year, respectively, which were issued in connection with the August 2013 stock offering.

In addition, the fourth quarter and 12 months of 2013 GAAP results include a $611,000, or $0.02 per share, charge for the write-down of the account receivable from StraTech to its estimated realizable value. After the end of the quarter, we reached a settlement agreement with the former owners of StraTech. Under the terms of the agreement, the former owners agreed to release the entire 242,805 shares of Datalink common stock that were being held in escrow in exchange for a payment of $100,000 and the release of certain other claims. Based upon the value of Datalink common stock on the date of the agreements, we will recognize income before tax of approximately $877,000 in the first quarter of 2014.

So turning to the quarter then, our revenues for the quarter ended December 31, 2013, increased 18% to $173.4 million compared to $147.3 million for the prior year fourth quarter. Sequentially, revenues from Q3 to Q4 increased 24%. Revenues for the year ended December 31, 2013, increased 21% to $594.2 million compared to $491.2 million in 2012.

For the rest of my comments on the income statement, I will be referring to non-GAAP amounts and percentages as reported in today's press release. A detailed reconciliation between GAAP and non-GAAP information is contained in the tables included in today's press release, but let me remind you that the primary adjustments to GAAP results relate to acquisition accounting adjustments to deferred revenue and costs, stock-based compensation charges and the amortization of intangibles net of income tax.

So in the fourth quarter of 2013, our product revenues increased 14% to $111.6 million, and our service revenues increased 23% to $61.8 million compared to the fourth quarter of 2012. Within the service component of revenues, we saw customer support revenues increase 14% to $46.9 million, and professional service revenues increased 61% to $14.9 million.

On a sequential basis then, we saw our product revenues increase 33%. Our customer support revenues increased 3%, and our professional service revenues increased 47% over the third quarter of 2013.

For the year, our product revenues increased 17%. Our customer support revenues increased 26% and our professional services revenues increased 39%. As we have talked about in the past, this trend of professional services growing faster than product is important as services carry considerably higher gross margins than product and will help offset any decline in product margins due to changes in the competitive environment of product mix changes.

Turning to revenue mix, our revenue mix for the quarter was 36% storage, 18% networking and servers, 9% software, 1% tape and 36% service. Our overall gross margins in the fourth quarter of 2013 were 23.5%, which is up from 22.6% in the fourth quarter of last year and 21.5% in the third quarter of this year. Now let me spend a little bit of time on the increase in gross margins that we saw on the fourth quarter. As we discussed on our third quarter conference call, we saw gross margins decrease about 1.5% from levels we had been trending over the past couple of years. We also said that about half of this decrease was due to 2 large new logo acquisition transactions in the third quarter, and that we expected this portion of the decrease in margin to come back.

The other however was due to customers scrutinizing large store purchases more and a reluctance from some of our vendors to assist with additional discount, a trend which we did not expect to change in the near term. But while we continue to see this trend in the fourth quarter of 2013, we saw that our margins actually increased from 21.5% in Q3 to 23.5% in Q4. This 2% increase was primarily due to the absence of new -- of large new logo acquisition orders in the fourth quarter, and a stronger mix of storage versus networking revenues during the quarter.

In the third quarter, storage was 31% of total revenues, and networking was 20% of total revenues compared to 36% and 18% in the fourth quarter. If we had seen the same mix in the fourth quarter as we did in the third quarter, which I feel more closely reflects our split going forward, gross margins would have been approximately 22.3%.

Throughout, margins will continue to fluctuate quarter-to-quarter due to new logo acquisition orders and product mix. For 2014, we still expect our product margins to be under some pressure, which will cause them to decline from 2013 levels. As we have stated in the past, our strategy is to offset these declines in product margins by selling more services which carry higher gross margin. As a result, I would expect our combined product and services gross margins for 2014 to be in the 22% to 22.5% range.

Operating income in the fourth quarter of 2013 was $12.2 million, or 7.1% of revenue, compared to $9.4 million, or 6.4% of revenue, in the fourth quarter of last year and $4.2 million, or 3% of revenues, for the third quarter of this year. For 2013, our operating income increased 16% to $29.9 million, or 5% of revenue, compared to $25.7 million, or 5.2% last year.

Our earnings per share for the fourth quarter of 2013 was $0.34 compared to $0.31 in the fourth quarter of last year. The fourth quarter of 2013 EPS reflects the full impact of the 3.8 million shares issued in the follow-on offering in August, and the dilution from the additional shares was approximately $0.05 per share in the fourth quarter. For the year then, we reported earnings per share of $0.93 compared to $0.88 for 2012, and the impact on the follow-on offering for the whole year was approximately $0.04 per share. We ended the quarter with just over $76 million in cash and investments and no debt.

Now -- Let me now turn the call over to Paul.

Paul F. Lidsky

Thanks, Greg. And the numbers that Greg just outlined show strong sequential and year-over-year growth. Let me quickly recap the fiscal year numbers before I go on to talk about what they mean for the company and our strategy.

As Greg reported, total revenues were up 21% year-over-year. That includes increases of 17% on our product revenues, 26% in customer support revenues and 39% in professional, managed and Advanced Services. Our operating income increased 16% from $25.7 million to $29.9 million, with a slight decline in operating margins from 5.2% to 5% due to the strategic investments we are making in Advanced Services and Cisco, and we will talk about those shortly.

Non-GAAP earnings for the year were $17.9 million or, $0.93 cents per share, compared to $15.3 million, or $0.88 per share in 2012. And finally, our cash position is strong. We ended the year with just over $76 million in cash and investments and no debt. All of these numbers add up to a strong performance that is being driven by the strategic initiatives we have put in place over the last few years. These include our emphasis on newer converged data center infrastructures that allow us to sell into more complex IT environments, our partnerships with major vendors like Cisco and NetApp, our broader portfolio of products and services designed to increase customer wallet share and our ongoing expansion of higher margin professional service offerings. All of these are paying off as we build our business. You can see this in our customer numbers so let's look quickly at those before addressing each of these areas individually.

First, our base revenues from repeat customers grew 19% from $447 million in 2012 generated by 106 -- generated by 1,666 customers, to $534 million in 2013, generated from 1,786 customers. The growth is due in part to the customers we gained in the StraTech acquisition last year, and to the fact that we continue adding products and services spanning the complete IT life cycle that generate repeat sales as well as increased wallet share from each customer.

Because of the ongoing expansion of our portfolio, we also continued to see an increase in the number of customers who spend more than $1 million with us this past year. Between fiscal years 2012 and 2013, the number of million dollar customers grew 22% from 102 in 2012 to 124 in 2013, and their total spend rose from $298 million to $361 million. This again shows that we are becoming more relevant to our customers, becoming a true IT partner that supports all of their strategic and tactical data center needs, thus, increasing customer wallet share in the process.

We can see this also in our new customers as well. We generated $60 million in revenue from 440 new customers in 213 (sic)

compared to $44.6 million from 452 new customers in 2012. So while we had 3% fewer new customers, these customers spent 35% more. We think this is very relevant. Keep in mind that this represents only a 1-year spend, and that many of our projects have multiyear roadmaps where we would expect to bring in additional revenue from these same customers in the future.

One of the main drivers behind these customer trends is the converged data center infrastructure that I mentioned earlier. As many of you know, this is a growing trend that unifies network computing storage platforms to help businesses achieve greater agility and efficiency than with siloed products. It is also closely linked to trends like virtualization and private and hybrid clouds that are becoming the new normal in data centers today.

Datalink embraced the converged concept 4 years ago as part of our data center transformation strategy, and it has become the cornerstone of our business. Examples of that, in 2013, we closed 98 converged deals with $91 million, or $1 out of every $6 for this year. This compares to 83 converged sales worth $78 million in 2012. I should also point out that nearly 2/3 of our converged sales in 2013 were for NetApp's FlexPod infrastructure consisting of integrated components from NetApp, Cisco and VMware. That marked an 85% year-over-year increase in FlexPod sales, up from 33 in 2012 to 61 in 2013, and a 79% increase in FlexPod revenues, rising from $34 million to $61 million. This is very important because both NetApp and Cisco, our key strategic partners, and a lot of the revenue growth from both of them that we will discuss in a minute, comes from converged infrastructure sales.

Our 2013 converged infrastructure wins include some interesting business cases that show why this technology is strategic to our customers and, therefore, to us. For example, we have an international beverage manufacturer that's using FlexPods in every one of their breweries to support applications that control the brewing process, support automated production lines equipped with touch screen technology, enables centralized visibility and control of all locations via centralized IT organization, and at the same time reducing power and maintenance needs.

We also have a global electronic payment processor, who's using FlexPods to standardize the complex IT environment created by multiple acquisitions, lined in the managing reactive variable or cyclical user demands to their data center workloads, integrate multiple data -- remote data centers, improve disaster recovery and business continuity and enable rapid response to new business needs.

Our ability to design, deploy and support these converged systems is a real competitive advantage for Datalink, and one that will continue to be pivotal in our growth for several reasons: First, very few providers have the scope of services or the experience we offer in this area. So that positions us to take business from product-oriented competitors.

Second, converged infrastructure is directly connected to Datalink initiatives like cloud services, data center transformation and migration, and assisting IT teams in transitioning from technology provided to service brokers. For every converged system we sell, there is a potential multiplier effect from selling other consultative services. I will also let you know that according to IDC, the converged infrastructure market is growing at 40% compounded growth. That kind of demand obviously creates growth opportunities for us, and we are very well-positioned to take advantage of them.

As I indicated a few minutes ago, our growth is also being fueled by partnerships with vendors like NetApp and Cisco. Here, again, our numbers in 2013 were very strong. As an example, our year-over-year NetApp revenues climbed 22% from $148 million in 2012 to $180 million in 2013. Roughly 25% of that $180 million was from the NetApp portions of FlexPod sales with the rest of the storage systems that are still a big part of our businesses, because of the ongoing explosion in enterprise data storage.

Our year-over-year Cisco revenues increased 75% from $60 million in 2012 to $105 million in 2013. This far exceeded our $80 million Cisco sales goal, and almost all of it came from converged infrastructure sales. These examples, these numbers, show why we have put so much effort into our Cisco business despite the margin pressure it creates. With this combination of compute network, storage and virtualization components, Cisco's UCS and Nexus switch offerings are at the heart of the converged data center environment. Our growing Cisco relationship enables us to participate in the converged systems market, and this enablement is central to our growth.

Greg and I have both mentioned the 26% increase in customer support revenues and the 39% increase in professional managed and Advanced Services that we recorded between 2012, 2013. Much of our focus this year has been on expanding our Advanced Services portfolio and building out the team to deliver it, both to counterbalance the downward trends in product margins and to provide a revenue and profit stream that is not affected by product sales or fulfillment. These new services are allowing us to participate in more complex discussions with our customers and increase our relevance to them. And this increase in relevance translates into increased wallet share as we can earn more of their IT spend.

Since the average gross margin on the Advanced Services is 35% to 40%, having a strong offering in this area will have a long-term impact on our profitability as well as our revenue growth. To that end, in 2013, we made significant investments in Advanced Services that affected our operating margins in the short-term, as I mentioned earlier, that will help us create an important, high-margin, product-independent revenue stream for the future.

Specifically, we hired Steve Zipperman, formerly the Global Services Director in the EMC Consulting division, to fill the new position of General Manager of Advanced Services. We established 3 practice areas including data center transformation, cloud service management and IT resiliency. We hired an outside expert to run the cloud service management practice and promoted 2 of our internal thought leaders to head the other 2 areas.

We expanded our Advanced Services team from 30 people to 48. And finally, we hired a National Director of Sales for Advanced Services, and we are building out a specialized sales force to support our field account executives in driving both Advanced and managed services business. These actions are already beginning to bear fruit. In our last call, after the third quarter, I mentioned several Advanced Services projects that we had closed in the last 18 months.

We closed other significant Advanced Services wins in the fourth quarter of 2013. For example, we booked a $110,000 consulting engagement for an education company that needs data migration services in conjunction with a hardware purchase. We sold a $232,000 disaster recovery strategy project for a paper mill that is expected to contract for additional services work as well as significant product upgrades, and we added an $855,000 follow-on services order to an earlier $650,000 engagement with a Fortune 500 company for the second phase of a major data center relocation and corporate data migration project. Contracts like these demonstrate the market demands for a data center solutions provider who can help organizations navigate their way through today's complex data center environment and the shifting world of IT departments. Our Advanced Services portfolio will fill an important need in the market while also helping us build revenues and profitability over the long term.

And now I'd like to wrap up and talk about guidance. Looking out to the first quarter of 2014, we expect reported revenues of $152 million to $162 million for the upcoming quarter. This represents a 14% to 21% increase over revenues of $133.6 million in the first quarter of 2013. We expect first quarter 2014 net earnings to be between $0.08 and $0.13 per share on a GAAP basis, and between $0.14 and $0.19 per share on a non-GAAP basis. This compares to net earnings of $0.06 per share and $0.18 per share on a GAAP and non-GAAP basis, respectively, for the same period in 2013. These forecasts are based on our current backlog entering Q1, our sales pipeline, our current customer spending patterns, and it incorporates the lower gross margins that Greg talked about at the end of the third quarter and earlier in this call today.

With that, I'd like to turn the call back over to the operator so that we can take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Chad Bennett with Craig-Hallum.

Chad M. Bennett - Craig-Hallum Capital Group LLC, Research Division

I guess, a couple of things. First, on the service business, which has been growing pretty strongly here for a couple of years now, a couple of questions. First, is there a target, looking this year, in terms of exiting the year of where you want that business as a percentage of revenue, and if that target's changed at all? And then secondly, on new procurements from customers, or new deals from customers, can you give us an idea of what your attach rate of services has grown to or been looking out the past couple of years to today?

Gregory T. Barnum

I'll get -- the first part of your question, Chad, is our professional services run about 7% of revenue. This year, it was a little bit more than that. But yes, our goal is to increase that. By the time we get to the -- in the billion dollar neighborhood, we'd want that to be 13% to 15% of total revenue to be the goal. So if you are talking about this year, 2014, we'd like to see that number to be more like 8-plus percent of our total revenues, 8% to 9% range. And the second -- does that answer that one?

Chad M. Bennett - Craig-Hallum Capital Group LLC, Research Division

Yes. And then the catch rates of services on new deals?

Gregory T. Barnum

Well if you're talking customer support, it's 100%. No one buys a product without a maintenance contract, generally speaking. You're talking -- so but if you're talking about our pure consulting, that's not attached to product, usually. That's ahead of the product purchase. Is that what you're asking?

Chad M. Bennett - Craig-Hallum Capital Group LLC, Research Division

Yes. And then if I could...

Paul F. Lidsky

Yes, Chad, the Advanced Services, the reason -- one of the reasons it's so exciting for us is it's product independent, and so it either occurs ahead of a product cycle or it actually pulls through a product cycle, but we can engage customers in Advanced Services. For instance, we can help them to design a cloud environment that they can run in their own data centers totally independently of the infrastructure they will ultimately need to do that.

Chad M. Bennett - Craig-Hallum Capital Group LLC, Research Division

Got it. Makes sense. And then next question for me, probably for Paul. Considering you get a healthy amount of your business from existing customers every year, where do you think we are in the whole wallet-share strategy that you guys have been focused on the last few years? Can you give us some perspective of how much runway you have left there?

Paul F. Lidsky

Sure. It's an ebb and flow kind of number because obviously, the budgets of IT organizations change with every year. But I would say that generally, if I were to blend across all of our customers, I think that we're somewhere in the 20% to 30% of available wallet share for what we do as a company. Obviously, there is IT spend that goes for things that we don't do. But I think we have quite a bit of runway left both in the customers where we're already experiencing a broadening of our portfolio and in the customers that we are just starting down that journey.

Chad M. Bennett - Craig-Hallum Capital Group LLC, Research Division

Got it. Last one for me, probably for Greg. Greg, how should we think about operating margin expansion this year?

Gregory T. Barnum

Well, we ended the year, the non-GAAP on a 5%. So we're planning on it trending upward as we grow the revenue and we're -- we still feel that at $1 billion, it could be an 8%-type operating margin business. So it should -- we've made our investments now, and we don't expect it to go backwards like it did the last 2 years. We expect now that the investments are made, we'll start to improve the operating margin going forward.

Operator

Your next question comes from the line of Glenn Hanus with Needham.

Glenn Hanus - Needham & Company, LLC, Research Division

Maybe, could you just spend a minute on product gross margins? Some of the issues from the third quarter, with vendors putting a little more pressure on channel partners, could you address what you've seen over the last quarter and a little more on how you're thinking about that going forward?

Gregory T. Barnum

We saw -- I would say, it did not get any worse. It did not deteriorate, we've got our message across our major partners. And they're all working on a solution for that, for us. I think a lot of times those solutions happen in the start of their new year as opposed to in the middle of the quarter or the middle of the year from them. So I guess, I would summarize it as we have not seen it deteriorate, and I think we've made good progress in improving it, but it'll take another couple of quarters to get those programs in place.

Paul F. Lidsky

And Glenn, this is Paul. I think that the major of the volatility, as Greg said earlier in his prepared remarks, really comes from product mix, and, as he said, we really want to be 20% networking and servers. And some day that may go to 25%, but as I demonstrated, that's a very important part of the overall growth of the company. And the relevance we have to the data centers we serve. And at the same time, in a quarter, as we had in the third quarter, but in a quarter where we have new logo acquisition in the multimillion dollar-size range, and we are certainly going to look at those as they become available to us. In a quarter where there's a higher concentration, that will create a shorter-term volatility. But as we saw this year, as we saw with the fourth quarter numbers, one quarter's volatility can be counterbalanced by the next quarter. And so overall, I think the margin guidance that Greg gave in his remarks is very correct.

Glenn Hanus - Needham & Company, LLC, Research Division

Okay. Good. Could you talk about -- I mean, you have a lot of company-specific things you're doing that are yielding these positive results. Can you talk a little bit about sales cycles you're seeing? I mean, certainly NetApp continued to see some extended sales cycles, and others have talked about customers sweating assets a little bit more. What trends are you seeing in your customer base out there?

Paul F. Lidsky

I think -- we've seen a couple of things. We've had a number of customers this quarter who have indicated to us that they're going to increase the original intended spend for the quarter, which, I think, is good news. But -- and built in to our forecast, our guidance, is the consideration for customers being a little bit more introspective about their sales. But we have not seen a significant delay in the final components of a sales cycle. In other words, from the time that the customer decides they're going to make a purchase, we have not seen elongated time frames between that and the time that they actually signed the PL. So and when customers are introspective or spend a little bit more time on their considerations that, oftentimes, gets absorbed inside the sales cycle. I think the risk that some of our manufacturing partners talk about really exhibits itself once the customer's made a decision but not given you a PL. And as of yet, we have not seen that type of elongated cycle. But we have seen some very interesting behavior where customers are looking to maybe make a little bit larger investment.

Glenn Hanus - Needham & Company, LLC, Research Division

Okay. And last question. I don't know if you want to maybe give some color about your expectations for 2014 growth, revenue growth overall. You've made some comments in the past and -- do you see it about where we left off from last quarter or a little stronger or perhaps a little weaker?

Gregory T. Barnum

I think -- I don't think we've -- anything that would make us change and we've always said we could grow 2 to 3x the industry, and the first quarter guidance is for that 15%, 16% in the midpoint-type revenue growth and that would all be organic. So I don't know if I would go out on a limb and say that's going to be the growth for the whole year on an organic basis, but we're not coming off the kind of growth we've seen over the last couple of years. No. We're not reducing there.

Operator

Your next question comes from the line of Eric Martinuzzi with Lake Street Capital Markets.

Al Sullivan - Lake Street Capital Markets, LLC, Research Division

This is Al Sullivan, on for Eric. Okay. I think we've touched on some of this, but I just wanted to clarify one little point, just about the revenue mix. I know that we've shifted the storage and networking mix from the third quarter, the storage, I think, was high 30%, 36% is that what you said, and networking more around 18%, and that, that was representative of the targets that you guys have set out. Should we really be thinking about a high 30s percent storage mix?

Gregory T. Barnum

Well what I meant to say was Q3. I thought I said that. Q3 is more representative, where networking's more like 20% of our revenue. What we saw in the fourth quarter, I think, that is quite common in a way. Most of budget flush you see pertains to storage more, because if you have some money to spend, it's easier to spend it on a storage purchase than it is on servers and networking. So I think the 18 -- networking being 18% of revenue in the fourth quarter is not our typical model going forward. That makes sense?

Al Sullivan - Lake Street Capital Markets, LLC, Research Division

Yes, yes. Perfect. And I may have misheard you. I'm sorry about that. We just talked about NetApp, and sort of them speaking about the slower decisions and elongated sales cycles. Sounds like that may be being offset by this opportunity in converged infrastructure, and I'm wondering if you might offer any more color on sort of framing our thinking around that opportunity?

Paul F. Lidsky

Sure. This is Paul. First of all, I think, when our manufacturing partners guide on their conference calls, they take into account, obviously, all the sectors of their business, whether it be Federal, whether it be Asia-Pac, whether it be EMEA, developing countries. I mean, there's -- there are all kinds of pressure points for our manufacturers that they have to deal with. The only pressure point we have to deal with is commercial sales in the United States. And so that is sometimes the biggest reason that our numbers don't reflect the overall guidance or points of view of our manufacturers. That's #1. I think #2, converged infrastructure has been a high-growth area for NetApp as has clustered ONTAP, both of which have been extremely successful for us since they -- since both of them were introduced to the market, and create a lot of differentiation for us and pull through a lot of services. So we're able to use converged infrastructure to have a different conversation. Then we're not talking storage, we're talking used cases, we're talking business decisions, and that's allowed us to carry our conversation to a higher level of relevance, which has allowed us to grow the company. And I do think that, that changes our growth trajectory in each of the quarters where that takes place because we get to participate in more of the spend. And again, commercial, United States, enterprise sector, in terms of the type of customers we deal with, are very interested in converged architectures of many kinds. And so it's easy to get the meeting, there are used cases we can attack that you could not attack if you were just talking storage. You really need to have the combination of storage with Cisco, with virtualization, to have a discussion about a particular use case like the couple that I exampled, and that allows us to continue to grow even if the sector by itself, say storage, is not growing as quickly. So we're leveraging different points. Does that make sense?

Al Sullivan - Lake Street Capital Markets, LLC, Research Division

Yes, that makes sense.

Operator

Your next question comes from the line of Prab Gowrisankaran with Canaccord.

Prabhakar Gowrisankaran - Canaccord Genuity, Research Division

Just a quick question, one, on the new Advanced Services, you've talked about a 15% of revenue target longer-term, like $1 billion revenue level. Maybe you could talk through what you think and what are the new services that are a key terms of the sequence of what will get you there?

Gregory T. Barnum

I'll let Paul talk about the services, but it's not -- let me say, 15% is not just Advanced Services. It includes all our services, which would be managed service, field service, which includes installation of product. But it's stuff that we touch. So we don't expect the Advanced Services to be 15%. It’s the grouping of all those to be 15%.

Prabhakar Gowrisankaran - Canaccord Genuity, Research Division

Okay, all the professional services.

Gregory T. Barnum

All of them.

Paul F. Lidsky

Yes, because they blend together so much. For example, and I can kind of combine an answer that covers both of your questions. But when you look at data center transformation, these are the 3 practices of data center transformation: cloud services, management and IT resiliency. Our national practice is that we can apply to any customer in the United States that we do business with or that we want to do business with. But when it comes to, for instance data center transformation, one of the big practices within that is data and application migration. So for customers who are changing different storage and computer arrays, we can provide them with a consultative services that allows us to help them to migrate all of their data and applications. Now when we do that, Advanced Services is designing that roadmap, they're project-managing it, they're doing a lot of the application and data dependency mapping, but our field services engineers, our field engineers are very much involved in many aspects of that as well. So we go to the customer as a combined team of consultants and experts, even though part of the group comes from Advanced Services and part comes from field engineering. And we blend that into a work team that you -- where you can't tell the difference. And so when we think about that 15%, we're always going to think about what our field engineering team is doing in conjunction with our Advanced Services team, and then managed services is really a process sale. It's about solving for our customer's problem, and both of those groups work together to do that, so which is why we combine them. And I think over the course of the next years, that blend will become just a common occurrence in much of what we do. But -- and the same way would go for an example of a data center relocation, where Advanced Services has the project management design components of that, but our field engineering team is integral to moving infrastructure and putting it back together, getting the customer back up. So that's how we see that going forward. Does that make sense?

Prabhakar Gowrisankaran - Canaccord Genuity, Research Division

Yes, it's very helpful. Then in terms of the services gross margin, right, you talked about fiscal '14 being -- blended margin being 22% to 22.5% as the mix goes back to Q3 levels. But in terms of services, at the current 24% level, as your Advanced Services increases, do you expect it to trend up, as you talked about a 35% to 40% margin, where do you see that trend Like how should we be thinking about services gross margins?

Gregory T. Barnum

Total services, when you take customers for professional services. Customer support part won't trend -- will trend up slightly but not much, but we expect the professional services, which is at 29.5% to start trending up to 35% over the next year or 2. So the overall result is professional -- total services, which runs about 24.1% in the fourth quarter, it was 23.9% in the third quarter, we expect that number to trend up each quarter. Professional services will [indiscernible] I'm sorry, go ahead?

Prabhakar Gowrisankaran - Canaccord Genuity, Research Division

So do you expect the services uptick in margins to be offset with some product margin erosion that happens every year? Is that how you're thinking about it?

Gregory T. Barnum

Right. Yes. It'll take time. We had to -- we saw a 1% -- basically, a 1% drop in product margins in Q3. So since product is still 60% of our total revenue, it's going to take time to recover from that 1%. So it won't happen in a year, but we think we can grow the services business and margins to gain back that 1% of what we lost and anything else we would lose over the course of 2, 3 years, let's say.

Paul F. Lidsky

And then -- and also remember, that all of the Advanced Services and much of the field engineering that blends with that in these projects is all incremental business to the company. We could not have addressed anything along the lines that I described had we not invested and built our Advanced Services team. So as that business grows, that's all incremental and something that we're going to want to watch and share with you in the way of progress that's very important to the long-term growth of the company.

Operator

Your next question comes from the line of Alexander Renker with Sidoti & Company.

Alexander Renker - Sidoti & Company, LLC

So I just want to get clear on the terminology here. Professional services are product-independent services?

Gregory T. Barnum

No. Professional services include -- about the 3 major components, okay? The Advanced Services, which is product independent as you said, okay? managed services, which, in a way is product independent but we're managing a data center like backup or monitoring the networks for a customer we'd most likely sold product to at one -- at some time or another, right? And then the biggest part of it still, today, is our engineers going out and installing product that we sold, which is, obviously, product dependent, okay? So those 3 things, okay.

Alexander Renker - Sidoti & Company, LLC

Okay. And that engineering component is distinct from ongoing support contracts?

Gregory T. Barnum

Yes.

Alexander Renker - Sidoti & Company, LLC

That's the upfront installation.

Gregory T. Barnum

Yes, and there's some design -- yes, an upfront design, too, sometimes we get paid for, yes.

Paul F. Lidsky

So as Advanced Services scales up, its growth rate is not dependent on product growth rate because they're product independent, whereas field engineering is somewhat dependent on product because they're doing the installations and design work around product, and managed services is designed to be sold to our installed base. So while it's not directly related to a product sale, it is related to the customers we have today.

Alexander Renker - Sidoti & Company, LLC

Okay. That's helpful. And then did you guys mention a target, a long-term target for Advanced Services in the mix on a percentage basis?

Paul F. Lidsky

Oh, in the 13% to 15% from -- over time?

Alexander Renker - Sidoti & Company, LLC

Yes.

Paul F. Lidsky

No, we didn't. My opinion -- this is Paul, I think as we head towards the $1 billion, and as Greg said, the Advanced Services combined with the field engineering and managed services will be about 13% to 15%, I think the reason that we don't have a hard number coded for Advanced Services is that today, we have 3 national practices with multiple offerings. I'm quite sure, by the time we get to $1 billion as a company, there'll be more than that. I think that the landscape in IT is changing, and what we see as a morphing of Advanced Services and field engineering to meet that next-generation set of needs. So for now, today, as we look towards that $1 billion, we have been more focused on what we believe will be the combined numbers. But I don't think we have the visibility to be able to pick it apart completely in the last years of that journey.

Alexander Renker - Sidoti & Company, LLC

Okay. Understood. And who are the -- what's the competitive landscape like there? I mean, who -- what kind of firms are you competing with for those, let's just say Advanced Services?

Paul F. Lidsky

Advanced Services? That's a great question. Well, the -- I would say that our primary competitors today, certainly for the data center transformation components, are the manufacturers themselves. And we have done very good job of competing against them in some of these larger wins, if for no other reason than we have an independence about us that the manufacturers don't have with their consulting. And our company touches so much more of the data center infrastructure than any one manufacturer does, right? So our approach with data center relocation is not going to just include the storage, even though we may be competing with a storage consulting arm, but it includes every aspect of the production system. So it gives us a competitive differentiation against the manufacturers, and there are a number also of smaller consulting companies that have different specialties. And again, our competitive differentiation there is that we have a broad data center specialty, not a niche specialty, and we can do more for our customers. And when you talk to customers who are, for instance, moving a data center or designing a cloud that they can operate for themselves, they're looking for a complete package of design and project management and implementation and ongoing consultative help. They really don't want to string together a group of different niche players who do components of that in the services. So by creating the set of national practices that we have, we're able to really have a complete conversation around data centers, which really kind of separates the conversation. And that's how we go to market.

Alexander Renker - Sidoti & Company, LLC

Okay. Understood. Yes, so it's more an integrated approach?

Paul F. Lidsky

Yes, which our customers are resonating with.

Operator

Ladies and gentlemen, this concludes our question-and-answer session. I would now like to turn the call back over to Mr. Paul Lidsky for closing remarks.

Paul F. Lidsky

Thank you, operator. Let me just thank all of you for joining us today. We always enjoy getting the chance to speak with you. As we travel through the course of this year, we will certainly work hard to keep you updated on these new trends in our business, how we're reacting to them, the growth of our new services initiatives and our strong partners and you could be assured that we'll continue to track that for you throughout the year. With that, I'd like to say good afternoon, and thank you for joining us.

Operator

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.

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