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Executives

Tonya Chin

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

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

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

Analysts

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

Kent Schofield - Goldman Sachs Group Inc., Research Division

Benjamin A. Reitzes - Barclays Capital, Research Division

Troy D. Jensen - Piper Jaffray Companies, Research Division

Ameet Prabhu - RBC Capital Markets, LLC, Research Division

Brent A. Bracelin - Pacific Crest Securities, Inc., Research Division

Erik Suppiger - JMP Securities LLC, Research Division

Tavis C. McCourt - Raymond James & Associates, Inc., Research Division

Ashwin Kesireddy - JP Morgan Chase & Co, Research Division

Timothy Long - BMO Capital Markets U.S.

Kip Clifton - Deutsche Bank AG, Research Division

George M. Iwanyc - Oppenheimer & Co. Inc., Research Division

Aruba Networks (ARUN) Q2 2014 Earnings Call February 20, 2014 4:30 PM ET

Operator

Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Aruba Networks Q2 Fiscal 2014 Earnings Conference Call. [Operator Instructions] I will now turn the call over to Senior Director of Investor Relations, Tonya Chin. You may begin your conference.

Tonya Chin

Good afternoon, and thank you for joining us on today's conference call to discuss Aruba Network's second quarter of fiscal year 2014 results. This call is also being broadcast live over the web and can be accessed in the Investor Relations section of the Aruba website. With me on today's call are Dominic Orr, Aruba's President and Chief Executive Officer; Keerti Melkote, Aruba's Co-Founder and Chief Technology Officer; and Mike Galvin, Aruba's Chief Financial Officer.

After the market close today, Aruba Networks issued a press release announcing the financial results of its second quarter of fiscal 2014. If you'd like a copy of the release, you can access it in the News Releases section of the company's website.

I'd like to remind you that during today's call, management will make forward-looking statements within the meaning of the Safe Harbor provision of Federal Securities Laws regarding our business and financial outlook, including the anticipated benefit of our .11ac and cloud offering, expected operating results for our third quarter and fiscal 2014, as well as our anticipated growth rate and sales leverage. These forward-looking statements involve a number of risks and uncertainties, some of which are beyond our control, which could cause actual results to differ materially from those anticipated by these statements. These forward-looking statements apply as of today and you should not rely on them as representing our views in the future. We undertake no obligation to update these statements after this call. For a more detailed description of these risks and uncertainties, please refer to our most recent report on Form 10-K filed with the SEC on September 24, 2013, as well as our most recent Form 10-Q filed with the SEC on December 5, 2013, in addition to our earnings release posted a few minutes ago on our website.

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

Lastly, I'd like to announce our planned attendance at the following conferences: first, the JMP Securities Technology Conference in San Francisco on March 3; second, the Morgan Stanley Technology, Media and Telecom Conference in San Francisco on March 5; third, Pacific Crest Technology Investor Forum in Boston on April 2; and fourth, the Wells Fargo 4th Annual Transformation Summit in San Francisco, also on April 2. We hope to see you there.

Now I'd like to introduce Dominic Orr, President and CEO of Aruba. Dominic?

Dominic P. Orr

Thank you, Tonya. Good afternoon, and thank you joining us to review our fiscal Q2 results. I'm pleased to report that we delivered another record quarter. In addition to the revenue and EPS exceeding our guided ranges, operating performance in nearly every area of the business exceeded our expectations.

Total revenue grew to a record $176.4 million, above our guidance range and up 14% year-over-year. 6 months ago, we shared with you our plan to reaccelarate [ph] our year-over-year revenue growth back on to the path to 20-plus percent sometime in the second half of fiscal 2014. This plan is based on the strength of our product portfolio together with a significant increase in our sales and channel capacity.

I'm very pleased with our team's execution on this plan and believes that the benefits of these initiatives speak for themselves. The bookings momentum we saw in Q1 continue into Q2, with notable strength in North America and EMEA. In fact, our EMEA region had its third straight quarter that outperformed our overall growth. This strength was partially offset by 2 factors: first, a slowdown in the order flow in our U.S. federal business, which we had factored into our Q2 guidance; and second, the year-over-year decline in our Asia Pacific theater. We're seeing good growth across many areas of our business. We continue to do well in our core verticals, and I'm especially pleased to see our strong penetration into the general enterprise in Q2.

The next-generation mobile workplace requires Wi-Fi that is faster and more reliable. Aruba's 11ac wireless LAN uses purpose-built hardware and software technology to maximize performance on all the devices used by today's mobile workforce. Demand for our 11ac flagship products continue to grow in Q2, making them the fastest ramping access point in Aruba's history. By using our ClientMatch technology to prioritize time-critical, unified communications traffic, our 11ac solution delivers nearly 3x faster speed than 11n technology and significantly outperforms competitive solutions in the market.

Our ClearPass solution provides an innovative approach to address enterprise BYOD phenomenon, which represents one of IT's most challenging issues. Demand for our ClearPass solution continue to show strong momentum in Q2, with bookings growing in the high double digit year-over-year. In Q2, we won 2 new Fortune 100 ClearPass deals, further demonstrating its penetration into the large enterprise. Additionally, we were pleased to be classified as the leader in Gartner's Network Access Control Magic Quadrant, in only our second year of consideration for the category.

We also had another record quarter with Aruba Instant product line which grew well over 100% year-over-year. Instant continues to gain traction in the disputed enterprise. Strong demand for Instant was a key factor in Aruba being named CDW's Partner of the Year in December. We have expanded our share with CDW significantly in recent quarters, and we were pleased with this recognition.

Our public-facing enterprise solutions also continue to garner strong interest. We entered into a number of new engagements for this solution in the quarter, including wins with one of the top global commercial

property development companies and the world's largest airport terminal. To support this new area of business, we are putting significant resources into the development of our location-based Meridian solution. This exciting new market allows us to expand our discussions with customers outside our IT office, giving us access to budgets beyond that of the CIO and into the deeper pockets of the marketing and sales organization.

Our MOVE architecture is differentiator for us, playing a key role in enabling us to win a record number of new customers in Q2. This customer engagement includes a Fortune 500 supplier to the aerospace and defense industry that deployed the full suite of products; a Fortune 100 producer of soft drinks and snacks that deployed ClearPass to manage the wired and wireless infrastructure from our largest competitor; a big time university in the Midwest had selected Aruba for an extensive 11ac upgrade; a Fortune 500 provider of IT services and solutions that selected our 11ac products AirWave and ClearPass for their locations worldwide; one of the world's largest IT consulting companies that selected Aruba as its wireless LAN solution for over 250 of its offices worldwide; and finally, one of the largest arts and crafts specialty retailers in North America that is deploying our entire MOVE solution, including ClearPass, in over 1,000 of its stores.

Aruba unifies access management network infrastructure and mobility application into one cohesive solution that strengthens security and simplifies BYOD initiatives. Our offerings has evolved over time and so have the needs of our customers. Recently, we are seeing mobility solutions becoming a more integral aspect of corporate culture. To further promote this discussion in the market, we recently launched our Generation Mobile, or GenMobile, marketing campaign. This campaign sends us a lot of reports we commission that study the habits of a new generation of employees that are demanding change from the traditional workplace. GenMobile employees typically own 3 or more mobile devices and work more productively by being able to work anywhere, anytime. We believe that helping our customers understand and cater to the needs of this growing workforce, enables both a more productive staff and a competitive employment position for forward-thinking companies.

In Q2, we continued to execute extremely well against our sales hiring and enablement plans, and are beginning to see the productivity ramp. Our commitment to innovation enable us to extend our leadership in the industry. With an outstanding platform and expanding addressable market and strong execution on our operating plan, I am optimistic about the momentum of our business going forward.

With that, I will turn the call over to Mike for a detailed discussion of our financial results.

Michael M. Galvin

Thank you, Dom. In Q2 2014, total revenue was $176.4 million, representing an increase of 10% sequentially and 14% year-over-year. Product revenue of $141.8 million increased 8% both sequentially and year-over-year. Professional services and support revenue of $34.6 million grew 15% sequentially and 41% year-over-year. In the quarter, we had a $2 million professional services engagement for implementation of a large public-facing enterprise customer. While we are developing a professional services practice for our software platform, this was a unique transaction in size and structure, and will not be a recurring revenue moving forward.

U.S. revenue grew 5% sequentially and 21% year-over-year, representing 65% of total Q2 revenue. EMEA revenue increased 30% sequentially and 18% year-over-year, representing 19% of total revenue. Asia Pacific grew 6% sequentially and it declined 13% year-over-year, representing 14% of total revenue. The EMEA theater continue to show strength as it has the last several quarters. Asia Pacific, while not performing well against 1 year ago comparisons, posted its second straight quarter of solid sequential growth. The weaker economic and service provider conditions in Asia Pacific that we have previously discussed continued in the quarter.

Total non-GAAP gross margin was 72.2% in Q2 compared with 72.5% in Q1 '14 and 73.4% in Q2 '13, and within our targeted range. Q2 non-GAAP product gross margin was 71% -- 71.6% compared with the same 71.6% in the prior quarter and 73% a year ago.

Q2 non-GAAP services gross margin was 74.8% compared with 76.3% in the prior quarter and 75.4% in the same period a year ago. As I mentioned earlier, we had a $2 million professional services engagement in the quarter, which carries lower gross margins than our traditional support business. Going forward, we expect our services gross margins to be within recent historical ranges.

Looking forward, we expect total gross margin to continue to be within our near-term target range of 71% to 73%. Q2 non-GAAP research and development expense was $29.9 million. As a percentage of revenue, R&D decreased to 17% compared with 17.5% in the prior quarter and 15.7% a year ago. Non-GAAP sales and marketing expense was $57.9 million in Q2. As a percentage of revenue, sales and marketing expense was 32.9%, up from 32.4% in the prior quarter. This growth reflects the full impact of our Q1 sales hiring and the incremental impact of our Q2 hiring.

In Q3, we will continue to absorb the expense impact of our investments and we expect sales expense as a percentage of revenue to begin to improve in Q4 of this year. Non-GAAP G&A expense was $10 million in Q2, down from $10.3 million in Q1 '14. As a percentage of revenue, G&A expense in Q2 was 5.7% compared to 6.4% in Q1 '14.

Total headcount at end of January was 1,687 compared to 1,567 at the end of Q1, an increase of 120 heads. Like in Q1, a substantive portion of our Q2 new hires was in our sales organization to support our growth initiative.

In total, Q2 non-GAAP operating expenses were $97.9 million, or 55.6% of revenue, down from 56.3% of revenue in Q1 '14. Our non-GAAP operating profit in Q2 '14 was $29.4 million, or 16.7% of revenue, compared with 16.2% in Q1 '14 and 22.3% in Q2 '13. We expect operating margins to continue to improve from current levels in the second half of our fiscal year.

Our non-GAAP tax rate for the quarter was 27.8%. We expect our full year 2014 non-GAAP tax rate to be in the range of 28% to 30%. As a reminder, our overall tax rate is subject to change, including the projected geographic mix of the company's revenue, as well as changes resulting from any new U.S. or international regulations or interpretations.

Non-GAAP net income for the quarter was $21.4 million, or $0.18 per diluted share, above our guidance range. This compares to $18.9 million, or $0.16 per diluted share in Q1 '14 and $27.3 million, or $0.22 per diluted share, in Q2 '13.

On a GAAP basis, our net loss was $10.7 million, or $0.10 per share, compared with a Q1 '14 net loss of $7.8 million, or $0.07 per share, and Q2 '13 net income of $5 million or $0.04 per share. A reconciliation of both GAAP and non-GAAP information is contained in our press release issued this afternoon and also available in the supplemental financial information located on the front page of our IR website.

Now let me turn to the balance sheet. Cash and short-term investments at the end of January were $278.3 million, a decrease of $46.7 million from the prior quarter. Cash flow from operations was a very strong $33.4 million during the quarter. Once again, we were active in our stock buyback program during the quarter, purchasing 4.7 million shares at a purchase price of $80 million. The weighted average shares outstanding impact of the buyback on the quarter's diluted share count was approximately 2.5 million shares. Our repurchases in the quarter completed the third $100 million installment of our $300 million repurchase plan. As you may have seen today, we announced a further $200 million expansion of the repurchase plan. We will continue to evaluate our capital structure and cash needs and repurchase our stock when those variables are aligned. We ended Q2 with $82.2 million of accounts receivable, an increase of $13.9 million from Q1 '14. Days sales outstanding were a strong 42 days, compared with 38 days in Q1 '14 and 41 days in Q2 of '13. Our target range for DSO remains 45 to 55 days.

Total deferred revenue of $175.4 million increased 12% from Q1 '14 and was up 48% from Q2 '13. Short-term deferred revenue of $133 million increased 13% sequentially and also 48% year-over-year. Our deferred revenue balances primarily consist of inventory stocking orders from our value-added distributors, annual maintenance contracts from our customers and transactions which have certain acceptance or deployment provisions and will be recognized as revenue in the future.

In Q2 that we just finished, the primary factor in the deferred revenue build was inventory stocking orders from our distributors. Aruba's inventory totaled $37.4 million at the end of Q2, an increase of $3 million from the end of Q1.

Moving on to guidance. We are pleased by our continued execution in Q2, both financially and operationally. In Q3, we expect revenue to be in the range of $178 million to $182 million, an increase of 1% to 3% sequentially and 21% to 24% year-over-year. Estimating 115 million shares on a diluted basis, we expect non-GAAP EPS to be approximately $0.19 to $0.20 per share.

Before I turn the call over to the operator for questions, Tonya wanted me to take this opportunity to remind you about Aruba's Investor Day at our Atmosphere event on March 12 in Las Vegas. This year's event marks the first time that we have held our Investor Day in conjunction with our user and partner conferences, and it looks to be a large and exciting event. We hope you can join us.

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

Question-and-Answer Session

Operator

[Operator Instructions] Your first question is from Jess Lubert with Wells Fargo.

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

2 questions. First, based on your results and those from your largest competitor, it looks like you once again gained a quite a bit of share. So, I guess I was hoping you could help us understand some of the specifics that are enabling you to win versus them? And as their full suite of 802.11ac solutions that we filter into the market, how are you expecting the competitive dynamics to change? And do you think you can continue to win at the current rates?

Dominic P. Orr

Yes. Our -- we are pleased with the market position we have shown in the last quarter. Basically, there are multiple advantage that we have. Starting with the 11ac platform that are not just 11ac access point, but it's highly differentiated with our ClientMatch technology at the system level, coupled with lots of software features in Layer 4-7 area that highly differentiate the traffic from the air that further gives all wireless uploads a high quality of service. And that is something that cannot be overcome just by our competitors introducing 11ac access point of various kinds. So this is a system level advantage. Second is a lot of this 11ac environment is coupled with strong BYOD management needs. And our ClearPass clearly has shown -- is highly, highly differentiated against our competition that the 2 coupled together plus our AirWave 7.7 given the visibility and the capacity planning capability is really the combination that give us the advantage. And then on top of that, our Aruba Instant, as I stated, has outgrown the Meraki solution despite traffic expansion of the sales force. So, we are very confident both in the high end and, in this year, we have very defensible weapons.

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

Okay. And then the second one for me, it seems like you've got very strong business momentum here, yet you're guiding for a much smaller sequential increase than we've seen the last several quarters. So, I was just curious to understand to what degree you're baking in conservatism in here, what your expectations are from a seasonality perspective with respect to the April quarter, and how come you're not guiding for a bigger sequential uptick in the April period?

Dominic P. Orr

I'll let Mike answer that one.

Michael M. Galvin

Yes. I think, Jess -- yes, a couple of things on the guidance. Obviously, Q2 was a strong result. The dollar increase of our guidance, if you look at it in dollar terms, is a very solid guide. The way we're looking at it, Q2 was strong. Q2 did have a -- we had a very good December, a calendar year-end budget flush, if you will, from the customers. That definitely helped the quarter, and so, we're trying to be a little bit prudent as we look out to Q3. Our fed business, as we mentioned, did soften up in the quarter a little bit, and so we're factoring a little bit of that in. But those things aside, the year-on-year growth is 21% to 24%, and frankly, we feel very good about that. And we think that the numbers we put out there are prudent ones, but ones we feel good about.

Dominic P. Orr

And it is a guidance we believe will lead us to solid gains of market share.

Operator

Your next question is from Kent Schofield with Goldman Sachs.

Kent Schofield - Goldman Sachs Group Inc., Research Division

You mentioned 2 wins with Fortune 500 customers. Whether it's those customers that are on the ClearPass side of things, whether it's those customers in particular or just some of the larger wins that you've had, how much are they building out ClearPass early on? What's kind of the ultimate opportunity? And what are some of the kind of key differentiators against your big competitor or any other competitor that you're running into that you think is helping to drive the growth there?

Dominic P. Orr

So first of all, I like to point out that both of the Fortune 100 competitive win was a deinstallation of our competitor's product after they had tried out and it showed that it cannot be implemented at such large scale. And in both situations, we feel very hopeful that it will lead to further business beyond ClearPass.

Keerti Melkote

And in terms of competitive differentiators, in addition to the scale that Dom talked about, stability at scale is the keyword there, and as we see, BYOD adoption occurred as a lot more devices that are coming into the environment in these Fortune 500 companies. And to handle that scale, you need the platform to be stable across the range and we believe we clearly have an advantage there. And then, in addition to that, we have a feature differentiation, which is significant as well in the area of simplification of BYOD onboarding or in the area of guest access, which continue to be important differentiators for us.

Dominic P. Orr

I'd like to highlight also one thing about our largest competitor is -- compared to them, Aruba really has only one architecture. The Aruba Instant architecture is really a derivative of the control base architecture. And in fact, we have the HybridControl model to link the 2 together. So, this is a continuous spectrum of solution that can scale from very small highly-distributed to very highly-centralized large canvas environment, single architecture supporting 11n, 11ac. As compared to our competitor who basically have 4 different solutions sets that are architecturally incompatible, some of them takes multiple quarters to work together and some of them will never work together.

Kent Schofield - Goldman Sachs Group Inc., Research Division

Okay. And then, maybe on the expense side of things, Mike, you mentioned that you made the big sales headcount push. You talked about some absorption of that. Are you going to continue to hire aggressively there, or is it kind of a onetime slug, and now we can look at some absorption and some return on that over the next couple of quarters?

Michael M. Galvin

Yes. The first half was definitely a significant investment. Important to know, we are -- it's not a -- we're going to keep investing in sales and the rest of the organization, albeit that the first half was a significant jump in that. But as we've talked about, we've delivered leverage, if you will, and operating margin the last 2 quarters, and we'll continue to do that and believe the leverage is absolutely in the model. But we will also say that the productivity and the output of who we brought on so far is mapping to what we wanted and maybe even doing a little bit better. So, the ROI on that investment so far is very good. So, we're going to continue to monitor that through the year. But investment will continue.

Operator

Your next question is from Ben Reitzes with Barclays.

Benjamin A. Reitzes - Barclays Capital, Research Division

I wanted to ask you competitively. You mentioned a little bit on -- in your competitive differentiation versus Cisco on the Instant and ClearPass and some of the other products. I mean, how about just overall? I mean, they were down 4% in the quarter. It was hard to figure out where they went head-to-head with you. You obviously did a lot better than that. Have you noticed any change, have you noticed your guidance doesn't seem to indicate any change whatsoever into the second half and that you really can run away with this early lead in the wireless AC cycle for a few more quarters. So I was just wondering how you put it in that context of your offering versus theirs, and then your lead on the AC cycle.

Dominic P. Orr

Yes. I think there a couple of factors here. One is, as I mentioned early on, we have a single unified architecture that support AC. They have basically 3, and it's going to -- so it's going to be very confusing for some of the customers to really figure out what architecture to choose. And whereas Aruba, because we have a single architecture, we can put out stability for high-performance code with much more much rapid flip. So, we think that we will continue to be doing that. I think also what we -- as we get into some deals, for example, retail, we used to cut 2 competitors in the public-facing enterprise retail business, which is the Cisco and Motorola, and we have now seen significantly a reduction in Motorola. But a lot of the deals we actually do still see 2 competitors, which is Cisco core wireless LAN and Rocky. So sometimes it's actually a little disorienting, but that's the state of affair. So, I think that will continue for a while, I think.

Operator

Your next question is from Troy Jensen with Piper Jaffray.

Troy D. Jensen - Piper Jaffray Companies, Research Division

Maybe 2 questions here. Can you talk about maybe the number of deals, the percentage of deals at, either in the quarter in the pipeline, or ac versus n?

Dominic P. Orr

Well, as we mentioned, we had -- 11ac, definitely, is the fastest ramping product line in our access point in history offering in the last decade. In fact, the history of the company. So, we will not break out specific product top line but I'll just leave it at that.

Michael M. Galvin

Yes. I mean, it's obviously with the results we've been posting. It's a very real part of the pipeline and an emerging part of the pipeline, but we won't give exact statistics.

Dominic P. Orr

And the encouraging thing that we see, Troy, is that this is not tied to a single or a couple of verticals. It is across the board. One would expect that with the -- for example, the high education market where Aruba is very, very strong. You see some early adopters, but it is an issue of early adopters. It's an issue of people really seeing the value of our 11ac solution to the benefit of, not only 11ac clients, but 11n clients. And also, this is honestly the last upgrade of the wireless LAN without changing wire cabling infrastructure and backlog technology. So basically, if you have gigabit ethernet from the wire-in cluster on Cat 5, Cat 6 cables to the ceiling, 11ac Wave 1 is the last generation of technology that allows you to pick gigabit Wi-Fi into a high-density or high-multimedia environment at a very small premium in overall solutions. So a lot of the -- our customer who have major refresh or have new greenfield sites, that's a no-brainer.

Troy D. Jensen - Piper Jaffray Companies, Research Division

Okay. And now with the -- could you guys touch base a little bit on the Aruba Central to cloud offering? Anything you could share there with respect to the customer there would be helpful.

Dominic P. Orr

Yes. I think it is doing very -- I mean, in cloud, Aruba Central is doing very well. When we introduced it, we set expectations, this is going to be a multi-quarter output. Significant fact here is with Aruba participating in the cloud Wi-Fi business. For the first time in the industry, you are getting enterprise-grade secure Wi-Fi into the cloud-enabled market sector, and that is the significant factor, and the industry noticed that.

Operator

Your next question is from Mark Sue with RBC Capital Markets.

Ameet Prabhu - RBC Capital Markets, LLC, Research Division

This is -- Dom, it's -- this is Ameet Prabhu, on behalf of Mark Sue. Maybe you could -- could you help us understand the changing dynamics as it relates to partnerships with MDM vendors, considering the AirWatch acquisition by VMware. So, does Aruba need to acquire, potentially build additional expertise, considering the blurring lines between the policy management and device management? And how does that play into your long-term software strategy?

Keerti Melkote

So, I can talk to that. It's Keerti, here. So when we launched ClearPass and talk about BYOD, we've come at it from a network-centric perspective. In other words, when you bring in a new device into the enterprise, they're able to recognize it's a new device on-boarded on to the network and apply the right policies on the network side. And MDM, as you know, has been focused more on device policies, especially the most important policy that enterprise actually cares about seems to be the remote Wi-Fi capability. And what has happened in the recent history and we have, in the past, talked about this capability as additive to the core knack capability that we bring to the market with ClearPass. With the recent consolidation that happened in the MDM space, with AirWatch being acquired by VMware, Citrix acquiring Zenprise, IBM acquiring Fiberlink. We see that as an extremely positive sign in the sense that now mainstream players are entering the market. And we have done the work doing deep integration with each one of these partners. And so, what we're going to propose is, now, to our enterprise customers, a joint solution that solves for the entire mobile security puzzle. And, both mobile knack, which we bring, and MDM are integral to solving the problem. And of course, we will take the heavy partner-centric approach with each one of those players.

Ameet Prabhu - RBC Capital Markets, LLC, Research Division

Okay, that's helpful. And how should we maybe think about additional services beyond ClearPass? And what does that sort of mean to your longer-term gross margin profile?

Keerti Melkote

In terms of additional capabilities in ClearPass, as you can expect, we talked about GenMobile as a new trend, and we are squarely aiming ClearPass at what GenMobile means to the enterprise. And fundamentally, there's 2 issues that IT cares about the most. One is a set of issues surrounding security, which we are focused on thus far. And the other is on enablement. Basically, simplification of mobile applications and mobile devices and how they connect into the network environment. And those 2 trends are what we're going to capitalize on in terms of features. One example I will tell you beyond BYOD onboarding, if you've seen a lot of traction with, is a capability that we call AirGroup, which allows you to take your mobile device and interact with corporate assets like printers and projectors inside the network. So, we're going to keep our eyes trained on those kinds of opportunities for differentiation. And from a gross margin perspective as ClearPass continues to do well, it will obviously have a positive impact on our gross margin profile. However, we're not -- it's baked into what we're thinking in terms of our guidance for where gross margins will be.

Dominic P. Orr

And of course, for the public-facing enterprise guys, we are, as I mentioned in my script earlier, that we continue to invest to build up some Meridian solution on location-based applications, and that would help with the trajectory of software, and so this is, as well. But that is still in the early stage.

Operator

Your next question is from Brent Bracelin with Pacific Crest.

Brent A. Bracelin - Pacific Crest Securities, Inc., Research Division

Dom, quick follow-up, if I could. I'm really trying to assess the sustainability of this return to 20% growth. As you look at kind of the Big B race here and guide, how much would you attribute to an improving macro in Europe, some budget flush versus more company-specific drivers? AC, ClearPass cross-selling with the instant success that seems more sustainable. Just trying to carve out how much of the momentum you're seeing is macro-driven versus more company-specific drivers? That would be helpful.

Dominic P. Orr

There are really 3 specific set of factors. One is our competitive positioning with 11ac platform, with all the software features on top of that as the system, not just 11ac access point. The ClearPass initiative, Aruba Instant and public-facing enterprises, those continue to be our 4 growth drivers that will be beyond multiple quarters, I believe. It's going be multiple years. That's one. Second is we do see a resurgence of our Continental European business, and that seems to continue into current quarters. We have seen it for 3 quarters now and we're delighted to see the actuation there. And third is all this few headcount and channel development that we are just seeing the early result. This thing has a 4 to 6 quarter ramp, so it's this new established sales force and partners ramp. You will see the productivity come in. So, I think all those 3 drivers led me to believe that this is very, very sustainable phenomenon.

Michael M. Galvin

Yes, Brent, and just on your question. I mean, the macro Europe has definitely helped, Americas has been very solid. But just in light of that, as we pointed out, fed was soft in Asia Pacific for us, continues to have headwinds. So the results were very strong even in light of those 2, right? So, it's a pretty good balance of the strong factors.

Dominic P. Orr

And our market position and product advantage in U.S. federal market actually is even stronger than the commercial marketplace. So, as federal comes back, there will be dry powder we can draw in.

Operator

The next question is from Erik Suppiger with JMP Securities.

Erik Suppiger - JMP Securities LLC, Research Division

So, a couple of questions here. First off, previously, you had also talk about reaching 20% operating margins by Q4. Is that still your expectation, or what's the situation with that?

Michael M. Galvin

Yes, Erik. Yes, so we've, obviously, we've been very happy with the ROI on the investment so far. But yes, we are targeting 20% operating margin exiting the year. We're going to continue, we evaluate, we're getting into the meat, I guess, of the return analytics on that sales investment hiring as we hit Q3. And we'll continue to monitor that in the second half of the year. But yes, we are targeting that for the end of the fiscal year.

Erik Suppiger - JMP Securities LLC, Research Division

Okay. Very good. And then you talked about distribution taking some inventory and taking up deferred revenue. Is that a seasonal development, or is there something that's getting your distributors to take up their inventory levels?

Michael M. Galvin

No. There's not really anything seasonal about it. They run a very tight P&L and a very cash-strapped P&L, so they only take inventory on when they know they can get rid of it. The one thing I would say to you guys, if you look over the last good 6 quarters, there's been very healthy growth in that area. And it's, one, a reflection of the business, and two, we have been moving some of our international distributors to stocking, where they previously were passed-through distributors. So, there is an element that we've seen over the last 1.5 year, or a bigger percentage of our overall business is going more into stocking distributors. A reminder to everybody, we recognize revenue on sell-through only, so that's a factor to keep in mind. But it's a healthy picture. They don't take on inventory if they can't get rid of it, so.

Dominic P. Orr

A plus in Aruba -- when Aruba Instant ramp, you can expect that the solution channel will be picking a bigger piece of that pie.

Erik Suppiger - JMP Securities LLC, Research Division

Okay. Then, finally, you talked about service provider in Asia Pacific remaining soft. What exposure do you have there? And I think Cisco had alluded to some of that, and they had noted that some low cost players were taking some share there. Is that the trend that you see, or what is the situation with that?

Dominic P. Orr

Well, in the service provider business, in our experience, Cisco sometimes is the low-cost provider. And the comment about service provider in Asia Pacific is that we have, as you recall, extracted our sales out a couple of years back from the low-cost market; and second, last year, we had some very strong service provider partner deploying our Wi-Fi business, Wi-Fi hotspots and then they basically switch to the full LTE build-out, and so our Wi-Fi initiative, they are -- our statement basically reflected our continuing to be in that state. I don't think anybody is picking market share. It's just that market is in a breather in between, so it is quite a build-out. And we continue to be growing the relationship with service providers in all theaters, particularly in Asia Pacific, but as partner of managed [ph] services for enterprise rather than participating in the -- they only focus in the third-party infrastructure business. And that is the situation. And we pretty much -- the exposure is going forward. It's minimal because now we pretty much gone through the periods of comparable, so year-over-year comparables. So, we feel comfortable that we are going to be pretty lean on service provider revenue in Asia Pacific to begin with, starting this quarter.

Operator

Your next question is from Tavis McCourt with Raymond James.

Tavis C. McCourt - Raymond James & Associates, Inc., Research Division

Gentlemen, I wonder if you talk a little bit about the success you're having in AC, maybe a qualitative feel for how much of those deployments are actual competitive displacements versus upgrades or transitions of existing Aruba networks? In other words, is this a real sustainable share shift in your mind, or is it just Aruba benefiting from the upgrade cycle, perhaps a little earlier than some of your competitors because of product availability? And then, secondly, a clarification, Mike, for you on the Q3 guidance. I think you mentioned sales and marketing as a percentage of revenues will be up again, but you also said non-GAAP operating margins should improve sequentially. So for those 2 to be true, where is it? Is it just higher gross margins, or is there going to be more leverage than we've seen in recent quarters on some of the other OpEx lines?

Dominic P. Orr

Okay. Let me take the first one. I think, clearly, we do have our installed base going for 11ac upgrade. But I can tell you that as far as my visibility goes, a vast, vast majority of head-to-head competition related project in the last quarter in 11ac. I have not come across any large deal that we have seen tense head-to-head competition against either the largest competitor or other competitors that are not 11ac. So, I've got to believe that .11ac is a real competitive edge in the new account front. I would say, I feel we'll completely agree with that.

Michael M. Galvin

Yes, Tavis. So, on the guide on the profitability, so yes, there still will be an absorption of sales expense into Q3, but really where we get the leverage there in Q3 will be some in the R&D and G&A lines, and that's not to say that there is not investment in those lines, there are. But just with the revenue ramp that we're projecting and guided to, there'll be some leverage there. And sales is, for Q3, is right around kind of breakeven in terms of -- it could go plus or minus depending on how the quarter goes. So -- but the goal, again, is to combine those factors in any gross margin moves with an improved operating margin in Q3.

Operator

Your next question is from Rod Hall with JPMorgan.

Ashwin Kesireddy - JP Morgan Chase & Co, Research Division

This is Ashwin Kesireddy, on behalf of Rod Hall. I got -- I was hoping you could give us more context around this sort of additional provision services engagement that you had during the quarter. Maybe, you could talk about the circumstances that led you to provide these additional services. Was it more customer-driven, or was it a proactive approach by you guys? Also, just on revenues, could you give us any sense of how much of the cost to your revenue per price during the quarter, and maybe for the guidances coming from your large -- existing large deals versus .11ac requirements.

Dominic P. Orr

So let me just preface -- this a the large deal. It's not like there isn't a one-off deal. We see a lot of these large public vendor size deals, as normally we go in shoulder-by-shoulder with a system integration lead. It's just, in this particular case, the situation is that, that Aruba has to take the prime system integration lead, and that's the only exception about it. Anything else about a deal is actually pretty normal, and we win many of those projects. It's just because of the customer situation, Aruba has been asked to be the lead system integrator, and that's why you see the accounting. After that, I'll let Mike...

Michael M. Galvin

Yes, yes. And as you guys have seen over, at least, 1.5 years or so, we've been talking about that professional services investment for the ClearPass and software platforms. And we've seen a downtick in the services gross margin over the last 4 to 6 quarters because of that. That is definitely going to continue, not the decreasing gross margin, but the fact that we're focusing on that business. The size of this deal, per what Dom said, was we took -- because of a customer desire, we took prime on some elements of the PS services that are not things we would do on every single deal. And we're really focused on the architectural and design elements of PS deals with ClearPass and the different software, and that's kind of our sweet spot. So, we took prime on a bigger deal here that we normally wouldn't, but Dom said that the dynamics of that deal, in terms of what the customer was deploying and putting in place, was very standard.

Operator

Your next question is from Tim Long with BMO Capital Markets.

Timothy Long - BMO Capital Markets U.S.

Yes. Just 2 and then, 1 for Dom. First, you talked about the traction and the better growth rate with AC. Just curious if you can plot along that first, what's going on with pricing? So, is pricing kind of taken the same as normal trend? Or since it's ramping faster, are the prices coming down? And therefore, they cost a little more aggressively. So, anything on kind of changing and pricing. And then, Mike, just back to the 20% margin exiting the year, it sounds like you're still working on how you'll get there. It looks like you might need a big jump in Q4. Part of that guidance was also 21% to 22% in early 2015. So, is that something that's still there, meaning if you get a big pop in Q4, you think that'll be sustainable for the first half of next fiscal year?

Dominic P. Orr

Okay. For the 11ac, basically, we did not see any pricing or discounting behavior change with AC relative to AC compared to our other business. I think if you look into all the vendors like 11ac, the pricing structure for access point is roughly 15% to 20% premium to the high-end 11n. But bear in mind that every $1 that go into any wireless infrastructure project, only about $0.30 or so goes actually into the wireless LAN itself. There are labor costs, there are wired backhaul, and so on. And then, within that wireless LAN component, if it is a campus base, you have controller, you have software, the network management and so on. So with this -- when we talk about AC being 15% to 20% premium to 11n, you are talking about the access point component of that. So, if you are a customer looking at the overall implementation of the new building and new campus, actually 11ac versus 11n, it's a very minimum premium.

Timothy Long - BMO Capital Markets U.S.

Okay, it's helpful.

Michael M. Galvin

Yes. Tim, on the op margin, yes, as we move through the quarters, it's definitely a combination of obviously revenue growth and expense management. So we're -- we navigate that every quarter and still targeting that goal. And then, in the first half of FY '15, yes, targeting to get back to the original operating model that we talked about a year ago, almost a year ago, at Analyst Day.

Operator

Your next question is from Brian Modoff with Deutsche Bank.

Kip Clifton - Deutsche Bank AG, Research Division

It's Kip Clifton, filling in for Brian. I just had a question on the -- so on the AC, and if you think about Wave 2 of AC, if you can give us sort of a timeline of when you see that coming to market? And also, what you see is the price differential, because I imagine it's much more significant than this first wave.

Keerti Melkote

Kip, this is Keerti, here. Yes, Wave 2, we expect our products to hit the market in 2015. And it's too early to tell when in 2015, but sometime next year. And I cannot really comment at this point on the pricing structure, or what Wave 2 will look like. I think overall, as a solution, you can expect a higher ticket price, simply because a Wave 2 11ac access point will require multi-gigabit backhaul. And therefore, you'll need an upgrade to the wiring closet switch. And so, if you want to take the full benefit of Wave 2. So as a result, we expect a fuller system upgrade to occur when Wave 2 actually hits the market, and we expect that to happen sometime next year with the early phase of it.

Kip Clifton - Deutsche Bank AG, Research Division

And you, guys, you expect you'll be on time with that, as opposed to maybe some of your competitors with the first wave of AC here?

Dominic P. Orr

Well, I think, if you look at the history of Aruba with every almost single 11ac standard, we're always the first to market, and we obviously uplift, strive to continue to be the same. That's our hallmark.

Michael M. Galvin

[indiscernible] standards

Keerti Melkote

It's not just first to announce, it's first to volume shipments.

Dominic P. Orr

And then, also, I like to highlight, Kip, one more point, in my earlier remark, I mentioned that the AP itself is just a small portion of the overall cost the customer has to incur to upgrade an infrastructure. And I think one thing that Keerti mentioned that I want to highlight is, to go from 11ac Wave 1 to Wave 2 requires a lot of infrastructure upgrades in many cases, including cabling infrastructure outbreak. And that, we believe, is going to be a cost prohibitive for some of the even large customers. So, there is going to be a chasm between Wave 1 and Wave 2, a chasm that is bigger than the 11n to 11ac Wave 1 upgrade.

Operator

The last question comes from George Iwanyc with Oppenheimer.

George M. Iwanyc - Oppenheimer & Co. Inc., Research Division

Dominic, can give us a sense of how much opportunity is still available to you in Europe from a greenfield perspective? And how much of the headcount additions have been going towards that region?

Dominic P. Orr

Yes. If you look into our market share globally, in Europe, actually our market share is not as high as in the other theaters. So, we have a long way to come. And that's why I'm very encouraged about the new plans that we've put in place and new leadership we've put in place in Europe and the resulting results, because I think there is a lot of market share we can pick up in Europe. So, you can be assured that, that will be a one big area of concentration of our near-future investment, including my own personal time.

Michael M. Galvin

Yes, George, and the headcount investment was definitely a global investment. But Europe absolutely got a chunk of that headcount, relative to their contribution in the last few quarters.

George M. Iwanyc - Oppenheimer & Co. Inc., Research Division

Okay. And from a -- just a vertical standpoint, are they all behaving fairly well, or any there any areas of a bit more softness than normal?

Dominic P. Orr

I think on a worldwide basis, you can refer back to our earlier comment that we are seeing good solid business in our core verticals other than federal-related. And everywhere, we are seeing an increase in our enterprise activity and also in the public-facing enterprise including retail. And Europe is no exception to that.

George M. Iwanyc - Oppenheimer & Co. Inc., Research Division

Okay. And just one final question. I know you gave us some benchmarks on how well ClearPass and Instant have been doing year-over-year. Can you maybe give us a sense on how much they're contributing on a sales basis, just either one getting close to that 10% level?

Dominic P. Orr

I'm sorry I cannot give you that.

Operator

That was our final question. I will now turn the call over to Dominic Orr.

Dominic P. Orr

Well, thanks again to be on the call today. And we look forward to seeing you in March in Las Vegas and to sharing our Q3 results in May. And thank you, all the partners, employees and customers.

Operator

This concludes today's conference call you may now disconnect.

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