Gigamon's CEO Discusses Q1 2014 Results - Earnings Call Transcript

| About: Gigamon, Inc. (GIMO)

Gigamon Inc. (NYSE:GIMO)

Q1 2014 Earnings Conference Call

April 24, 2014 5:00 PM ET

Executives

Cynthia Hiponia – Investor Relations

Paul Hooper – Chief Executive Officer

Duston Williams – Chief Financial Officer

Analysts

Kent S. Schofield – Goldman Sachs & Co.

Jason N. Ader – William Blair & Co. LLC

Alex Henderson – Needham & Co. LLC

Kulbinder S. Garcha – Credit Suisse Securities LLC

Simon M. Leopold – Raymond James & Associates, Inc.

Ben A. Reitzes – Barclays Capital, Inc.

Tal Liani – Bank of America Merrill Lynch

Operator

Good day ladies and gentlemen and thank you for standing by. Welcome to the Gigamon’s First Quarter 2014 Earnings Conference Call. During today’s presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator Instructions) This conference is being recorded today, Thursday, April 24, 2014.

I would now like to turn the conference over to our host Ms. Cynthia Hiponia, Investor Relations. Please go ahead, ma’am.

Cynthia Hiponia

Thank you, Saul. This is Cynthia Hiponia, Gigamon Investor Relations, and I am pleased to welcome you to Gigamon’s conference call to discuss its first quarter 2014 earnings results. After the market close today, Gigamon issued a press release through PRNewswire. The release is also available on the company’s website at gigamon.com. The call is being webcast live on the Investor Relations page of the Gigamon website and will be available for a period of one-year.

During the course of today’s presentation, our executives will make forward-looking statements within the meaning of the federal securities laws. Forward-looking statements generally relate to future events or our future financial or operating performance.

Forward-looking statements in this presentation include, but are not limited to statements related to our business and financial performance and expectations and guidance for future periods, our expectations regarding our continued focus on our current strategy, our expectations regarding macro trends in the market, our expectations for our products and our expectations regarding our customer base and purchasing pattern. Our expectations and beliefs regarding these matters may not materialize and actual results in future periods are subject to risks and uncertainties that could cause actual results to differ materially from those projected.

These risks include those set forth in the press release that we issued earlier today, as well as those more fully described in our filings with the Securities and Exchange Commission, including our annual report on Form 10-K. The forward-looking statements in this presentation are based on information available to us as of the date hereof and we disclaim any obligation to update any forward-looking statements except as required by law.

Please note that other than revenue, the financial measures to be discussed on this call will be on a non-GAAP basis. The non-GAAP financial measures are not intended to be considered in isolation, or as a substitute for results prepared in accordance with GAAP.

A discussion of why we present non-GAAP financial measures and a reconciliation of the non-GAAP financial measures discussed in this call to the most directly comparable GAAP financial measures are included in our earnings press release that is available on our website.

On this call, we will give guidance for the second quarter of fiscal 2014 on a non-GAAP basis. We do not make available reconciliation of non-GAAP guidance measures to corresponding GAAP measures on a forward-looking basis due to the high variability and low visibility with respect to the changes, which are excluded from these non-GAAP measures.

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

Paul Hooper

Thank you, Cynthia. Good afternoon and thank you for joining our first quarter 2014 earnings call. On the call with me today is Duston Williams, our Chief Financial Officer. For the first quarter, revenue was $31.8 million, which is higher than the revised guidance of $31 million to $31.5 million that we provided on April 7 and below our original guidance of $34 million to $35 million.

As we stated in our April 7 press release, the shortfall was related to one expected loss transaction from an existing service provider in EMEA region that did not materialize, as well as certain other transactions that were expected to close late in the quarter, but slipped into the second quarter.

Let me expand on both of these events. In the March quarter, we anticipated the closing of a large service provider deal in the EMEA region, specifically for our high-end 100-gigabit products. The service provider is an existing Gigamon customer and while we closely monitor the progression of this deal during the first quarter, it did not close as expected, although we remain in active and ongoing discussions with the customer regarding this project. we’re not including this opportunity in our forecast or pipeline for this or future quarters.

Additionally, we saw other transactions that were expected to close in the first quarter, slipped into the second quarter. We believe this is a function of both longer sales cycles to larger transactions and the need for additional levels of fiscal approval within the customer.

The majority of the deals that slipped still remain in our pipeline and we have seen several of these deals close in the second quarter, some within 24 hours of the close of Q1. while we remain very disappointed in our results, let me clearly state that we continue to believe that our market, our business and our solutions remain relevant, strong and healthy. We have a committed, energized global sales team and company and our objective is to rebuild your confidence in the quarters ahead.

Turning to the core business, we continue to deliver new and innovative solutions to maintain our leadership in this market. Early in the first quarter, we launched a new GigaSMART application, NetFlow Generation. Addressing the network optimization space, this application has opened the door for new set of discussions with both existing and prospective customers and it has allowed us to expand our relevance within the IT organization.

While NetFlow Generation is not unique function, the combination of the pervasive intelligent reach of our visibility fabric coupled with the predictability of our NetFlow Generation does set us part. NetFlow is one of the most widely recognized and adopted network monitoring and management protocols, and that solution is more agile, capable and flexible than other solutions in the market space.

On first day of the second quarter, we launched our latest visibility fabric mode, the GigaVUE-HC2. This next generation platform offers market leading agility and versatility as it combines the power of our GigaSMART platform, a combination of high-density line card options, and support for integrated network TAPs technology.

This product, part of our expanding H Series, offers the performance, versatility, intelligence and quality of our Visibility Fabric in a compact form factor. While it is still early in the product’s life, just over three weeks since launch, we have already received our first customer order and we’re seeing solid traction within both existing and new customers.

To quote one of the beta field trial customers, a multinational Fortune 50 organization, the GigaVUE-HC2 is a significant value play where Gigamon is setting a new standard for scalability and flexibility at an attractive price point. This platform enables enterprises to future-proof their monitoring infrastructure with a compelling mix of modularity, port density and functionality.

As I have reported on prior calls, we believe the attach rate for our GigaSMART applications’ platform is a clear proof point to both the market required a higher level of intelligence within their monitoring fabrics and the tangible demonstration of our differentiation.

By way of a reminder, in Q2 of 2013, that in-quarter attach rate for the H Series GigaSMART platform was 38%. In Q4 of 2013, it had expanded to 44% and in Q1 of 2014, it extended even further to 67%. While this metric may fluctuate, it does indicate the strength and value of our GigaSMART offering.

Not only does this platform create an opportunity for upselling additional applications and capabilities into existing customers, it more importantly highlights the need for much more than just simple TAP and aggregation. We grew our total customer count 30% year-over-year to 1,390 by the 70 new customers in Q1, including 9 Fortune 1000 accounts. We are close to completing the build-out of our new regional sales manager team, the team that is tasked with finding new accounts, and then opening new doors within targeted accounts for us on a weekly basis.

I would like to turn now to some interesting customer purchases during the quarter. A large retail company in the Pacific Northwest continues to our fabric to meet that in-line protection and out-of-band monitoring needs. They have multiple data centers worldwide with each one being protected by a variety of security, monitoring and management tools.

Our solution offers both the agility of both in-line and out-of-band in one platform, so that all traffic can be directed to either in-line screening or out-of-band detection, or both. One of the most recognizable technology companies on the globe continues to expand their security and performance monitoring tools in one of the largest data centers in the country, hosting a combination of both customer facing and internal applications.

They represent a perfect example of a big data customer with significant volumes of network traffic, and as a result, our large user of our Visibility Fabric solution. They have been a customer for many years and they remain an active and ongoing purchaser of our platforms. One of the world top universities adopted our Visibility Fabric solution as a standard to management and monitoring tool connectivity.

In the quarter, they purchased a combination of H Series fabric nodes to GigaSMART platform, along with some specific applications. This was a competitive win for Gigamon, as the differentiated scale, intelligent and value of our solution decided the outcome.

One of our 70 new customers in the quarter was a large diversified financial services company in the Midwest. Given their status and focus information security is of utmost importance. They have a powerful combination of RSA's NetWitness, Blue Coat Solera, Q1 Labs, Websense, and FireEye products, and the fact that our solution is agnostic to the attached technology was a significant factor in their decision. We won this transaction due to our flexible and versatile architecture, the power of our flow mapping technology and our GigaSMART capabilities. Worthy of note, that considering NetFlow is a differentiator in the solution, and it’s now under evaluation for future deployments.

Before handing the call to Duston to cover financial results in detail, I want to clearly state that while we’re disappointed with the results of Q1, we firmly believe our business is healthy and our products are being adopted well by the market. The secular market trends continue, and the transition of 1-gig to 10-gig is now being supplemented by the migration of 10-gig to 40-gig and beyond.

After having traveled around the U.S. and Asia in the first few weeks of this quarter, it is clear that our worldwide sales team is engaged, focused and optimistic. Our objective is to prove that Q1 was an anomaly, and in doing so, work to regain the confidence of you, our investors.

Let me now turn the call over to our CFO, Duston who’ll review the first quarter in detail and provide the outlook for the second quarter of fiscal 2014. Duston?

Duston Williams

Thanks, Paul. I’ll review our Q1 actual results, and then I’ll follow that up with our outlook for Q2. The following analysis of our Q1 results is based on non-GAAP. Our references exclude stock-based compensation and then related payroll and income taxes.

Please refer to our press release available on the Investor Relations website for the comparable GAAP results, along with a reconciliation to the non-GAAP figures. Total revenue in Q1 was $31.8 million; our product revenue in Q1 was $20.1 million, representing a sequential and year-over-year growth rate of minus 37% and 15%.

In our services revenue in Q1 was $11.7 million, representing sequential and year-over-year growth rates of 3% and 41%. Our top 10 end user customers accounted for 20% of the revenue in Q1, compared to 24% in Q4. We had no 10% end user customers in Q1 with the largest end user customer representing 3% of revenue.

Turning to the distributors on a non-end user basis, Interlink accounted for 45% of revenue versus 47% in Q4, while Arrow also on a non-end user basis accounted for 19% of revenue, versus 15% in Q4. And both Arrow numbers include the impact of their Computerlinks acquisition.

From a geographic perspective in Q1, North America accounted for 82% of revenue, EMEA was 12% and APAC was 6%. On a year-over-year basis, North America grew at 37%, EMEA at 10% and APAC at minus 41%. The decline in APAC was primarily due to a large service provider transaction in the prior year quarter.

Looking at the verticals, enterprise accounted for 72% of bookings in Q1, versus 61% in Q1 of 2013. Service providers accounted for 18% versus 31% – 34% and the government vertical accounted for 10% versus 5%. On a year-over-year basis, enterprise grew at 25%, service provider declined by 43% due to a non-recurring large deployments in Q1 of 2013, and government grew by 119%.

Gross margins in Q1 were 75% versus 79% in Q1 of 2013. Product gross margins were 66% versus 73% and service margins were 89% versus 92%. The total gross margin performance for the quarter was unfavorably impacted by approximately four percentage points and product gross margin was impacted by seven percentage points, due to a net charge of $1.45 million to excess inventory.

Without this inventory charge, overall gross margins would have approximated 79%. At the time of our pre-announcement on April 7, we anticipated this excess inventory charge to be $2.3 million. Shortly after the April 7 pre-announcement date, we were able to return 850,000 of excess inventory back to one supplier. It probably make sense to elaborate a bit more on the excess inventory charge as there is no relationship between this excess inventory charge and any margin pressure or competitive dynamics in the marketplace.

At this point, I would like to expand on this excess inventory charge and the reasons why the charge was necessary. Our inventory reserve policy states that we are required to reserve any inventory that is generally in excess of our forecasted 12 months of demand. For example, if we had a rolling fourth quarter forecast of 100 units of demand for a product and we had inventory of parts supporting 150 units, then we would take a charge for the 50 units of potential excess inventory.

The $1.45 million inventory charge consists of $400,000 for excess long lead time, 100 gigabit parts that were procured in advance of the large order that did not occur at the end of Q1. We have eliminated this deal from our forecast resulting in excess inventory per the policy I outlined above.

On April 7, the date of our pre-announcement, the portion of this charge was thought to be $1.25 million, but was later reduced after $850,000 inventory was successfully returned to the parts vendor, which fully accounts for the difference from the pre-announcement estimate of $2.3 million total charge and the current $1.45 million charge.

Looking at the remaining $1.05 million of charge, part of this charge results from excess inventory related to a reallocation of our forecast from other existing products towards the new HC2 product. While this reserved inventory is believed to be good usable parts, due to the changed forecast mix of products, we have inventory supply in excess of 12 months of demand for some non-HC two products. The other component of this charge is for miscellaneous inventory related adjustments.

This is obviously much more detail than we would ordinarily share with you. Hopefully, this clarifies the situation. And just to reiterate again, this inventory charge in itself should not be construed or correlated to competitive pricing pressure or any change in our pricing strategy going forward.

Now looking at expenses, operating expenses for Q1 were $27 million versus $26.3 million in Q4 of 2013 and $20 million in Q1 of 2013, reflecting sequential and year-over-year growth rates of 3% and 35%. The ending head count for the quarter was 391 versus 352 in Q4, reflecting a net increase of 39 heads in the quarter. The operating loss for Q1 was $3.3 million; the net loss for Q1 after a $1.1 million non-GAAP tax benefit and other miscellaneous expenses was $2.2 million, or $0.07 per share on a weighted average basic and diluted basis.

Turning quickly to the balance sheet, cash, cash equivalents and investments ended the quarter at $142.7 million versus $138.2 million in Q4. We generated $1.8 million of cash from operations in Q1. DSOs were 47 days versus 52 days in Q4. Inventory turns were 18 versus 20 in Q4. And just a quick note regarding our inventory balances going forward. Currently, our manufacturing subcontractor maintains ownership of all finished goods until shipment to the customer. To this service, we pay a carrying charge based on the value of the inventory. Starting in Q2, we will start to take ownership of all inventory once it’s placed into finished goods.

Our Q2 inventory balance will be incremented by $5 million to $6 million based on this change. There result of this change is that we will start paying carrying charges related to the inventory volume. Capital expenditures were $2.3 million versus $1.5 million in Q4 and service deferred revenue in Q1 was $39.7 million versus $40.2 million in Q4 of 2013, and $20.8 million in Q1 of 2013 for a sequential and year-over-year growth rate of minus 1% and 41%.

Now, for the outlook for Q2. The following guidance for Q2 is based on non-GAAP results and excludes any stock-based compensation expense. Revenues of $38 million to $42 million, gross margins of 78% to 79%, operating expenses of $28.5 million to $29.5 million, and non-GAAP tax rate of approximately 35% and based on an estimated average diluted weighted shares outstanding of approximately $34.5 million, this would lead to a $0.02 to $0.07 earnings per share for the quarter.

Operator, if you could now open it up for questions that would be great. Thank you.

Question-and-Answer Session

Operator

Thank you, sir. We will now begin the question-and-answer session. (Operator Instructions) Our first question comes from the line of Kent Schofield with Goldman Sachs.

Kent S. Schofield – Goldman Sachs & Co.

Great. Thank you, Paul and Duston. First question is, as we think about the dynamics around HC2, we’ve obviously seen the path of some appliance vendors that there can be a pause associated with demand in some of the other platforms that might be affected by new platform launch. Can you just give us a sense for, if you expect that to happen, if you are incorporating that in the guidance, if it’s a smaller, overlap with some of that legacy product, a little bit of color there, I think it would be helpful.

Paul Hooper

Hey, Ken, thanks for the question. So, yes, with every new launch, there always is some degree of cannibalization, but we spent a good deal of time considering this launch, it is a big launch for us. It’s a next major note in our expanded H series family. And we certainly factored all of these considering into the guidance that Duston just gave you here.

But to be clear, the HC2 is who know there are some elements of cannibalization of other portions of the portfolio. We do see it is being a very new accretive to the portfolio. It’s got a new level of agility, versatility and flexibility that we haven’t gotten some of the other line items in the portfolios. So we see this being accretive. Although there will be some marginal cannibalization of some of the other portfolio, but we’ve actually factored that in for sure.

Kent S. Schofield – Goldman Sachs & Co.

Okay. And when you look at EMEA and Asia APAC realize that there is still small, so they are a little lumpy, but can you just give us an update as to how you think you ramp in those regions in terms of just your thoughts and distribution is coming along and what some of your kind of, do you want to call it through 2014 expectations are as to what the opportunity is there?

Paul Hooper

Ken, so we’ve invested a lot of focus in building out both of those regions. As I said, we mentioned in the last earnings call we push the head with building out a specific service provider team in both territories and that team to – is well in process of being established. We have distribution in place. And as Duston mentioned on his color on his notes that briefly, Computerlinks was a reseller and so was a distributor in Europe and now that’s part of ours. So we got additional leverage to that relationship with Europe. But we’re still working to set up new distributions across the Asian region and some additional ones in the European region.

It's far from a complete process and we have, but we’re not finished by any stretch the imagination, we still got lot of work to do. But we believe we have the right pieces in place to expand and grow both the service provider and the enterprise regions in both of those cases about Europe and Asia. So it’s going to be ongoing progress, but we believe we have the right pieces in place and now as we continue to focus of execution and driving more and more awareness of that solution in both of those markets.

Kent S. Schofield – Goldman Sachs & Co.

That's helpful. And when do you think it would be, I mean obviously that sort of move can take time. I mean, when do you think it’s fair for us to come back to you and say, that we should see some improvement, is it at second half of 2014, is it more of a 15 event? What’s a reasonable bar for us to think about?

Paul Hooper

So, I would suggest the second half of 2014, we should certainly start to see some movement and some momentum and some growth in those territories. As I said in my notes, I was over in Asia as recently as a week back here meeting with the wholesales team, and they’re a optimistic team. And I have confident that they’ve got some good traction and they’ve got some good momentum. So I think to answer the question specifically, the back half of this year is when you should start to see some recovery in 2015, we should see some strong growth.

Kent S. Schofield – Goldman Sachs & Co.

Thank you, Paul. Thank you, Duston.

Operator

Thank you. Our next question comes from the line of Jason Ader with William Blair.

Jason N. Ader – William Blair & Co. LLC

Yes, thanks. Hey, guys. So the guidance of 38 to 42 to make sequential uptick from March, and you are talking in the comments about longer sales cycles partly be able to slip in Q1. What gives you the confidence that you will continue to have issues with the forecasting business because of sales cycle lengthening and have you accounted for that in your guidance?

Duston Williams

Yes, Jason, this is Duston. Yes, we’ve taken a pretty thorough look at the pipeline and deals and the type of deals there. And we believe we’re taking a reasonable approach to the guidance, assuming that somethings may close and somethings may not close as far as some of the deals go. So, as I say, we’ve actually spent probably a lot more time this quarter having those discussions and those thoughts. And at this point in time the 38 to the 42 make sense for us.

Paul Hooper

And as Duston said right, and if I can just add one other bit of color on that, Jason. The fact that deals are lengthening while it does represent a slightly new characteristic that has been growing over time. But the lengthening cycle can be construed as being good news as much as it can be a challenging news. The good news in it is that we are seeing more and more customers start to think about how technology is being designed in at the outset rather than being purchased to particular address a burning pain or burning problem. There are customers thinking about this is being a much more full design in and which is just a longer sales cycle as infrastructure builds out. So there is good news, bad news regarding the longer sale cycle. But we’re seeing as good and so far as people are thinking about it strategically. It clearly represents a challenge as you get closer to the end of the quarter, but as Duston said, we’ve been very thoughtful about early thought about guidance this quarter, obviously.

Jason N. Ader – William Blair & Co. LLC

So just to clarify it’s fair to say that you’ve adjusted your closed rates down in terms of the forecast?

Paul Hooper

I'm not sure; I would put it that specifically. We looked at deals and obviously we have some deals coming in from Q1 that didn’t close in Q1, that’s going to help Q2, and we looked at other deals that can potentially go from Q2 to Q3. So, the closed rate and the win rate, I don't think we’ve adjusted that what hits in the quarter, we have taken a practical view.

Jason N. Ader – William Blair & Co. LLC

Okay, got you. All right. and then when you think about your penetration of the Fortune 1000 top-tier service providers and large government agencies and such, which is obviously your kind of market focus today. What kind of penetration do you think exists there for your type of solution?

Paul Hooper

So if you look at it numerically, we’re in – on 300 in the Fortune 100 remaining 700 still available to us. Inside of the federal agencies and the government agencies, what we’re making some very good progress and our federal business is something where we are very proud of, it's definitely getting some momentum in legs, the army deal back in Q3 was definitely a high milestone, but it’s definitely set a pace of increased momentum for our federal teams. so we’ve got more and more potential there, but I think we are hardly penetrated in that pace to allow a significant amount of opportunity in the federal market for us.

And the other point to notice, although we talk a lot about the Fortune accounts and the Fortune 50 and our forward-looking multiple was now 48 times the value of the first transaction when it was 47 last quarter if I recall. While a lot of our business has been for a good period of time, came outside of the fortune, and so we are not dependent upon the fortune accounts, but they do represent very large and good multiple repeat business opportunities whereas, but we still have a lot of business outside of the Fortune 1000 list.

Jason N. Ader – William Blair & Co. LLC

Okay. And then actually Paul, when you think about what’s happening in data centers now and particularly the cycle towards can 10-gig and 40-gig, how big of a catalyst do you see that for your business? And what sort of the timing when we should expect if it is a catalyst kind of the real impact to start to occur?

Paul Hooper

Well, the impact of one to 10 when we spoken Jason awhile back there, the impact of one to 10 has always been one of the bigger catalyst throughout the business as customers move to 10-gig, they need to change the way they think about instrumentation was a phenomenal driving factor for us and opportunity for us and we are starting to see that. As I mentioned in my remarks, we are starting to see that translated to 40-gig and I will go so far as to say there is also some 100-gig being tried. So the adoption of 40-gig is clearly not the pace of 10-gig, but it is starting to get some momentum and starting to attract some interest and we are starting to do some 40-gig transactions here.

I think if I look out the bigger driver inside of the data centers virtualization Jason rather than particularly speed. But if you’re thinking about milestones, I think 40-gig is probably going to be the back-end of this year and for good part of next year and then 100-gig will get a little bit more mainstream, but 100-gig today is still, if you 100-gig, it is critical to get 100-gig and we do have ongoing conversations with prospects around 100-gig solutions, today because of the – the limited ability to instrument that kind of scale of network, we provide a very valuable solution in that space.

Jason N. Ader – William Blair & Co. LLC

And the VM product that you sell is that – do you have any metrics on that?

Paul Hooper

We don’t break down metrics on that, we continue to track. it is the combinations of VM component plus the FM, which is the fabric manager that goes beside it. we don’t break out software separately Jason – but recognize , it also calls through the hardware component to deliver the information to and over the course of the years ahead, we see VM becoming a more and more strategic component of our portfolio.

Jason N. Ader – William Blair & Co. LLC

Thank you.

Operator

Thank you. Our next question comes from the line of Alex Henderson with Needham & Company.

Alex Henderson – Needham & Co. LLC

Thank you very much. I was hoping you could talk a little bit about the international expansion plans in terms of what you’re doing in terms of adding new sales teams and other elements of that mix to drive that accelerated growth over there. Obviously, the percentage is so much lower; it seems it’s very ripe turf for expansion?

Paul Hooper

Hi, Alex. yes, we agree with you, it is ripe turf. We are going to be – over the course of this year, we are going to be doubling the headcount we have in international arenas, whereas the vast majority of those heads are sales heads. we intentionally divided the team going into the start of this year where we had one large team – one team, complete team; we decided to break it into service provider team and an enterprise team in both regions and we’ve invested the heads to build out both of those teams, as we see both of those markets as being highly accessible and highly relevant for us. So we’re going to continue to add headcount. We’re not complete in that build out we will be over the course of the next couple of quarters here, but we see both Europe and Asia as being nascent opportunities for us go and take share in.

Alex Henderson – Needham & Co. LLC

So, just going out the international side for a second since it was an international customer that had the issues in the quarter, just to be absolutely crystal clear on this point, in your opinion, was no way that your sales team could possibly have seen this issue at that particular customer showing up since as I understand it, the customer’s customer pulled order for the service which caused a derive demand fall back on the demand for your infrastructure build. Therefore they couldn’t have seen it. I assume you’re saying that as a result of that there’s no need to change or alter the structure, or compensation or any other factors in the way your sales teams are managing that geography?

Paul Hooper

A good question. We don’t believe, we look very closely at the deal multiple times, given the size of the deal they had a lot of tension across throughout the whole organization and we were getting right up until very, very late stage in the quarter. We were still getting positive buying signals from the customer. And then the customer really reset the decision date, it is the best way I can describe it and move the decision date out to, a yet-to-be determined fixed date, which resulted in the – ultimately results in this slip.

We haven’t changed sales compensation, we’ve certainly looked at our processes as we dual processes is inside the business. And we will make change when necessary, but this one event didn’t cause us to make any compensation changes, or major process changes, or anything else, we don’t believe our sales team could have seen this deal slide until it slid literally the 23 out of the quarter.

Alex Henderson – Needham & Co. LLC

Okay, great, thank you. That’s very helpful

Paul Hooper

Thanks, Alex.

Operator

Thank you. Our next question comes from the line of Kulbinder Garcha with Credit Suisse.

Kulbinder S. Garcha – Credit Suisse Securities LLC

Hi, thanks for the question. Sorry guys to keep bisecting this, just a couple of things that occurred to me. So you guys – the major $3 million mix in revenues in Q1 was driven by largely one existing customer. I guess my question is, when you were putting again, effectively a 10% customer into the guidance, is it typically that lumpy that you’re forecasting forward? And is there any such assumptions for newer wins going forward? That’s one question. The second thing is, you emphatically believe this isn’t a competitive loss, it’s just a push out, that’s the second clarification that I want.

And in the third thing is, although there was a number of other ways that your revenues were going to grow, new customers, penetration within existing customers, geographic expansion. And I guess what surprises me a little bit is all of those other areas that have so much potential just didn’t quite come through this quarter, but they should come through going forward. Because I guess things are always missing and coming in versus the guidance. I also have the impression that we’re still early in the penetration curve that this kind of mix wouldn’t really happen at this stage. Am I missing something though?

Duston Williams

Yes this is Duston, I’ll take the first part and I’ll let Paul pitch in on the other two pieces. As we look at our Q2 guidance to the $38 million to $42 million there’s no one big similar transaction assumed in that guidance. We certainly welcome one of those, but there’s nothing assumed from that magnitude in the guidance.

Paul Hooper

And so let me take the second part of your question I hope I’ll get it over tool vendor, if I don’t, take me back to the but that I missed. In kind of order that I had, do believe it to be a competitive loss. No, there is no ordered placed to the best of our knowledge, there was no order placed for this equipment. We are still in active dialogue with the customer as recently as few day ago here providing a new configuration or amended configuration for equipment to serve his need.

So we didn’t not believe it to be a competitive loss, I’m sure the customer is considering alternatives. We are convinced this is not a competitive loss given the fact they’re still asking for quotations. The second point, I think, if I got it right, that the second point you made was, given some of the other drivers inside the business, the penetration, the new customers. How come Q1 with Q1, if I’m pleased to raising a comment for that.

Duston Williams

Yeah, basically right when we met Mobile World Congress there was so many other areas of revenue growth, new products, new sales channels, the exiting penetration with existing customers, repeat activity. Top twenty five customers were still growing. And so I’m just kind of none of that stuff was good enough to offset in Q1 then I guess, is it just a time thing and it’s unfortunate?

Paul Hooper

Well its certainly unfortunate I don’t disagree with line of single second and now I believe it to be a timing thing related to be a slit. Let me go through some of the other metrics then. Firstly, penetration that the multiple that we get out on that top 25 is now 48 times. So lager customers still continue to buy more, we added 70 new customers. We launched the new products and we’ve got, as I mentioned in my prepared remarks net flow is generating a lot of interest and the HC2 in its early days recognizes not a Q1 thing, but the HC2 is also generating good interest, we have and some of the other smart modules that we launch right at the back-end of calendar 2013 are also starting to get some traction in the market. But the overarching comment I was kind of like to make Kulbinder, is that Q1 is always is easily challenging quarter for us variety of reasons and it was this quarter.

And this one deal kind of – in this slide out of the few other transactions due to some additional approval cycles and some just beyond the sales cycles made it an even more challenging quarter for us. But we don’t see as I said in my prepared remarks, we don’t see anything inside of our business that would point towards anything other than the healthy business. We still got great relationships with the top customers. We are still adding customers. We still got sales teams that are very animated. We got an engineering organization is turned out seven or eight software modules and one complete new chassis family over the course of the last 60 days.

So, we remain positive regarding the future and our guidance to some degree reflect that we have been appropriate the way we said guidance and we've taken into account all other things that are going on around our business, but we remain an optimistic about the future of this business in this market we still believe it would be healthy growing market.

Kulbinder S. Garcha – Credit Suisse Securities LLC

Great. Thank you.

Operator

Thank you. Our next question comes from the line of Simon Leopold with Raymond James.

Simon M. Leopold – Raymond James & Associates, Inc.

Great thank you very much. A couple of things. First, I just wanted to clarify Duston your comments about the change in inventory in the carrying practice, and basically the carrying charges going away. I am assuming that that was showing up in cost of goods sold. So, just if we could understand from a modeling perspective, where those charges were showing up. And in effect, how does that change things? Because I would have thought, if I am interpreting it correctly, that eliminating the carrying charge should help your gross margin be higher. Could you explain that a little more?

Duston M. Williams

Yes, but not to a great extent. You’re right. We had the liability for this inventory anyway and it just was not on our books until it hit the customer effective until we shipped to the customer. And the carrying charges are 100 and maybe max of 200,000 a quarter. So, it’s not substantial, but when you look at it, we are getting close to zero on our cash balance. So, it’s a good trade-off for us. But it's not a substantial margin boost, but it slightly positive.

Simon M. Leopold – Raymond James & Associates, Inc.

Great. That's helpful. And so let's look back at the gross margin guidance, indicating 78% to 79%. That is just a bit lower than I think where we were thinking of the majority of the gross margin level you put up in 2013. So maybe you could help us understand what is the difference versus last year?

Duston M. Williams

Yes. There’s really not much difference. The consensus for Q2 before our pre-announcement was 79%. So, we’ve guided 78% to 79% as you that kind of in where we were before the pre-announcement are really no change from that perspective. Again, if you want to pick on something that some point in time international is going to grow, service providers is going to grow, we’ve talked about having slightly lower margins there. But, we really don’t view that the whole lot of the change with the 78% to 79% guidance.

Simon M. Leopold – Raymond James & Associates, Inc.

Okay. And then just the last thing, I wanted to go back to the big customer cancellation order. Had that order come in, would that customer have reached the 10% threshold of sales or been just shy of it?

Duston M. Williams

After – it wouldn’t have been close to a 10% customer.

Simon M. Leopold – Raymond James & Associates, Inc.

So, that's a big surprise. Now one of the things prior to this pre-announcement, we didn’t think that we faced the material risk of customer concentration. And I think you pointed out that your next biggest customer this quarter is like 3% of revenue.

Duston M. Williams

Correct.

Simon M. Leopold – Raymond James & Associates, Inc.

So this is – I want to make sure I understand that this case is really an outlier. Can you think back to your history and let’s say the last six quarters as kind of a window to think about. So, not when you are small, small company. Have you ever had a customer that was in that range of high single digits to 10% of revenue and, really tried to get a better understanding of our risk profile in terms of concentration?

Duston M. Williams

Yes. It’s great question. I think there has been coming on the exact quarters from a revenue perspective. I am talking bookings, but from a revenue perspective, we had a couple of 10% – maybe 11% customers. It was a service provider as one of our biggest customers. One time, I believe it was – when we were a private company, probably actually both times, I have to go back and check probably both times as a private company. So it hasn’t happened recently from the revenue perspective, it’s usual. It can certainly happen, again. We mentioned that 38 to 42 does not assume. we need to get a 10% deal to make that guidance, but as we focus more and more on service providers, hopefully, these type of transactions will turn to be upside rather than having to make a forecast.

And as we said, several times in Q1, we had other deals that simply slipped out. And in fact that is even our top 25 didn’t participate strongly in Q1, right. It’s a weak quarter in general and we had some lower purchases from the top 25, some of those guys are rebounded strongly already in April with some purchase order. So it’s more of a combination of things there.

Simon M. Leopold – Raymond James & Associates, Inc.

That’s very helpful. Just to maybe then close out on that topic and finish up for me is in terms of this – the guidance for the quarter, is there some metrics you can help us understand the concentration of the customers in that pipeline for the June quarter outlook?

Paul Hooper

I’m not sure what you’re trying to get Simon…

Simon M. Leopold – Raymond James & Associates, Inc.

Well, I’m wondering – yes, I’m wondering if in that guidance, are there several customers that could be 5% to 10% of revenue, really how concentrated of a customer base in the pipeline?

Paul Hooper

No, there are not several customers, that could be 10% customers in the quarter.

Simon M. Leopold – Raymond James & Associates, Inc.

What about high single digits?

Paul Hooper

Now you’re starting to get into details, Simon.

Simon M. Leopold – Raymond James & Associates, Inc.

I’m just trying to assess my risk.

Paul Hooper

Again, we looked at the pipeline. There’s no big significant deals baked in that outlook, the 38% to 42% that’s required to make that guidance.

Simon M. Leopold – Raymond James & Associates, Inc.

Great. I appreciate your patience. Thank you.

Paul Hooper

No problem.

Operator

Thank you. Our next question comes from the line of Ben Reitzes with Barclays.

Ben A. Reitzes – Barclays Capital, Inc.

Yes, wanted to ask about partnerships with switch vendors that you don’t currently compete with. We saw something on the wires about Dell kind of doing something with big switch and obviously, it might not be that bigger deal. but using some of their monitoring capabilities, it just got us thinking that might be right for you guys to do a partnership given – given what just happened – and there might be some without some volatility and has there been any interest from the OEM side?

Paul Hooper

So Private partnerships at the moment Ben, what I would refer to as in the tool vendors, it’s the FireEye, it’s the Riverbed, it’s the Compuware, those kind of guys along, we spend the most time partnering with. We are starting as I mentioned in a previous call, we’re spending a bit of time now looking at systems integrators. And you know the list of names there, but we’re starting to engage with as being designed into some of their technological solutions. I wouldn’t necessarily call out OEM at the moment. But we haven’t looked, haven’t explored network switch vendors and it’s one area of opportunity that we kind of go ahead, but at the moment, we believe we got more than enough opportunity with the partnerships that we have on the table that was still continuing to build down.

Ben A. Reitzes – Barclays Capital, Inc.

Okay, great. I mean we could talk more about that off-line.

Paul Hooper

Sure.

Ben A. Reitzes – Barclays Capital, Inc.

But maybe there is something structurally that also makes it more awkward, but with regard to – and then Duston, just a clarification on the inventory and we really appreciate the detail. The thing I got the most questions on frankly was just run miscellaneous. Why would there – I think the large customer inventory and then the stuff around older product actually made sense to most people. How big was miscellaneous and why would that be in there? Or every quarter – is there miscellaneous in every quarter and just clarifying that I think would be really helpful? Thanks.

Duston Williams

Sure. Yes, I mean at the end of the day, we’re running a business, and yes, every quarter, there is miscellaneous stuff, it’s usually in 100,000, 200,000 300,000 of stuff that we never hear about, because it’s not we’re talking about. But we always have something, all right. There’s always some changes here and there, so that is not unusual at all.

Ben A. Reitzes – Barclays Capital, Inc.

Yes, okay. Well, I appreciate it. It’s just something that when you’re getting into this much detail, I think people may just get confused that there’s always a miscellaneous part in there and you didn’t just kind of throw it into this write-off. so I appreciate the detail. I appreciate it. And it’s something that if you don't follow the stuff that every moment, you get questions on so thanks.

Paul Hooper

Yes. Thanks.

Duston Williams

Thanks, Ben.

Operator

(Operator Instructions) Our next question comes from the line of Tal Liani with Bank of America Merrill Lynch.

Tal Liani – Bank of America Merrill Lynch

Hello, guys. Hope you can hear me.

Paul Hooper

Yes, Tal.

Tal Liani – Bank of America Merrill Lynch

Hello. I have two questions. One is on the numbers and one is more complicated. If I look at my spreadsheet before you pre-announced negatively, I expected for June $41.3 million. Now we are roughly in the $40 million, so that's a 3% or maybe lower. If a few deals pushed out from this quarter to next quarter, although one could be canceled but if a few deals pushed out, why do I have to reduce my numbers for June rather than increase my numbers for June versus my expectations before? So what change in the environment that drives you to lower the numbers for June versus previous ones? Let's answer that and then I have another question not related.

Paul Hooper

Okay. Sure. So I’ll take that piece. We talked about, yes deals taking a little bit longer, some slipping into Q2 from Q1, and likewise there could be from a forecast perspective some slipping in from Q2 into Q3. So, we’ve kind of looked that it from that perspective and then the fact is, we just came off a miss and everybody is disappointed about Q1 and quite honestly little embarrassed and nobody wants to go through that again. So taking all that into consideration sitting here in April 24, we believe 38 to 42 is the right number for the quarter.

Tal Liani – Bank of America Merrill Lynch

Got it. Second question is kind of related. It's more kind of big picture, maybe for Paul. I drew the correlation between quarterly change in 10–gig port shipment versus your product revenue growth, the percentage and the correlation is just amazingly high. I'm talking about hardly having no outliers. It goes up and down in the same way. So the conclusion, and that goes back eight or nine quarters. The conclusion is that your revenues are highly correlated with 10-gig port shipments at least historically.

And same thing by the way happened this last quarter, 10-gig was relatively weak versus what we saw before. And 10-gig on 2013 decelerated to 7% growth from 20% before – from 31% before. So 10-gig continues to decelerate, just because of size. So the question here is two things. Number one, what is the evidence that your revenues can break out of the 10-gig correlation? Meaning you sell more applications. It's kind of add-ons to customers on top of just the basic 10-gig connectivity and visibility. So that's number one. Number two, can you talk a little bit about the competitive environment? And I joined the call a little bit late, so if you already touched it, we’ll cover it off-line. And the third point is important about the 40-gig. The 40-gig is growing, it’s growing 100% plus a year. What is your position in 40-gig versus 10-gig? And do you have the same benefits in 40-gig versus 10-gig? Can you talk about that? Thanks.

Paul Hooper

Absolutely. Good question Tal. So, firstly you were the first if I recall to draw the proxy between end market and the 10-gigabit adoption right. And certainly, if you look back a few years, one of the biggest drivers for our business was the migration of one to 10 as customers were facing a challenge and how to instrument to 10-gigabit network.

Well since that change that has this market has developed, and that I would go back to saying that was when the days at the market was a tap and aggregation basin, we are still in that market. But, over the course of the last few years, the market evolved into a greater focused around transformation of traffic rather than just taping the traffic and putting the traffic out of the 10-gig link, how can you transform that traffic and towards the proxy for that is a gig small for touch.

And there why we look at that is how what’s the tax rate the small in a quarter to the number of chassis that we sell. And as I mentioned, you might have heard remarks, but just briefly over the course of the last three quarter – four quarters here, we’ve gone in Q2 of 2013, we were 38% in Q4 of 2013, we were 40%, just over 44% if I recall.

And then, in Q1, is just close the– we are 67% and that is that’s the measurement not of accessing the network it was video accessing. I thought a one conversation or 10 conversations or 40 conversations. That’s an application platform conversation. So, more and more of our customers are now buying into the small platform, which gives us the opportunity to scale beyond just the access performance and the speed and fleet conversation. We are now moving into the true intelligent conversation.

The other aspects that’s not to be overlooked here and probably a longer conversations Tal is, it how the market moving from just accessing information to now trying to set tier that information and more and more of our transactions today are built around the security. Which isn’t necessarily a speed related function in actual fact can be a lower speed function than high-speed data centers. So, we get more and more pro link for security type transactions, which to me is another catalyst for growth going forward with all of the events going at around our industry. Securities getting a more and more prevalence in the bias consideration.

We have a moving to our third point, if I got it right. You’ve mentioned the 40-gig market is growing at 100% year-over-year. Well, the G series, which was our original portfolio, which was the bread and butter of the business for a good number of years, was not 40-gig capable. Since, we launch the H series that started in July of 2011, later on 18 months after that time, we came out with our first 40-gig and since that time we kind of with multiple 40-gig. So, you’ve now got 40-gig available in our HD4, 40-gig in the HD8, you’ve now got 40-gig on the TI-1, you’ve now got 40-gig on the HC2.

So, we put 40-gig across that portfolio. And as you know, we will show added a 100-gig. Because we see that thing the next inflection point. and I believe as the network gets faster, in other words, the Fortune 100, the need to instrument those networks intelligently is, just increasing significantly, because now, there are very few tools, if any of tool, you can keep up with Fortune 100 gig. and so you’ve really got to be able to do some form of intelligence, filtering, selection and transformation of traffic before you deliver it to a tool. And that’s fair market. So we see as the Fortune 100 moves, although it may not have the same volume of attaches. It certainly got a greater demand for some of the intelligence that we can offer.

The other final point that you ask there was around the competitive landscape. It remains, as it always has been, there are ebbs and flows with the competitors. and it’s still at a healthy market, and there are still a number of competitors in the market, which is in my opinion, a good sign of a healthy market and we continue to compete. we, as one proxy tool, if we look at discounting in Q1, it was marginally down in other words, less discounting than we would normally have. So the first proxy of a competitive landscape, as when discounting starts to create, to be able to wait to ensure the win rate.

Our discounting is going in the opposite direction, almost very marginally, very, very marginally. But it’s an indication of the competitive landscape. It’s not changing that module, or we certainly do hear about this market becoming more and more interesting. For obvious reasons, customers need it more and more. So, as a long answer to your short question, but hopefully, that provided you some color. We can certainly continue off-line if you want that.

Tal Liani – Bank of America Merrill Lynch

Perfect. Thank you.

Operator

And Mr. Hooper, we have no additional questions. Please continue with any closing remarks.

Paul Hooper

Thank you, Saul and thank you everybody for joining the call. Just a very brief closing comments, I’d like to remind you that we’re hosting our first Analyst Day in New York on May 1. our management team will be providing a detailed overview of our business strategy; our solutions, the market opportunity; we’ll talk about the competitive landscape tile and also the financial model. With several Gigamon customers joining us on hand to describe the decision process and implementing our platform and how our solutions are enabling them to solve an increasingly diverse set of security network and virtualization challenges. So for those that are unable to make it in person, the event will also be webcast on the Investor Relations website. Thank you and I look forward to hopefully seeing many of you in New York on May 1. Thanks, operator.

Operator

Ladies and gentlemen, this concludes our conference for today. Thank you for your participation. You may now disconnect.

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