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Brocade Communications Systems, Inc. (NASDAQ:BRCD)

Q2 2014 Earnings Conference Call

May 22, 2014, 05:30 PM ET

Executives

Ben Jones - Senior Director, Investor Relations

Lloyd Carney - Chief Executive Officer

Daniel Fairfax - Chief Finance Officer

Jeffery Lindholm - Senior Vice President, Worldwide Sales and Field Operations

Ken Cheng - Chief Technology Officer and Vice President, Corporate Development and Emerging Business

Jason Nolet - Vice President, Data Center Switching and Routing

Analysts

Matt Robison - Wunderlich Securities

Ashwin Kesireddy - JPMorgan

Chad Bennett - Craig-Hallum

Mark Sue - RBC Capital Markets

Andrew Nowinski - Piper Jaffray

Jayson Noland - Robert Baird

Vijay Bhagavath - Deutsche Bank

Srini Nandury - Summit Research

Kim Watkins - Citi

Kent Schofield - Goldman Sachs

Aaron Rakers - Stifel

Scott Schmitz - Morgan Stanley

Operator

Good day, ladies and gentlemen, thank you for standing by and welcome to Brocade's second quarter 2014 earnings conference call. As a reminder, this conference call is being recorded. And now, I would like to turn the program over to our speaker, Ben Jones, Senior Director of Investor Relations with Brocade. Sir, please go ahead.

Ben Jones

Thank you, Doris. Good afternoon, and welcome to Brocade's fiscal second quarter 2014 earnings call. By now you should have seen our press release and prepared comments, which are available on our website, brcd.com. The press release was also furnished to the SEC and will be distributed by MarketWired.

Before we take your questions, investors should note our comments today may include forward-looking statements regarding Brocade's financial results, plans, assumptions, strategy and business outlook, revenue, tax rate, cash, stock buybacks, OEM inventory, prospects, when we expect to have certain fiber channel products in the market as well as U.S. federal spending and order flow, and IT spending, which are only predictions and involve risks and uncertainties, such that actual results may vary significantly.

These and other risks are set forth in more detail in our Form 10-K for the fiscal year ended October 26, 2013, and our Form 10-Q for the fiscal quarter ended January 25, 2014. These forward-looking statements reflect beliefs, assumptions, outlook, estimates and predictions as of today, and Brocade expressly assumes no obligation to update any such forward-looking statements whether as a result of new developments or otherwise.

In addition, this presentation includes various third-party estimates regarding market share and other measures, which do not necessarily reflect the views of Brocade. Further, Brocade does not guarantee the accuracy or reliability of any such information or forecast.

This presentation includes non-GAAP financial measures. The most directly comparable GAAP information and a reconciliation between the non-GAAP and GAAP figures are provided in our Q2 2014 press release, which has been furnished to the SEC on Form 8-K, and in our slide presentation and prepared comments on our website, brcd.com.

Here to take your questions are Lloyd Carney, Brocade's CEO; Dan Fairfax, CFO; Jeff Lindholm, Senior VP, Worldwide Sales; Ken Cheng, CTO and VP of Corporate Development; and Jason Nolet, VP, Data Center and Campus Networking.

I will now turn the call over to CEO, Lloyd Carney. Lloyd?

Lloyd Carney

Thank you, Ben. Good afternoon, everyone, and thank you for listening to today's Q2 conference call. Before Dan reviews our Q2 results and Q3 outlook, I wanted to take a few minutes to remind you of our long-term strategy that we outlined at our Analyst Day, more than six months ago.

Our mission is to be the network provider of choice to the world data centers. We will build on our number 2 position in data center networking and focus on the world's largest enterprise, Telco and cloud-service providers. We will continue to increase our investments in innovative software networking and fabric-based technology that challenges the status quo and disrupt the traditional hardware-oriented network.

We remain committed to our strategic goals and have made solid progress against our operational target through the first six months of this fiscal year. For example, we said we're increasing our two-year target model for gross margin and operating margin. For the first half of 2014 we're operating better than our two-year target model for both of these metrics.

We said we'd focused on data center, and we have seen year-over-year growth in that business through the first six months of this fiscal year. We said we'd focus our Ethernet switch strategy on the data center, and our Ethernet switch business has seen year-over-year growth through the first six months of this fiscal year.

We said we would invest in emerging markets, where we have the ability to grow at faster than market rates. While managing our expenses, we're investing in Asia-Pac, Eastern Europe and Latin America, and have already seen the benefit of these investments. We set a goal to create more operating cash flow in FY '14 than any other year in the history of the company, and we have met more than half of our annual operating cash flow target for the fiscal year.

We express confidence in the stability and growth prospects of our SAN business, despite some prediction to the contrary. The fact is that, after normalizing for the sale of our network adapter business, our SAN business through the first six months of this fiscal year is flat with the same time period last year and was up 2% in the most recent quarter.

We told you we would consider paying a dividend, in order to diversify the ways in which we return value to our shareholders, and today we announced a dividend that will be payable beginning in Q3 2014.

We said we needed to hire an impactful marketing executive, and we brought onboard Christine Heckart. We're building a world-class network function virtualization and software-defined networking technology team. We hired a number of top technology strategist and software engineers from Cisco and Juniper. These individuals have significant experience working with some of the world's top enterprises and service providers.

We announced the first 10 gigabit virtual router for carrier-class networks, OpenFlow 1.3 support across our entire IT portfolio, multitenancy and 100 gigabit connectivity on our Ethernet fabric products and the addition of a virtual load balancer through our Vyatta NFV platform.

We made a decision in Q2 to shift a greater portion of our ADX product development resources through our virtual solution. Our decision to do this is an indicator of our growing expertise and commitment to software networking. We are aligned with increasing interest amongst our customers and a significantly higher growth rates for the software-based Application Delivery Controller market.

We remain excited about disruptive technologies like Network Functions Virtualization and software-defined networking, which create opportunities in the networking industry. These new architectures break the closed, proprietary model that is long favored incumbency.

Vertical architectures are giving way to open solutions that allow customers to select best-of-breed technologies that enable new services and networks optimized for the customer's own specific requirements. I can say without hesitation that openness is an integral part of nearly every discussion I have with customers, and I firmly believe it is creating meaningful business opportunities for Brocade. Disruption in the data center is real and is happening today.

I'm excited about the increasing engagements we have with more than 30 top-tier customers and proof-of-concepts across the globe. Some examples of used cases for these active proof-of-concepts include, virtual provider edge or VPE a top global carrier, which allows for seamless WAN and cloud service to Telco customers. This will enable carriers to attract to cloud services seamlessly that are existing enterprise VPN customers, driving incremental revenue per customer.

Virtual customer edge or VCE at several global carriers, which will replace proprietary hardware CPU equipment and allow delivery of enhanced network services centrally from the data center, eliminating tough rolls and simplifying service provisioning and lowering operational costs.

Virtual route reflector or VRR at a top global carrier, which will replace extensive proprietary hardware routing equipment from incumbent vendors. We're able to outperform the incumbent solutions at a fraction of the cost. Virtual sales site routing at a top mobile carrier where we will support the content distribution and transloading services to optimize real-time near delivery to the end-user, improving overall quality of experience, while eliminating potential network congestion.

Lastly, we're being included in the Telefónica NFV reference architecture, where we support the carrier-grade open-stack virtualized infrastructure manager, NFV infrastructure and virtual network functions. Overall, I am pleased with our progress. The market for networking is undergoing a significant transformation and brokerage will be at the forefront with a disruptive strategy that capitalize on the opportunities this creates.

And I would like to return the call over to Dan, who will give a brief financial review of Q2 as well as our planning assumptions and outlook for Q3. Dan?

Daniel Fairfax

Thank you, Lloyd. I continue to be pleased with Brocade's execution and financial performance. Our revenue for Q2 was towards the high-end of our expectations and we exceeded our outlook for gross margin and operating margin during the quarter. In addition, as part of our commitment to return more than 60% of free cash flow to shareholders, we announced earlier today the initiation of a cash dividend.

I'd like to now cover some of the key financial highlights from our second quarter. In Q2, Brocade reported revenue of $537 million, flat year-over-year and down 5% sequentially.

For our total SAN business, including hardware products and SAN-based support and services, Q2 '14 revenue was $379 million, up 1% from Q2 '13 and down 8% sequentially. Our SAN revenue in the quarter saw strong performance in our switch and embedded product families.

For our total IP networking business, including hardware and IP-based support and services, Q2 '14 revenue was $157 million, down 4% year-over-year and up 3% sequentially. The year-over-year decline was due to lower revenue from our U.S. federal customers as well as product lines that have been impacted from the change in our strategic focus over the past year. These reductions were partially offset by increased IP networking base support revenue due to the extra week in the quarter.

This sequential increase in IP networking business revenue was principally due to higher IP networking base support revenue as well. Our federal revenue did not recover in the quarter and was approximately $13 million, down 36% year-over-year and essentially flat quarter-over-quarter.

At our September 2013 Analyst Day, we outlined the strategic areas of focus for our business. These included data center focus products and services for service providers, other enterprise customers and the public sector. Our commitment is continue to innovate and lead in this area with one of the most complete portfolios of high performance routers, advanced fabric switches for both SAN and IP data center networks as well as virtualized networking software for both NFV and SDN applications.

You saw from Lloyd's comments that we have been delivering strongly on the strategy. We also announced at Analyst Day that certain products and older initiatives would likely no longer be a fit with our business goals. In Q4 of '13, we announced the shift and how we serve our LAN campus customers wireless need by announcing a partnership with Aruba.

In Q1 '14, we announced that we have divested our network adapter business and today we have announced the reorganization of our application delivery controller business to focus more of our engineering resources on our software-based ADX products.

We believe these changes will allow us to accelerate future development to meet our customers growing demands for software-based networking application. As a result of these combined actions, we expect our revenues to decline approximately $85 million from the annual run rate in fiscal 2013. In September of 2013, we have previously estimated that revenue will decline in a range of approximately $80 million to $100 million.

The impact of these collective actions on revenue in Q2 was approximately $15 million. We have considered the impact of the Q2 '14 shift and engineering focus on our ADX products and determine that the resulting drop in forecast revenue has resulted in a non-cash goodwill impairment charge of $83 million.

Non-GAAP gross margin for Q2 was 66.7%, up 160 basis points from the second quarter of '13 and down 100 basis points from Q1 of '14. The year-over-year improvement in gross margin was due to lower manufacturing and overhead cost, a favorable revenue mix shift to more SAN product and a favorable product and customer mix within the IP networking business. The sequential decline was primarily due to seasonally lower volume, a less favorable revenue mix shift to less SAN products and higher overhead cost, due to the additional weaker spending in the 14-week quarter that was our second quarter of 2014.

Non-GAAP operating margin was 23.2% in Q2, that was up 420 basis points from Q2 of '13 due to lower operating expenses and was down 470 basis points from Q1 of '14 due to lower revenue and the increased operating expense from that extra week in Q2 '14.

Q2 '14 GAAP loss per share was $0.03, down from EPS of $0.10 in Q2 '13. Non-GAAP diluted EPS was $0.19 in the quarter, up from $0.17 in Q2 '13. The Q2 '14 GAAP loss was principally due to the $83 million non-cash goodwill impairment charge associated with the Brocade ADX product family.

We generated $168 million in operating cash flow and repurchased 5.3 million shares in the quarter for $50 million. Subsequent to Q2, we have repurchased an additional 6.1 million shares for $51 million and have approximately $759 million remaining in our Board authorized repurchase program as of May 21.

As was mentioned, we have initiated a quarterly cash dividend of $0.0350 per share of common stock to our shareholders of record as of the close of market on June 10, 2014. Annualized, the dividend represents approximately 13% of our adjusted free cash flow target for fiscal '14.

Looking forward to Q3 '14, we consider a number of factors including the following, when setting our outlook. As we model our business in Q3 '14, we took into account the impact of the divestiture of the network adapter business and the shift in strategies in the Brocade ADX product line and wireless business. The estimated total revenue impact of these actions is $15 million compared with historical quarterly run rate.

For Q3 '14, we expect SAN revenue to be down 2% to 5% due to the seasonal buying patterns of our OEMs. In addition, we consider potential disruption from ongoing business transitions within certain of our OEM partners. When adjusted for the sale of the network adapter business, we expect our SAN product revenue to be down 2% to up 1% year-over-year.

We expect our Q3 '14 IP networking revenue to be up 9% to 16% quarter-to-quarter, principally driven by a seasonally stronger quarter for our U.S. Federal customers and growth in orders from our enterprise customers. When adjusted for the sale of the network adapter business, we expect our IP Networking product revenue to be up 2% to 8% year-to-year.

We expect our Global Services revenue to be down 6% to 7% quarter-over-quarter due to the impact of one less week of revenue as compared to the 14-week quarter that occurred in Q2 '14. We expect non-GAAP operating expenses to be down 2% to 3% quarter-over-quarter, which is reflective of the impact of one less week of expenses compared with the 14-week quarter that occurred in Q2 '14.

At the end of Q2 '14, OEM inventory was approximately 1.2 weeks of supply based on SAN business revenue. While we expect inventory to be between one to two weeks in Q3 '14, OEM inventory levels may fluctuate due to both seasonality and large end-user order patterns with the OEMs.

We have assumed a structural non-GAAP tax rate of 25% to 27% for Q3 '14. We expect Q3 '14 operating cash flow to be lower sequentially due to higher working capital requirements, and the timing of variable compensation and bond interest payment. We estimate that DSOs will be within our target range of 40 to 45 days.

We expect Q3 '14 non-GAAP gross margin to be 65.5% to 66.5%, within or slightly better than our two-year target model range and non-GAAP operating margin to be at 22.5% to 24.5%, within or slightly lower than our two-year target model range. And finally, we continue to plan our business in accordance with the operating and cash flow model we presented at our September 25, 2013, Analyst Day.

With that, I will turn the call back over to Doris to begin the question-and-answer session. Doris?

Question-and-Answer Session

Operator

(Operator Instructions) And we'll go first to Matt Robison with Wunderlich Securities.

Matt Robison - Wunderlich Securities

Can you provide a little commentary on the routing business, which had a pretty tough comparison? And maybe talk about the gross profit impact on the ADC line, those two for starters?

Jason Nolet

Matt, this is Jason I'll tackle the routing question. So we did have a bit of softness in the quarter with respect to routing. This is the MLXe product line in particular. It was largely caused by some deals stall we saw as a result of some upcoming blades that are going to get released in Q3 and Q4 respectively around increases in density on 10 gig and 100 gig. And we had showed that upcoming release with the marketplace a month or two ago and we saw some deal stall as a result of that. So we expect that business to close, but it's going to move out to when those new blades are available into Q3 and Q4.

Daniel Fairfax

First on the ADX. So on the ADX gross margin impact -- Matt, I think that's a forward looking question, which is how is that going to affect the composite gross margin. Our ADX switches have always had a higher margin profile than our average Ethernet-based product. But it's been a relatively low revenue runner for us. So we don't expect it to have any significant impact on the business. That said, as we accelerate our investment and delivery of software-based, load balancers, and other Layer 4-7 offerings, we would expect gross margin to increase as those products get more revenue attraction.

Matt Robison - Wunderlich Securities

I think there has been some of the larger players in the industry have talked about the gross profit dollars contribution for software versus hardware in theory equivalent. I know that it sounds like you're going to have a bit lag before you get to uptick of the software to offset the exits from the hardware though.

Daniel Fairfax

I think that's correct. The software market is much smaller, but growing well at much more rapid rate, which is, again, is why we're shifting resources to attack that market more aggressively.

Lloyd Carney

This is Lloyd. We expect the ADX software business to grow about 30% and on the hardware side about 1%, 1.5% growth, so another reason why we strategically have move towards the software bases. And you're right, there is some bit of a lag. On the routing front, we had a less than stellar quarter, but there is a lot of good deals in the pipeline, there is some good opportunities, things are working. So we continue to invest in the routing space, especially focused on our data center and feel pretty good about the new products being released. The next generation router is on the block right now to be shipped end of next year, right.

Matt Robison - Wunderlich Securities

You guys last call talked about some pretty good strength in Brazil and China, mentioned a while away, no mention to that this time around and there has been a fair amount of volatility, particularly in Brazil, I think relative to recent periods. Can you comment a little bit about that?

Lloyd Carney

Matt, those are magic question. So last quarter we talked about a sizeable deal, a large deal we had last quarter was in Russia, which shows the focus we have in emerging markets, the BRIC countries. And our last quarter, we also had a significant deal in Brazil, I think we talked about. And you'll expect that this quarter that we will also have significant deals coming out of the BRIC.

And so we strategically decide to invest in those markets, because we have a less than fewer market share in those markets and their markets are growing well for us. We see good growth on both the SAN and IP in the BRIC countries, whether its China or Brazil or Russia and so in India. So we have continued to invest there and we're doing pretty well there.

Operator

We'll go to Rod Hall with JPMorgan.

Ashwin Kesireddy - JPMorgan

This is Ashwin Kesireddy on behalf of Rod. I wanted to ask you about the sustainability of year-over-year growth rates in Ethernet switch business, perhaps if you could walk us through some of the drivers of growth there and what do you see going out in the market? Are there any replacement deals where you are positively replacing an incumbent or some of the drivers there, if you could elaborate on that that will be hopeful?

And regarding the fiber channel market, one of your slides was showing sort of flattish market, also highlighting that you gained a lot of share in 2013. Just wondering what you are thinking in terms of your share gains for this year? Are you planning for sort of continued share gains and perhaps to reach 2009 levels? Any commentary around that will be helpful?

Jason Nolet

This is Jason. Let me take the first part of your question around Ethernet switching and growth in Ethernet switching. So as you probably know our kind of primary differentiation in Ethernet switching is around fabric technology. And we continue to grow that product line at a very steady clip. We were up about 22% year-over-year this quarter in the VDX revenue.

We had an all-time high for number of units shipped in the quarter. Our fixed portfolio, in particular, performed very, very well and we also had a record number of customers in a single quarter. So that continues to be a very differentiated offer for us. We're seeing success in mid-to-large enterprise and some cloud service provider and we continue to invest very aggressively in that product line. We expect it to be a growth engine for the company.

Lloyd Carney

And the question on the fiber channel space, we grew the fiber channel 2% in calendar year 2013, as you pointed out. We saw market share growth 2% in calendar 2013 and about 4% since the launch Gen 5. From what we were talking earlier about the BRIC countries, we're seeing good build out.

I mean as these countries are building out their data center infrastructure, mimicking what we did here in the west, and they're building out large SAN infrastructures and we're seeing some of the largest SAN infrastructures in the history of the company that we're looking at right now in some of these BRIC countries. So we feel pretty good about sustainability of our market share in that space and the ability for us to gain market share in that space.

Operator

And we'll go next to Chad Bennett with Craig-Hallum.

Chad Bennett - Craig-Hallum

I guess a couple of questions from me. So when you talked about the divestiture number that you gave, the range of $80 million to $100 million, back at the Analyst Day. And I think you mentioned now we're kind of looking at $85 million on an annualized basis. I guess as we sit today, do we see any other product lines or segments that we view as non-core or is this kind of the end of the kind of divestiture program for you guys?

Daniel Fairfax

Chad, this is Dan. So I'd say we are pretty much done. You would expect any company is going to continue to prune and grow different parts of its portfolio. But now, we're pretty much done with the kind of the major changes that we were talking about back at Analyst Day. So that's correct.

Lloyd Carney

And I think our technology is pretty aligned right now. I mean we've kind of told you last year we were going to be doing this large portion of data center, a portion on ramp to the data center. And we've pruned the portfolio to the products that are strategically aligned with what we're doing. So well, for now, this is where we're at. We're data center, data center, data center and storage expertise and that's NFV, SDN space and that's where we're aligned to.

Chad Bennett - Craig-Hallum

And then with respect to the IP networking business and growth rate, specifically the data center focus or segment that you talked about as being a real focus, you've talked about the data center piece growing 10%-plus or at least that's the plan. I guess, first, do you still believe that? And then secondarily, VDX is obviously growing great, but what really drives that growth to 10%-plus or where do the growth piece is, products within that business get to enough critical mass where they're really driving that topline. Any type of color would be helpful?

Jeffery Lindholm

It's Jeff Lindholm here. I think there is a number of things we're driving here that supports that kind of growth. We've been doing a lot of work on really developing more comprehensively our complete constituency of the channel. So we've been doing a lot of work with the OEMs to drive them into solutions involving IP.

As a sales strategy, we've been highly focused in the last year to drive activity in larger data center opportunities, larger transactions, more strategic accounts. Right now, we have in the queue the largest number of proof-of-concepts for fabric and data center solutions that we've ever had.

And in addition, we're driving strategies around the storage portion of the data center. Really look at a dedicated IP infrastructure to optimize the IP storage for many of the same reasons that people have bought fiber channel, predictability, segmentation of that storage network from the best -- this is the best effort LAN. So I'd say, there is an investment in channel strategy. There is an investment in major account focus. And then we can leverage our storage expertise to drive incremental IP opportunity going forward.

Jason Nolet

Chad, this is Jason. I'll just add to what Jeff said, from a product point of view, recognize that the data center IP the overall number is inclusive of a number of different product lines that are sold into the data center and data center use cases. So fabrics is obviously a lead technology and product line for us there, but the ICX product also sells into data center use cases as does the MLX routing product. In the case of ICX, for example, we grew that product line, double-digits quarter-over-quarter and year-over-year this quarter. So while the VDX is the flagship, we have a broader portfolio of technology that we're applying to data center use cases today.

Operator

We'll go next to Mark Sue with RBC Capital Markets.

Mark Sue - RBC Capital Markets

Gentleman, if I compare and contrast the commentary from HBA vendors, and their uptick in fiber channel over Ethernet and your stated views of fiber channel. Are there any changes or indications from OEM customers or end-customers about fiber channel over Ethernet, and recognizing that you can't support that, what have your thought through the implications and some of the migration path of this change?

Jason Nolet

Mark, this is Jason. So I'll tell you that we've obviously been paying very close to attention to customer sentiment on FCoE and customers have pretty much universally voted to stay with fiber channel. And you're seeing the analyst community continuously take down their forecast for FCoE, not just on the adapter side, but on the network side as well. And so we'll continue to satisfy that requirement where it exists.

We see a little bit of adoption of convergence from the server to the Top-of-Rack and we have very capable product there, including our 6740 VDX product that has FCoE support, but by and large customers have voted to stay with fiber channel, and as Lloyd said earlier, we continue to invest very aggressively there. With Fabric Vision, we'll be first to market we believe with Gen 6 in early '16. And there doesn't appear to be any lack of appetite for FC relative to FCoE.

Lloyd Carney

I mean, FCoE is that -- I mean it is that, you can quote us on that, only customers who are doing that are ones that who are doing on duress or something. We have seen more customers try FCoE end-to-end and go away from it than customers who have successfully deployed it. As a matter of fact, I think I'm challenged, I'm looking at 10 year to think of any customer who has gone FCoE end-to-end that we have seen, I mean, it just doesn't work, it doesn't provide you any?

Jason Nolet

We've seen them come back as you said.

Lloyd Carney

Yes, seen them come back. So as Jason said, Top-of-Rack, it's a good solution, it makes sense. In some cases, the more heavily virtualized those servers become, there are more demand for bandwidth from those Top-of-rack servers, you're seeing people even there go to separate fiber channel connections, because of kind of bandwidth they need. So we have great Top-of-Rack solution. If you pull the guys who are the storage guys, you pull CIO, CEOs, it is end-to-end, it is not a palatable solution.

Mark Sue - RBC Capital Markets

I'm recognizing that you can fortify your footprint with private channel as you move deeper into the data center. Maybe Lloyd and Kenneth, if you want to chime in how you're thinking about just multiplying these recomposed assets so that you can see a multiplier effect as you're going to reinvent the company? What else can you kind of tie in together, so that you can actually compete effectively, with not only the larger incumbents, but also the smaller players who might be going a little bit faster than Brocade?

Lloyd Carney

Well, first of all, if you look at our portfolio, we know where the world is going, right. The world is going towards SDN and NFV. We are the premier SDN, NFV platform based on the acquisition made by Vyatta. And there is no doubt in anybody's mind, that we're in a career where you can look out and say with a certainty where it's going its x86-based, right.

The laptop that you're taking your notes on here, your phone, I mean the same capability that has occurred, that in line enable your phone to be a camera, a video recorder, a GPS device, that same collate of chip technology is propelling the servers and the data center to be able to do more than just normal business out.

The servers and data center can do networking functions and every iteration of those chips sets in the servers, in the data center enable them to do the more network function. So that's where the world is going. We have the premier product there. Over 1.5 million downloads. We just shipped the first 10 gig virtual router in history of the world. So that's where it's going, and we have a dedicated team reporting directly to me now, they were reporting to Ken Cheng, our CTO, before, now report to me. So we are double down on that, that's where the world is going.

And one of the things that we're seeing as customers look to do proof-of-concepts, and we have numerous proof-of-concepts as we talked about earlier in that space going on right now with larger, some of those large customers, they're also pulling our traditional products. I mean, if you're using our virtual router as CPE virtual edge device, you want to collapse back to a router somewhere and they want to collapse back to our MLX router.

So it really is good synergy between our existing product and our new evolving product. And so we're not in doubt where the world is going and we have the best portfolio products today to embrace where the world is going. So I don't see a lot of time moving about competing with yesterday's technology and yesterday's architectures, and try to have a broad portfolio to cover everything people used to do. We have the best portfolio that's probably where people are going.

Operator

We'll go next to Andrew Nowinski with Piper Jaffray.

Andrew Nowinski - Piper Jaffray

Just a clarification on your ADX shipped here. The market leaders in that space has long claimed that to get ultra high-performance you need to have a hardware base solution. Given your strong presence in the telecom service provider market, I'm curious what those large customers have told you with regard to their willingness to move to a software-based solution?

Lloyd Carney

You'll always need as you virtualized these functions, you'll always need a big, bad core router. You always need a big, bad core firewall and a physical-hardware device for some applications. And again, as Intel improves the performance of their processors, and you can get 2 gig backup today across an Intel core, which you put software on it, it's a 2 gig router. Intel is improving that. We're going to get the 4.5 gig, 4.6 gig across those cores.

We're shipping 10 gig virtual capability today across an Intel architecture. So the analogy for you, again is your phone. I mean if you look at what happened to the market on small digital camera, they [ph] chunked, as phones became better cameras, you start a market for digital camera, small or medium digital camera, they'll fall off the edge of the cliff. But people still have big SLRs, people still buy big digital cameras, right.

And the same thing is going to happen in the load balancer space. You're going to have more and more of the functionality is going to be able to deliver the cost, a cost effective Intel platform, and yes, you'll have some corner case for firewalls, and routers and so on that you'll need your big heavy-duty SLR camera. But for a lot of market and every release of Intel processor there will be a smaller part of the market that needs those dedicated platforms.

Ken Cheng

I would just add to what Lloyd said, the suite spots of the market is between 80 gig and 100 gig in the data center. So we are going to focus on offering our customers a solution to satisfy that requirement. And so as Lloyd said, you always are going to have exception cases where people want to have the big firewalls and big load balancer, our strategy is to offer a service chain capability, so that when those need arises, those customers can be redirected to those device, but 90% of the time our solutions is going to be able to satisfy our customers needs inside a data center.

Andrew Nowinski - Piper Jaffray

And then with the upcoming launch of Intel's Grantley CPU expected in calendar Q3, can you just tell us how to think about to your Ethernet revenue and whether you saw an impact on prior launches such as Romley?

Ken Cheng

We believe that is going to be a positive for us, because as the CPU performance and processing power continue to increase, you're going to see a dramatic increase in the VM density. So as customers see VM density increase they are going to want to tear their virtual network and when they want to tear the virtual network they are going to want to have more advance network services. So you will see the release of these new architecture would drag in more need for virtual routers, a virtual firewalls and virtual net devices. So we believe that it's going to be a net positive for us.

Andrew Nowinski - Piper Jaffray

Okay, just last question for you then. With regard to 100 gig, do you have demand from your enterprise and service provider customers or is that mostly in HPC and hyperscale markets?

Jason Nolet

We are starting to see some demand for 100 gig outside of HPC. Larger service provider, larger enterprise, as they are building out kind of next generation data center architectures, they are thinking about 100 gig from the spine of the core and then beyond. So the good news for us is that we were early to market with 100 gig on the MLX routing platform and we're refreshing that as I mentioned earlier. And then we've very recently released 100 gig connectivity on the high-end VDX chassis as well. So we are very well-positioned to satisfy that 100 gig demand.

Operator

We'll go next to Jayson Noland with Robert Baird.

Jayson Noland - Robert Baird

Dan, I wanted to ask about gross margin in SAN and IP network, but I think SAN is trending up and toward the mid-70s at least. That's well above the guidance given last year. Are we sustainable up here? And then IP networking, should we expect -- or where are we first and then should we expect that to mix shift up with VDX strength?

Daniel Fairfax

So yes, we've been quite pleased with our gross margins. We're performing as you can above really where we guided on our two-year view of the marketplace. Certainly, on the SAN side, we're getting benefits from the complete portfolio of this in the marketplace and the value-add, the Fabric Vision, the software functionality we've brought, the Gen 5 portfolio has certainly helped that. We don't anticipate that that's going to change anytime soon. So we feel good about where we are there. And of course, we are major competitors in the market with competing products and has been for few quarters now.

On the IP side, as we look forward, one of the key reasons for our change in strategy to really on the focus on the data center is that the data center tends to buy the products that are more profitable for us. And as we're adding more software-based networking element, we would be very bullish on terms of where our gross margins for IP business go as several more quarters develop here. So we feel good about gross margin profile within the company.

Jayson Noland - Robert Baird

And is it fair to say SAN in the mid-70s and IP networking mid-50s headed north?

Daniel Fairfax

We're not giving any specific guidance there, but I guess if you read into how we guided based on some of the seasonal mix that impacts the IP versus SAN composition of our revenues, you're saying that we're still guiding that the business could be fairly stable on gross margins.

Operator

We'll go to Brian Modoff with Deutsche Bank.

Vijay Bhagavath - Deutsche Bank

This is Vijay Bhagavath on behalf of Brian. I have a question and a follow-up. The question is on your SAN business. In terms of trend line, how should we look at your SAN business heading into calendar '15? Give us some color on the SAN business year-on-year basis heading into next year?

Daniel Fairfax

Is that more a question around the trajectory of revenue?

Vijay Bhagavath - Deutsche Bank

Yes, exactly.

Daniel Fairfax

Or product offering?

Vijay Bhagavath - Deutsche Bank

It's more of the trajectory, want to trend line, like a one or two-year topline trend line for the SAN business.

Daniel Fairfax

Our most current guidance really goes back to what we've provided on Analyst Day, which was, now we're a few quarters adrift from that point in time, but we gave a three-year view that our view is that the fiber channel SAN would continue to grow in a rate 2% to 5% over that timeframe. '14 you can see, as we sit here halfway through the year, we haven't achieved that yet, but we had great results in our second quarter.

So if you take out an adjustment numbers for the divested HBA business 2% growth year-over-year. We're quite pleased with that. So I don't think we're prepared at this point to reframe that overall guidance. And we still feel, at this point comfortable to say, we'll operate in some place in that 2% to 5% growth rate, which is our view of the market overall at the time that we addressed, if that's helpful. We'll provide additional probably view by the time we get to Analyst Day later at the end of the summer.

Vijay Bhagavath - Deutsche Bank

And then the follow-up is around web-scale data center switching opportunities, I mean you saw at Cisco at Cisco Live, talking about the Nexus 9000, the ACI fabric. I think my question is would do you look to compete with Cisco and some of the other players at the leaf and spine, web-scale data center switching category. And also take what you have on the fabric side moving up to covering both virtual fabrics and also the underline physical network.

Jason Nolet

Good question. So we do compete in that web-scale space today. In fact, this last quarter, we won a sizeable deal with a Web 2.0, so called Web 2.0 Company, for data center leaf-switching. And so we are there today, often that ends up being a fabric deployment, and often that ends up being an ICX deployment, leveraging our ICX portfolio for kind of a more conventional non-fabric type of deployment.

So we intend to compete for that business. We've been successful thus far. And as you're pointing out, there is a number of trends that are emerging in that space around things like network virtualization, and SDN, of course, and an orchestration. I'll tell you that the key differentiation for us relative to somebody like Cisco is that we are open, right.

So our kind of embracement from the get-go on things like OpenStack, OpenDaylight's, open APIs and standard protocols is really what's different relative to a vertically integrated kind of lock-in strategy that Cisco is offering customers. So we expect to have that full architectural play. You'll see that evolve over the next year in terms of roadmap. And the key difference for us is going to be openness.

Operator

We'll go next to Srini Nandury with Summit Research.

Srini Nandury - Summit Research

I'm basically trying to understand the SAN market evolution. If you look at what the HBA guys are taking about, talking about declines in 5% to 10%, something in that range. And if you look at your guidance, basically it's implying a flat-to-down 2%. So basically, I'm trying to reconcile.

Lloyd Carney

So this is Lloyd. Guidance is not staying flat-to-down 2%, we're pretty much -- last fall, we talked about a 2% to 5% range and last quarter we did 2%. And so we feel pretty good about where we are. Now, on the HBA, HBA revenue growth has never tracked with fiber channel. HBA has always -- fiber channel storage always tracked server, and as severs become more and more virtualized, there has been requirement for less and less adaptor connectivity from those servers.

So if you look at what has happened over the last three years, the HBA numbers have been falling off and fiber channel has been stable. And so it is not surprising to us that the HBA numbers are falling off. Remember, we decided to get out of the HBA business, because we realized that this is not a growth market for us. So there really isn't any correlation between the HBA adaptors and fiber channel storage.

Jason Nolet

This is Jason, just to add to that. The way to think about kind prospects in SAN is to focus more on the storage side rather than on the server side, as Lloyd said. So if you look at the storage capacity growth, it's growing at double-digits and fiber channel attached storage is going to grow double-digits.

And the other case in point I've made for you is around flash and SSD arrays, right. The data we're seeing from all the vendors that we're working with and we're pretty much working with every flash array vendor in the industry today, is that more than 90% of the time, those flash arrays are connecting via fiber channel, because of the performance, because of the latency, because of the lossless nature of the environment. So that is strongly growing part of the storage industry and that's we would expect to see SAN continue to shine.

Srini Nandury - Summit Research

I have one more question. Your director revenue declined 8% year-over-year this quarter, but your switch revenue was up 9%. Can you comment or provide some color on the data center trends you're seeing and the architectural shift that are causing this, perhaps this is more driven through OEM, maybe something happening with the OEMs themselves.

Jason Nolet

It's a Jason. I would say your latter comment is right on. There is not really an architectural shift going on here. This as you've tracked us over time, you see this ebb and flow a little bit. We are expecting some very high-end storage refreshes from the OEM partners that we would expect would cause an uptick in director going forward. And so you'll see that kind of recover from that point of view.

The strength in the switching portfolio and the midrange of the SAN switching portfolio in particular is very kind of important for us. And that is, that it demonstrates that we're seeing new named accounts and new customers adopt fiber channel, because that's where they would start with the switching portfolios. So we're very optimistic about what that means in terms of growing the installed base going forward with the SAN technology.

Operator

We'll go to Kim Watkins with Citi.

Kim Watkins - Citi

Wanted to go back the Vyatta conversation, I know in the past, I've heard you talk about, Lloyd, the fact that at this point it's a land grab and you just want to get as many downloads as possible, but when does this transition into a revenue model? And I heard you articulate some very specific used cases to that product. So just wanted to kind of put some revenue around that or a timeframe when we could expect the revenue to focus through the model, that's the first question?

Lloyd Carney

Our expectation is that FY '15, next fiscal year, you'll see the revenue start to be something that measurable and we won't talk about probably mid-to-late next year. One of these, we're now in trials that are moving towards not just proof-of-concept when our fees being issued. And most of these are with large, if you look at the probably 30, maybe 25, very large enterprise customers, it will take while to get these rollouts to happen. So I would say it would be probably mid-to-late FY '15 before you'll see real revenue that we don't want to talk about.

Kim Watkins - Citi

And then two clarification type questions. One is the quarter-over-quarter impact, I think it's of the ADC business changes there, so my understanding based on your comments, this $15 million impact in the quarter year-over-year, but that was just same as last quarter, so I'm wondering where the increment is? And then on a sequential basis what the increment is?

Daniel Fairfax

Kim, this is Dan. There is several of factors. We really mentioned three different transitions that we're going through, the wireless, the HBA, which is now essentially done and we're not showing anymore revenue for that business in Q2, but wireless continues to come into the second quarter, delivered some revenue there, and then the tail on the ADP business. So there is several pieces of that that are moving. We can necessarily predict what they are.

So we wanted to give you that kind of in composite, when the tail is kind of done, when that's included into support tail, because the ADX products will have a reasonable support in deferred revenue there, that would be the $85 million. And that to date, we see the $16 million running through and there was $15 million in the quarter. As far as upper level provision I can give you.

Kim Watkins - Citi

I'm still a little bit confused on that, but maybe I'll follow-up when I call later. And then the other point of clarification is, was there any revenue in the quarter from the extra week? I know initially it sounded like you're planning for no incremental revenue from the week.

Daniel Fairfax

We had always state that, Jeff and I debate that, hey, which orders were the extra ones, and so we don't have clarity of agreements there. But what we do know is that the support revenues were enhanced by the extra week. So you can clearly see that on the IP support revenue side and somewhat on the fiber channel side as well, as much of those orders are booked, and then we amortize amount of the balance sheet in deferred revenue. So there was an impact. I did call out that we won't see that same support levels for revenue in Q3.

Kim Watkins - Citi

But just to be clear, when you gave guidance for Q2, you weren't anticipating the extra revenue, is that right?

Daniel Fairfax

We made our best effort at guessing what that was going to be when we put the range together we gave you at the beginning of the quarter.

Operator

We'll go to Kent Schofield with Goldman Sachs.

Kent Schofield - Goldman Sachs

You talked about in the slides. I think it was data center customers representing a high-50% of IP networking. It was kind of flattish Q-on-Q, but up year-on-year. Is that at a stable level given your data center focus? Should we expect that to go higher? How should we think about that mix shift?

Lloyd Carney

I think the answer to that is, yes. I mean there is a tremendous amount of focus on again on the data center. We're really optimizing and transforming the sales organization, to go after more and more of the data center business. As I mentioned, we are seeing a good healthy uptick in proof-of-concepts in Tier 1 enterprise and service provider. So I would expect over the next few periods we would see that continue to strengthen and be robust and reflect a key part of the business.

Daniel Fairfax

And, one, maybe just some modeling help a little bit on that is that these accounts are going to be a classic, once you engage in an opportunity six to nine months to develop the order flow. And we made these decisions maybe a year ago and just been working to reposition the team to even kind of get a sense for how this will feather in. And our expectation is that a share of the data center is of our overall IP revenue should grow steadily over time as we manage on that investment.

Kent Schofield - Goldman Sachs

And then on federal side of things, you mentioned that it was down last quarter, how are you thinking about that going forward?

Jeffery Lindholm

So we're typically next quarter is a growth quarter for fed spending. This is a result of the budget cycle. From my perspective, I think we've kind of hit a bottom, is a question of how rapid that recovery is as the funding starts to free up. The one thing that we've, I guess, suffered from a little bit is historically our business in federal has been fairly narrow and the customers that we serve. We've been doing a tremendous amount of work over the last year to diversify our footprint broader inside DoD and into civilians.

But I think the real growth there starts to happen, as we get built into new programmatic spending in that more diversified set of customers. So I think we're still dealing a little bit of the residual impact of being historically, narrowly focused. The dollars tend to be flowing to existing program, but as the spending starts to take off and new programs get funded, I think you'll see us becoming increasingly well-positioned and just a lot more opportunities across the spectrum of federal segments to the market.

Operator

We'll go to Aaron Rakers with Stifel.

Aaron Rakers - Stifel

So I just want to go back to the SAN growth assumption. So when I look at your Analyst Day event at 2% to 5% growth for fiscal '14, and given the guidance that you've implied and let's say midpoint, roughly flat year-over-year for the fiscal third quarter. I am just trying to understand what the assumption would be implied for the fiscal fourth quarter relative to the historical seasonality of plus 5% to 7%. Are you assuming with product cycles you actually see a stronger than seasonal fiscal fourth quarter to be in that, call it, midpoint of that 2% to 5% range?

Daniel Fairfax

Aaron, the guidance we gave you, the two-year guidance number last year, so it's 2% to 5% over two years. And as we said last quarter, we saw a 2% uptick. We saw Hitachi jump into a 10% customer bucket this last quarter. They had a new high-end storage release. You saw EMC kind of fall back, but EMC has a new high-end storage device coming out this quarter. So we just expect to see some strength on the EMC side.

So we feel pretty good about that range, 2% to 5% over two year window. And again, we might revisit that from next fall, but we need to look at it over a two-year window.

Jeffery Lindholm

And I think if I recall the comments we made in September of last year, we said, expect this to be on even more at the lower end for '14. And we're still very optimistic about how this business is going to develop.

Lloyd Carney

Jason covered up earlier, the hottest segment of the storage right now is SSD array. And we never released with EMC, where we had a joint product portfolio release with the EMC on new SSD array. We have other release coming out with other partners. We did one with IBM actually. And so we are aligned with the new SSD array's coming from attritional part as well as from the new breed of SSD array vendors.

Our engineered organizations rolled out SSD certification program, and if you look at the people on that list, it's all the people who you know and hear about in the alternative SSD array space. So with 90% of the SSD array's being attached to fiber channel and that being the hottest growth segment in storage, we expect to see over the next year that there is some residual effect for us, on us being connected to these arrays.

Aaron Rakers - Stifel

And just a build on that, one of the opportunities that seemed, you had alluded to at the analyst event was to gain share particularly in the largest storage vendor out there. Can you just gives us an update, how that relationship has evolved? Have you started to see signs where you're gaining share, what would you say your share position is today within that largest vendor?

Lloyd Carney

If I were to guess, and then I'd be guessing it be over the future center, the business coming our way, I think we'll do really well with them. I think we just did a launch this week with their SE force as a global launch. We sponsored the event and it was a very successful event for us in the past fiscal year ago. Our primary competitor would be very prominently displayed at that event and this year we were prominently displayed at that event. So there is no doubt in my mind or any of their SE's mind that we are much more preferred partner on a going-forward basis, but we feel really good about that relationship.

Operator

We'll go to Scott Schmitz with Morgan Stanley.

Scott Schmitz - Morgan Stanley

And I'll just make one quick one here. So Dan question for you. Your first half cash flow generation was over 50% of your full year total, and the second half is typically a stronger period, especially the fourth quarter. So can you just talk about any abnormal impacts that would affect the second half cash flow generation or do you expect a more normal kind of typical normal trend?

Daniel Fairfax

I think on a quarter-to-quarter basis you want to look at -- we do have a semi-annual variable incentive program for our employees that pays out. So every other quarter you see that impact. And it tends to align also with the period that we do the bond interest payment. And so you think on the guidance in the third quarter that our free cash flow generation will be down, but there is nothing unusual from capital acquisition or view in terms of the profitability of the business from a modeling standpoint.

Lloyd Carney

Well, thank you again for your time and attention on our call today. We're at the halfway point of fiscal year and we're making good progress. Our technology leadership and focus on the data centers are continuing to drive new opportunities in our business. And we're confident that we have the right team, the right products and the right strategy to take advantage of market trends that can drive our growth throughout this year and beyond. I look forward to sharing more with you about our specific plans and accomplishments in the months to come. Thank you and good bye.

Operator

And ladies and gentleman that does conclude today's presentation. We thank you for your participation.

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