Brocade Communications Systems' (BRCD) CEO Lloyd Carney on Q3 2014 Results - Earnings Call Transcript

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 |  About: Brocade Communications Systems, Inc. (BRCD)
by: SA Transcripts

Operator

Good day, ladies and gentlemen, thank you for standing by and welcome to Brocade's Third 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, Rob Eggers, Vice President of Finance with Brocade. Sir, please go ahead.

Rob Eggers

Thank you, Doris. Good afternoon, and welcome to Brocade's fiscal third 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 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 May 3, 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 growth 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, Vice President of Data Center and Campus Networking.

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

Lloyd Carney

Thank you, Rob. Good afternoon, everyone, and thank you for listening to today's Q3 conference call.

Looking at the quarter, we are pleased with our results as they demonstrate the tangible benefits of our focused strategy. Highlights in the quarter include achieving SAN growth of 5% year-over-year and IP networking growth of 6% year-over-year on an adjusted basis. It is clear we are executing well in key areas of our business delivering and in many cases over achieving on our commitments to our stakeholders. This includes fortifying our already strong position in the datacenter markets through focused and meaningful differentiation, increasing our leadership in the emerging software networking market through innovation and by forging a world class ecosystem of partners, enhancing shareholder value by returning at least 60% of free cash flow back to investors.

We are on track to achieve each of these key measures as outlined in the prepared materials published today. I credit the executive management team and Brocade employees around the world for the successes we achieved in Q3 and FY ’14 to date.

I am also pleased that these results position Brocade to capitalize on a changing state of the network industry that is creating new opportunities for growth. As I discussed in the past, the networking industry is undergoing a much needed market transition that is creating disruptive opportunities especially in the data center.

More importantly, customers in key segments such as mobile network operators, cloud service providers and large enterprise data centers are actively looking at ways to modernize their networks, using open, virtualized and easy to use features and technologies. These trends favor Brocade and our innovation, focus and strategy.

For example, I was impressed by the open dialog I have with federal customers and partners last week as part of the Brocade Federal Forum in Washington DC. The U.S. government is the largest IT organization in the world in terms of budget. However, all federal agencies are under pressure to drive efficiencies and cut costs. As encouraged by the level of enthusiasm I heard from our customers on our data center and software networking strategy and how it would help them with their modernization initiatives. As we execute, we will see good opportunities to loosen the grip that legacy behavior has had in locking up many parts of the federal market to a high cost, single incumbent vendor for more than decade.

I am hearing similar levels of enthusiasm in Open F for change from our customers in a large mobile network operator market. These companies already command sizeable budgets and we expect them to be even more significant in data center networking spending over the next several years.

Further this Telco market has been a catalyst for major advancements in software networking that Brocade has been driving over the last couple of years. We are seeing our progress materialize in dozens of proof-of-concept trials with the largest mobile operator in the world. We are excited about the performance and ease of these benchmark we established for Telefonica, the sixth largest mobile operator in the word, using our software networking products over Intel-based X-86 server. This successful test provides an important glimpse of how network architectures will rapidly evolve in the coming years and how Brocade is addressing these emerging opportunities.

We will share many more details about the go forward business and technology strategies at our Investor Day in New York on September 24. I hope to see many of you there. Now I would like to turn the call over to Dan, who will give a brief financial review of Q3 as well as our assumptions and outlook for Q4. Dan?

Dan Fairfax

Thanks Lloyd. Welcome everyone and thank you for joining our call. In Q3 we achieved topline growth, increased profitability from higher volumes, improved gross margins and lower operating expenses. It was a very solid quarter and I would like to briefly review with you some of the key financial highlights from the third quarter and product revenue in Q3 ’14 $325 million, up 4% from Q3 ’13 and up 1% sequentially.

Adjusting for the divestiture of our HVA business, SAN product revenue was up 5% year-on-year. Our strong SAN product revenue in the quarter was due to strength in international markets and continued customer migration to Gen 5. Our Gen 5 products represented approximately 79% of director and switch revenue during the quarter.

IP networking product revenue in Q3 ‘14 was $133 million, down 1% year-over-year and up 9% sequentially. Excluding network adapters, wireless and ABX hardware product, the IP network product revenue grew 6% year-over-year on an adjusted basis. The sequential increase was primarily due to higher sales to the U.S. Federal Government and strong VEx sales to data center customers, partially offset by lower (running sales and service) [ph] for other customers.

The impact from the discontinued products was approximately 15 million in Q3 unchanged from the prior quarter. In the quarter, we delivered non-GAAP gross margins of 67.2%, up 150 basis points from Q3 ’13 and up 50 basis points quarter-over-quarter. The year-over-year improvement in gross margin was due to a favorable revenue mix shift to more SAN products, a favorable product customer mix within the IP networking business and lower manufacturing and overhead cost. The sequential improvement in gross margin was primarily due to higher revenues combined with lower manufacturing and overhead cost.

Non-GAAP operating margin was 25.7% in Q3 up 410 basis points from Q3 ’13 and up 250 basis points quarter-to-quarter due to higher revenue, improved gross margin and lower operating expenses. In Q3, GAAP diluted earnings per share was $0.20 and non-GAAP diluted earnings per share was $0.23 in the quarter, both up quarter-over-quarter.

In Q3, we generated $106 million in operating cash flow and repurchased 12.8 million shares for $112 million during the quarter. In Q3 ’14, diluted shares outstanding were 4% lower year-over-year and during the quarter, we initiated a quarterly cash dividend of $0.025 for share of common stock.

Now looking forward to Q4, '14 we considered a number of factors including the following [indiscernible] in our outlook. For Q4 ’14, we expect SAN revenue to be in a range of down 1% to up 2% quarter-to-quarter. Typically, we see stronger buying patterns from our OEM partners in our fiscal Q4. However we consider the potential impact of the geopolitical environment in certain emerging markets and the business transitions that we see within certain of our OEM partners as we set our outlook.

For the full year 2014, we expect the SAN revenue will be up 1% to 2% on an adjusted basis that would be at the low end of the two year target model we provided last September. We will be updating our two year target model at our upcoming investor day on September 24th. We expect Q4, ’14 IP networking revenue to be up 6% to 15% quarter-to-quarter principally driven by growth in our service provider revenue with the launch of new high density routing products and a seasonally stronger quarter for our U.S. federal customers.

We expect our global services revenues to be up 2% for the quarter. We expect non-GAAP operating expenses to be flat to up 2% quarter-to-quarter. We have assumed a structural non-GAAP tax rate of 25% to 27% for Q4 ’14. We expect Q4 ’14 operating cash flow to be higher sequentially due to the timing of variable compensation and bond interest payments offset by slightly higher DSOs. We expect Q4 ’14 non-GAAP gross margin to be between 66% to 67% better than our two year target model range.

Finally we expect non-GAAP operating margin to be between 25% to 26.5% also above our three year target model range.

With that I will turn the call back over to the operator to being the question and answer session. Operator?

Question-and-Answer Session

Operator

Thank you (Operator Instructions) And we’ll go first Aaron Rakers with Stifel.

Aaron Rakers - Stifel Nicolaus

Yes. Thanks for taking the question. First if I can, talk a little bit more about the seasonal or sub-seasonal expectations for the SAN business in the current quarter. In particular, can you help us understand the delta relative to historical seasonal patterns as it will relate to the specific OEM transitional elements you’re going to? And if you can, also can you give us a comment on what OEM inventory levels look like currently in the SAN products?

Daniel Fairfax

This is Dan. Let me take those in reverse order, so currently the Q3 SAN, OEM inventory level was 1.4 weeks of supply that we are going to have which is probably middle of the range that we would normally expect a week or two weeks depending on what the various OEMs have in terms of visibility into their own order flows. So the number was up a bit quarter-over-quarter, but again right in the middle of the range that we would project. With respect to the seasonality there we look at the funnel that our sales force is working because in the larger transactions we factor that into our guidance and how we prepare that. And then we also look at what are the dynamics in terms of product launch within certain of the OEMs. We have one OEM has recently refreshed another one we expect to see refreshed product coming out very soon but we don’t know exactly when and as I mentioned we included some disruption that we see in emerging markets due to the geopolitical issues and that potential to go into other markets. We factored those things and which took us off a little bit in our normal seasonal strength in the fourth quarter.

Aaron Rakers - Stifel Nicolaus

And then as a quick follow-on, if I can. On the VDX product, strong growth there, I think 38% year-over-year. It looks like you’re probably running in that kind of $30 million a quarter range right now. First of all, is that the level that we’re at? And then secondarily, how do we think about the progression of that? And then I’ll get back in queue. Thank you.

Jason Nolet

Hi Aaron this is Jason. So your assumption about growth in the revenue being driven there is pretty close with 38% year-over-year and 37% sequentially, that by the way is about three times market growth for the spaces that we plan with the datacenter switching gear and we continue to be very focused on driving growth in this product line the value propositions of automation and efficiency and virtualization continue to resonate very well. As you heard in previous calls and probably hear some more today about getting more and more focused around the datacenter and around this product line we continue to be very bullish. So yes, expect us to continue to drive very strong growth in this product phase.

Operator

Thank you. From Wells Fargo Securities we’ll go to Jess Lubert.

Jess Lubert - Wells Fargo Securities

Hi, guys. Thanks for taking my question and congratulations on a nice quarter. A couple of questions, both on the outlook. First, regarding your expectations for recovery in the service provider business, can you help us understand what’s driving your confidence here? Are there specific large deals or opportunities that may be giving you a heightened sense of conviction, this business will strengthen going forward, or are you getting indications that customers have been waiting for the new products? Any insight here would be helpful.

Jason Nolet

Hi Jess its Jason again. So the softness is really a direct result of a couple of products not shipping on schedule for us, we had a couple of manufacturing delays that pushed both a new higher density 10 Gig-E blade and 100 Gig-E blade from this quarter to next and so that’s what gives us the confidence because we have line of sight to all those customers and all those opportunities. We're equally confident that none of that revenue was actually launched; it was just pushed in a next quarter so that’s a primary reason for the bullishness going forward.

Jess Lubert - Wells Fargo Securities

Anyway to quantify how much revenue pushed on those cards for the MLX?

Jason Nolet

Yes, there are both cards for the MLX and that’s kind of the sweet spot in terms of the MLX’s capabilities and so we were disappointed obviously to not have those shipped this quarter but we get here on the side of making sure that the products are meeting quality standards before they go. So, we just missed the quarter and we’ll start shipping those very shortly now.

Jess Lubert - Wells Fargo Securities

Okay. And then I also wanted to follow up on the SAN outlook, and specifically some of the geopolitical factors you mentioned on the call. Can you help us understand which of the emerging regions are driving the cautious forecast? What percent of your business comes from these areas, and maybe you can help us understand what you’re sharing in these markets today? Have you seen some of the activity in the emerging markets be impacted or are you just taking a cautious view? Thanks.

Lloyd Carney

Jess this is Lloyd. I think the best way to have on this whole global sphere is coming from [Madeleine Albright] who a couple of weeks ago said the world is the mess. We’re moving back and thinking about what you’re seeing going on in different regions on the world and it gives us reason to be prudent in our outlook. We continue to see strength in the BRIC countries except for Russia and Russia of course represents less than two third of revenue so it’s not only -- it’s almost de minimis but if you look at our performance over the last three quarters, three quarters back Russia was the largest deal we did in the SAN space and we had Brazil two quarters in a row, great investments and great traction going on in China. So the BRIC countries are doing great for us and we'll continue to invest in that space pretty aggressively.

But we look at the transitions going on over IBM for instance the fact they just got their approval to sell their business to Lenovo and what that transition is going and then you look at potential and for the issues in Russia to impact greater Europe. I mean people talk about the potential for Europe to fall into a recession based on what’s going on there. So we are doing great in the European market, we’re doing great in the BRIC markets but we just think it’s prudent to be cautious in our projections. But we feel good about where we are, I mean we are -- if the business is there we know we will get our on tier share because we’ve been taking share in the SAN space consistently and we continue to do that and we feel robust about SAN as a portfolio going forward but we are just being able to do that right now.

Operator

We will go to Rod Hall with JPMorgan.

Rod Hall - JPMorgan

Hey guys, thanks for taking my question. I wanted to go back to the split on the product, the blade push outs. I mean it sounds like that was probably in the guidance for this quarter and yet you guys have done well against that guidance. And then it’s lowering in the next quarter so it makes the underlying feel like it’s even a little bit worse next quarter. So I’m just trying to understand just how big that is in order of magnitude, is it pretty small or is it actually material for the numbers. And then based on that, if you can comment on what’s going on underlying trends a little bit more that would be helpful.

Lloyd Carney

So Rod you just want to go back to the guide. We feel pretty good about our IP business, a significant growth as you seen in our East African business 17% year-over-year, 27% sequentially. Component of that when you move on to the overall number and as you are pointing out that routing component was the only part that we didn’t actually execute really well on and we are if you combine what’s going on in the routing space we probably expect to see, we feel pretty good about our IP business in general and I think the forecast our performance this past year reflects the forecast, reflects it. We are not being overly aggressive in that space and the new products new blades doesn’t shifting yet, they will start shifting in the next two three weeks, the demand that we have for the quarter we’re not quite sure we will have enough blades right now to meet the demand for the quarter. So we are being cautious. I mean we could end up telling you the same thing next quarter because we have not been able to meet the demand that’s there.

Rod Hall - JPMorgan

And Lloyd can I just -- thanks for that. I just also wanted to follow up on your geopolitical commentary. Are you actually seeing in the sales funnel indication that this maybe impacting things or is it just more prudence on your part looking at the big picture and then telling new stores we all look at and so on?

Lloyd Carney

The place -- definitely we saw that the results is in Russia everywhere else we are feeling pretty good. We have the advantage of having the superior product, technically a superior product. The developing countries when we go into sell in those markets, they don’t buy based on brand, they could care less that’s CISCO is the dominant player. They’re going to think out of the box and they are going to plug it in and they are going to compare it feature for feature, performance for performance and they are going to buy the best technical solution. Let me get our [indiscernible] we have a high win percentage rate and so we win when we get into the developing countries the BRIC countries because of our superior technology. So we feel good about that, the pipelines are good there. Russia is the only thing on the horizon that we can actually see where the impact is on our Russian business and we feel we got -- and I think the overall theme is cautious because of Europe and the impact of what could happen if the overall European economy goes back in recession.

Rod Hall - JPMorgan

Can you guys quantify the Russian exposure and then Dan I just wonder if you could say how much exposure revenue wise you’ve got there?

Lloyd Carney

It’s less than 2% of our revenue on an ongoing basis. So that the impact really is on the bigger issue of what’s going to happen to Germany, what’s going to happen to France, all these countries are seeing GDP impact because of the restrictions of their [indiscernible] on commerce with Russia.

Operator

We will go Amitabh Passi with UBS.

Amitabh Passi - UBS

Hi, thank you Dan, I had a couple of questions around the model. Just on the gross margin guidance I think you were on the fourth quarter where you have essentially you’ve gone above your 66% target. Trying to understand the guidance for next quarter again pretty healthy gross margin guidance given softer storage sales. So are we just at a new level and should we be rethinking what your target range is. Just any clarity in terms of the gross margin outlook.

Dan Fairfax

Well you can see we have been very pleased with the profitability of the products and certainly how pricing has held up in the marketplace. And we consistently operated about the guidance we’ve set last year at our analyst day so we’ll kind of pause on that and we’ll update you in a few weeks in September when we come up with new guidance.

As we look at how we set that though, well first off, as you point out we’ll look at the mix between the SAN business and the IT business and what we set as our target and that we’re going to factor in inside the product family mix as to what the pipeline looks like we’re going to deliver there is, there is still some fairly significant difference particularly on the IT side, depending on what makes the products that we’re selling and of course one of the reasons why we said as a business we want to focus on the datacenter is that where our higher margin products are and there is a very strong value prop [indiscernible] market there so that all kind of ties together.

So we factor that in and then third will be where do we stand in terms of things like reserve formation, product transitions can from one quarter another create additional expense related to the foreign reserves to properly state the balance sheet and then maybe lastly just how we’re handing the seasonality of manufacturing overhead cost for say summer season for vacations. We factor all those items and we come up with the guidance range.

Amitabh Passi - UBS

Okay, and maybe just as a follow up again just on some of your metrics, cash conversions have gone from 60 to 10 days, how much better can you do there and just on headcount, you added I think 42 first this quarter I think the first quarter in a while, how should we think about headcount progression?

Dan Fairfax

Yes, so let me address and Lloyd may have some comments, so we’ve been very public about our interest in investing in our software networking engineering teams and so we’ve been doing that. A lot of the growth you’ve seen quarter-over-quarter is in that capacity that we brought on to the business. We’re looking for best talent in the market we’ve been very pleased as the people that will bring on board. That said is we are selective and so don’t expect to run away headcount hiring within the business. I’m sorry the first part of the question was --

Amitabh Passi - UBS

Yes, just related to cash.

Dan Fairfax

Yes, cash conversions, so we probably when we look back, look we may have hit a record in terms of our base sales outstanding in terms of hitting that little watermark of 32 days and largely that was driven by very strong early quarter shipments and we’re able to collect a lot of that cash before the end of the quarter. We wouldn’t normally plan at that level and so we baked going back to a more normal DSO percentage as day sales outstanding as we exit the quarter.

Amitabh Passi - UBS

Okay, thank you.

Lloyd Carney

On the headcount part I think we’re probably 500 behind where we were a year ago at this time but even when we’re going through our downsizing effort last year, we continue to invest in higher in key sales growth, key engineering rolls into support of our software networking, network function virtualization function. So, you should expect to see as we fill out that portfolio that we will be continue to hire people in key positions across the organization. The focus will be on efficiency however, I mean I think we have delivered through the marketplace now a business model that shows that we know how we expectedly we run this business and we’ll continue to do that.

Amitabh Passi - UBS

Yes I just want to second that. It sounds like we may see a steady progression up in most of the heavy cuts are probably behind?

Lloyd Carney

I would say so.

Operator

We’ll go to Andrew Nowinski with Piper Jaffray.

Andrew Nowinski - Piper Jaffray

Thanks for taking the question. Regarding the Ethernet business from a longer term perspective you talked about that business growing 6% to 7% and I think you said the normalized growth rate of products was 6% this quarter which is in line with your target however, can you provide any color with regard to the normalized growth rates within the datacenter carrier in campus? I’m just trying to gauge whether the long term target is still realistic base on the trends that are occurring within those three segments.

Lloyd Carney

Well, the long term target, we talked about the growth rate in the data center being between 10% and 12% roughly. We grew in that datacenter space in excess of that so we are growing fast in the market. We don’t normally call out a growth rate for the campus that I recall

Dan Fairfax

Well we did an investor day so we said that’s growing at about 4% of -- all that was wireless and the wired switching which is what we'll just say was essentially flat, that was our guidance coming to this year.

Lloyd Carney

So, our strategy going forward is to outpace the growth in datacenter which is 10%, 12% and we’re doing roughly 20%ish. Our strategy on the campus is to have campus products that enhance our access into the datacenter. We don’t have a wireless portfolio as you know we actually the wireless portfolio so our campus strategy is really campus were it enables us to get good things into data centers and we saw a good growth there in the last quarter also and in excess of what you traditionally see in the campus market but there is a lot of campus repurchase going on out there specially in the [indiscernible] environment, public sector environment, other people employing their campus assets over seven years and what you find here, you hear a talk about these cheap white box servers and switches out there, people combine those for their mission critical campus environment and they are going to buy from established vendors who can provide service and support to them. So, we’re having good success there.

Andrew Nowinski - Piper Jaffray

And then on the carrier side is that on track as well?

Lloyd Carney

The carrier piece for us it's a lot similar our business and Jason has a really good telemetry business going there and I think when we catch back up with these blades, we’re shipping this quarter, we’ll see that the carrier business gets back up.

Dan Fairfax

We’ll update these both market growth rates and let you know where we’re participating in a few weeks when we come back at Investor Day. The one thing to recall is that, we did say we’re focused more on the data center and that goes with the carriers, so we deemphasized some of our sales emphasis on carrier transport problems and more on the data centers. So as I mentioned telemetry, it’s a very strong routing application for the analog. And that’s where a lot of these products that we said where we had the pause because of the manufacturing delay we’ll slip into.

Andrew Nowinski - Piper Jaffray

Okay so just to be clear the 6% to 7% overall growth rates, if all three are outperforming on expectations that you’re still comfortable with that 6% to 7%?

Lloyd Carney

Yes, that’s we wouldn’t make any change to that at this point.

Rob Eggers

All right, Andy, thank you for question. Operator, we’ll take the next question please.

Operator

From Goldman Sachs we’ll go to Kent Schofield.

Kent Schofield - Goldman Sachs

On the SAN side of things the OEM transition that you’re seeing at the two partners, do you expect that to get through those this quarter or should we expect some more of that in the next quarter as well?

Lloyd Carney

On the IBM front, I definitely expect that’s a drag on for a little while longer, such a major transition to happen. So we do expect to see some effect however still expect to see SAN performing in the range that we’ve talked about which is minus 1% to 2% range for the quarter and we’re on track where we told you last year be the low end of that field overall guidance range about 2% for the year, I think. Now we’re feeling, the transition role is occurring, we’re keeping a really close eye on it. We don’t see that we’re losing well. We know that will be in the market share throughout these transitions there might be some delays but we actually manage to capture market share throughout these transitions. So we feel pretty about being able to manage through these transitions.

Kent Schofield - Goldman Sachs

Okay, thanks for detail there and then on American region, can you help us with just kind of the adjusted growth there. You’ve talked about it being down 11 in the deck. I didn’t see an adjusted growth basis and then more importantly I guess just what are some of the trends that you’re seeing underlying whatever that adjusted growth rate is?

Lloyd Carney

I don’t have the numbers broken up with the math exactly to your question. I think when we look at the numbers, the biggest impact on the Americas revenue was really the service providers the piece that we lost as a service provider would have registered on the Americas revenues. And that will be where you’ll find the difference almost all over right there.

Rob Eggers

Thank you, Kent. Operator, we’ll take the next question please.

Operator

We’ll go to Mark Sue with RBC Capital Markets.

Mark Sue - RBC Capital Markets

I guess on the SAN side, if I look it from a year-over-year point of you there seems to be a little bit of share gains for Brocade. Does the increasing wedge between VMware, VMC against Cisco, does that create an opportunity for you and maybe overall your case of share gains within as you strengthen it has to be other OEMs in SAN please?

Lloyd Carney

I think on the -- in general, Brocade partners are better comp in the world in the technology space. Nobody has better relationships with all the compute vendors and all the storage vendors in the industry. And we continue to execute really well on that front. So when our partners whether it’s CMC or HP or IBM or Dell or [Min Amp] have a choice to make as who their partners in the SAN side, it is becoming increasingly clear to them, that is only one valid choice, the only one valid choice they can partner with on the SAN side is Brocade.

And we’re seeing movement in all our partners that we’re getting closer relationships with all other partners. And the team is executing well on that front, so you should expect that as you called up the VMC, Cisco, VMware issue they have been -- we just one the next VMware datacenter build out in India now with head-to-head with all our major competitors. So again technology in this season are being made we have superior technology, so we win. So there is no partner today on the SAN side and that win by the way with an IT win that we did in India with VMware and they certainly could have chosen any vendor and they certainly chose Cisco and probably two years ago we would have been handed to Cisco.

Today we won based on our technical merits. So if you look across the partners, there is not a single partner who doesn’t realize or anyone who uses SAN products that we have a superior product. The Cisco SAN part was almost an afterthought. You just have to look at the platform. Physically look at them you can tell we have a better product, never mind the feature and functionality. So if the machine went off we have lost in a head-to-head against the Cisco with a superior product. So we’re doing well with our partners because they know we have a superior product.

Mark Sue - RBC Capital Markets

That’s helpful. And then a question for you, the company has been very investor friendly with capital returns. What sort of the framework in terms of cash returns now that you’ve exceeded you 60% and having then 80% and also the process of thinking about dividends in the future you’re paying dividend and we expect that you will be a consistent dividend growth as well.

Lloyd Carney

So Mark let me answer those on the reverse order. So on the dividend side that you saw in the press release, where we release earnings we also the board and declared a dividend for the fourth quarter so current course of speed with the visibility of the cash generation of the company the dividend should be a durable part of our return of cash to our investors. One thing if I go back and maybe just give some a little bit of insight to the dialog we have mentioned has internally around our strategy and then how we discuss with the board capital allocation we’ve got a really clear vision to what we want to do with the business. I mentioned earlier this software networking part of our business is quite interesting in terms of how we think that can be very disruptive in the marketplace.

So we’re looking at what can we do to make sure that our position in that market which is very strong right now continues to grow as the market adopts those new products. And so that we’re looking actively at both organic investments in engineering as well as in things we might be able to do inorganically. So no declarations there we’ll give you a little more guidance in September I don’t know how much we’ll actually release on that. So we do consider an inorganic use of cash and inorganic strategy as part of the key use of cash as we look forward.

Rob Eggers

Operator we’ll take the next question please.

Operator

We’ll go to Chad Bennett with Craig-Hallum.

Chad Bennett - Craig-Hallum

Good afternoon guys. Thanks for taking my questions. I guess first question what is the excuse me if I missed it. What is the service provider percentage of revenue overall and if you care to talk specifically about the exposure in IP networking that’d be great.

Dan Fairfax

So let me just kind of frame so service provider in the third quarter generated just under $50 million worth of revenue for the business and so that’s not a direct read on the router business because there is number of products that we saw onto this service provider market so to give you an answer there. And the other…

Chad Bennett - Craig-Hallum

You see as much as you can tell on the IP networking side, what that vertical is?

Dan Fairfax

We don’t usually breakout the IT networking number we breakout the datacenter number.

Chad Bennett - Craig-Hallum

Okay.

Dan Fairfax

It’s a risk for average, just the general thing. Look IP number -- I mean IP is a big networking numbers that was about 133 million in the quarter so that roughly again we haven’t been publishing that so just to give you a sense when we talked about service provider, it was about $47 million in the quarter for revenue there. And then of course we did as we talked, had to pause on some of the router business which would have added to that number.

Jeff Lindholm

This is Jeff and also it really doesn’t if we were to call it out it wouldn’t really reflect the overall service provider contribution because the vertical organization we have focused on service provider is focused on a finite number of large scale service providers. So there is a significant amount of engagement in other service providers that are executed by the regions.

Chad Bennett - Craig-Hallum

Okay. And then just quick update on Vyatta again sorry if you talked about this already. Where we at in terms of proof of concepts and when should we start to see at least some amount of revenue contribution to the IP networking business? Thanks.

Jeff Lindholm

So today we have incumbency into the largest cloud service providers we’ve had for some time and that’s kind of in annuity business it’s not a huge contribution to the IP number but it’s not immaterial. The POCs and so we’re involving about 30 POCs kind of globally generally with tier one providers I think where we’ll see the most impact in the shortest period of time as some of these very large carriers start to transition their service EDGE platform into a virtualized construct. As you know we just recently had an announcement from Telefónica where they’ve been testing our performance and we’ve come out very uniquely well positioned in terms of a performance point of view that’s part of their validation of wanting to put this in production. And there are other service providers like AT&T with their domain 2.0 initiative who are extremely aggressively in deploying virtualized network services for their service EDGE and they have very aggressive schedules to select vendors and to deploy that in very near term very much more aggressive than I’ve ever seen in organization like AT&T before deploy new platform. So I would expect us to see some of that movement shift into early 2015 in terms of actual production implementations of FC and NFV.

Rob Eggers

Operator, we will move onto the next question please.

Operator

We will go next to Vijay Bhagavath with Deutsche Bank.

Vijay Bhagavath - Deutsche Bank

Two questions if I may. The first question, Lloyd Carney, you made some interesting points around some disruptions happening in networking, fully agree with you in terms of architectural level shifts versus just new product. So, I would like to get your understanding of how Brocade is positioned in some of these architectural disruptions? And then how do you see that influencing your growth rate over the next year or two? And where I am coming from is, you have consensus sitting in the 1% range for the next year or two. How would you see your business growing over the next few years, so that it helps us model your company on a going forward basis? Thanks.

Lloyd Carney

Well I think we will breakout a lot of that detail in the September Analyst Day as we get closer to that day, we are doing some of those models ourselves, we are sharing with you. Over the architectural discussion, there is clearly a shift towards an open architecture and as customers look out to what they want to build for infrastructure next two, three, five years, they will ensure that they are buying from vendors who really embrace an open architecture. And so, we have an architectural strategy that we have embraced that we share with our customers that guarantee them that we are going to be able to enable their infrastructure to be able, some of our network function virtualization that we are going to provide them open architecture open solutions that we will be able to leverage cost effective x86 architectures with an Intel or AMD or even the new ARM guys are coming in the space.

So, that’s the first thing that comes when we are using the litmus test, is this an open architecture, can I run your software that you will deliver to me over time on x86 architecture. And in preparing to get there, they are looking at our Ethernet architecture and they realized that Ethernet architecture we have today enables to be STN rate, gives them an infrastructure that can roll out today because there is no architecture where there will be no switches, I mean at some point in time, you can get efficient to some amount or you can replace some of your firewall’s low balancers, routers, switches with x86 base architecture but there will be a requirement to have traditional switches at on RAMs to off RAMs into your existing infrastructure. And those switches have to have an open architecture also.

And so, with our own flow enabled routers or switches, we provide them with that transition from the architecture of today to the architecture of tomorrow. So, probably 9 engagement we have today with new customers. They want to know our STN new story is and they want to know how we are going to take them from the legacy stuff they have been buying for the last 20 years of architecture to this new architecture. We have products in Jason’s portfolio, it enable them to bridge them to Kelly’s portfolio, which is the STN portfolio. So, we have the best of both worlds. We can take you from where you are either rapid, early adopter phase or we can take you to transitional model to this new open architecture. So, the alignment we have between our hardware based architecture and their software architecture is an advantage for us when we are going to face these customers today.

So that’s the major shift. We are seeing new customer engagements because of our STN store that pulls through our routing products, that pulls through our traditional Ethernet fabric products. There is probably no engagement I can think of right now. We are doing a trial on our STN our NFV story where it doesn’t include traditional products also and so that is one of the benefits we have is I think we have a pull effect of the products on our traditional architecture. And then again on the revenue expectations, we will share that with you when we get to the September and the growth expectations when we get to September date.

Vijay Bhagavath - Deutsche Bank

A quick follow-up. You did mention about your U.S. fed sales picking up. You think fed spending has turned the corner and you see kind of an improving U.S. fed outlook for the next few quarters, what are your thoughts there?

Lloyd Carney

What I would say is that people in the DCO last week and instead of worrying about additional costs, they are actually, and I met with all the defense agencies, most of the non-defense agencies, everybody was talking about we have hit bottom, somebody was talking about cost of moving improvements in their budgets and so that’s the first one for about years. So, we definitely think that we have hit bottom and there were some reluctance to spend money on new things. They were targeting spending only on old things because the continuing revolution really hamstrings them how they can spend the money.

Now that they are beyond the continuing revolution, they have a budget even though it’s flat. They have flexibility to spend on new things, so we are definitely seeing an uptick from our standpoint on new projects that we are competing with, that we are well positioned with. So, we feel good and it speaks to Anthony Robins, who runs our group for us. I mean he really stuffed with it while other people were laying off in that region and cutting back. We leaned into it and we are investing in that region and we are not seeing the benefits of the investments we have made over the past couple of years

Rob Eggers

Operator please move on to the next caller.

Operator

We’ll go to Keith Bachman with Bank of Montreal.

Keith Bachman - Bank of Montreal

You suggested that the SAN guidance is related to product transitions at your customers. I would assume therefore you would endorse that either the next quarter; subsequent quarter would have better than seasonal trends as those customers work through the product transitions. Is that a fair comment?

Lloyd Carney

Product transitions at our OEM partners, the IBM guys selling their server business to Lenovo, transitioning we have embedded solutions with IBM, we’ve got traditional products they shifted are not embedded and now we’re having to work with Lenovo on that, we’ve got EMC shipping a new high end storage device.

Keith Bachman - Bank of Montreal

I understand that, but if there some transition issues and its sub-seasonal in the current quarter wouldn’t the subsequent quarter be better than seasonal as they have been launched those products. Or are you suggesting that fundamentals have changed in those businesses?

Lloyd Carney

No we don’t think fundamentals have changed, but we think that Lenovo transition is going to take more than a quarter, that’s stuck on a go away next couple of months. And that probably is the major IBM any quarters we’re number one or two for us as a partner, and so we have to be careful how the transition occurs.

Keith Bachman - Bank of Montreal

Do you think you’ll lose those business? Any kind of share loss there?

Lloyd Carney

We will not lose share, whatever transition is. The timing of it might be an issue but as far share a lot in the overall down space, no we won’t lose share.

Keith Bachman - Bank of Montreal

Do you think you pulled forward any revenues from the current quarter that you just closed in the same space that impacted the guidance?

Lloyd Carney

I don’t think, we always have big deals we talk about some of that impacting your OEM levels of inventory et cetera at the end of the quarter but nothing that we would really point to. We would adopt to your optimism about the future looks good for these technologies and our business but we’re also not guiding Q1 right now.

Keith Bachman - Bank of Montreal

It would just seem to me that Q1 should be better, Q1 or Q2 should be better than normal seasonality if you’re suggesting that the current guidance incorporates product transition and less seasonality or else the fundamentals would have changed. So something just needs to even out so to speak.

Dan Fairfax

I see Lloyd taking note to give Jeff higher quarter….

Keith Bachman - Bank of Montreal

Let me just ask one more. If I think you mentioned deal flow and interest in doing perhaps some M&A or inorganic growth. Is there any kind of dimensions you could add to that, what would be the sample size of the range deals that might be of interest to Brocade? Is there anything that would for instance be too large from a dollar standpoint that probably wouldn’t be of interest.

Lloyd Carney

Before Ken jumps in, let me say. So we would have pricing discipline. We are pleased we have a very strong balance sheet but it’s not as if you know – you earn the balance sheet and essentially the farm. So I think we’ll be cautious but ken maybe as a comment from the types of things you look in.

Ken Cheng

I would just say that we’re going to stay consistent with what Lloyd has shared with you in the last few conference call, which is we got to really focus on technology tuck ins and filling the gaps where we need to acquire assets to complement our product today and so that we can have a complete and industry leading datacenter staff.

Operator

We’ll go to Scott Schmitz with Morgan Stanley.

Scott Schmitz - Morgan Stanley

Just a follow up on Keith’s product transition question. Can you remind us what’s happened in prior cycles, so as your customers have launched new SAN products. Is there an immediate pull of your product? Is there a delay as to when you actually see the benefit?

Lloyd Carney

It’s a good question. So on the director side in particular we’ve had two of the top OEMs delivered new high end arrays, one of them releasing shift in April the other one we expect in the September timeframe. We do expect that to have a reasonably direct correlation with the director class products in the SAN portfolio. The switch business is a little more run rate and so this correlates to a new OEM storage release necessarily but on the director side we do see some correlation there.

So we’re optimistic about the effect of the two products that I mentioned, there is a very high end of the OEMs storage product portfolio and that should be good for the director business.

Scott Schmitz - Morgan Stanley

And then Dan maybe just a quick question for you and you may differ to the analyst day but you’re obviously operating well above your operating margin target. And so I am just curious as to are there investments out there and now that you’re through some of restructuring divestitures that you need to make, that brings you back down into that range or are we at a more sustainable level?

Dan Fairfax

I think we should differ that conversation to September now. The one thing I would reiterate what Lloyd talked about earlier is that we’re not kind of static in terms of telling the team here’s the money you have, keep doing what you’re doing. All of our teams are looking at how do they use the learning curve to become more efficient and the parts of the business that are going forward and were something as less strategic or tactical there redirecting resources on ever going basis within the business. So we’re all was making change now and the organization across the company is quite high to energy around that.

Rob Eggers

Thank you Scott. Operator we’ll move on to next caller please.

Operator

Our next question comes from Jayson Noland with Robert W. Baird.

Jayson Noland - Robert W. Baird

Great, thank you. Dan with the IP networking guide, you’re implying run rate of almost 600 million in that mid 50% gross margin but appear that you’re close to breakeven or better at this point, is that the right way to look at this segment of the business?

Lloyd Carney

We haven’t been putting up that what we would estimate there is profitability in the side of the business so I’m going to not actually break on that.

Jayson Noland - Robert W. Baird

Okay. Or just to take down inside IP networking a bit on VDX is it still fair to assume rally solid gross margin there low to mid 60s.

Lloyd Carney

The gross margins continue to be very, very good on those products. We’d say the gross margin profile of that business has allowed us to go more aggressively in certain large transactions because we have the head room with those products with gross margins has stayed up quite nicely with property that’s in the device.

Jayson Noland - Robert W. Baird

Okay. Then obviously you compete with Cisco there, do you see Arista much at all?

Dan Fairfax

Jayson we do see Arista from time-to-time I’ll tell you that I think we think we have superior offering and it will go back what Lloyd said about SDN enabling the Ethernet fabric that is a very strong scene in area for investment for us and we see a risk that deferring on SDN to others. And so we think we’re going to have a significant advantage there as the market continues to transition to SDN architectures. And then the other point I’d make is that just native to the Ethernet fabric product itself the VDX switch family a level of automation that we have built into that device far exceeds what can be achieved with rest of product line. So our customers are looking to reduce operating expense reduce the point in time and ultimately make their life easier with respect to the networking layer, we’ve got an advantage over there for sure.

Jayson Noland - Robert W. Baird

Okay. And last question from me, Lloyd how distributed as your fed gov business today relatively to the traditional strong holding defense?

Lloyd Carney

I think we’re making good progress on that Anthony said out actually couple of years ago to hit that diversity, the diversity not only in the agency complexion but also again in more program related businesses and less tactical. So we are progressing into civilian or progressing into Intel and getting out from underneath concentration in a couple of the DoD agencies and we’re expanding in the DoD as well. So we’re making progress we look at the pipeline, the pipeline consist of increasing rate of additional DoD and non-DoD agency opportunities.

Dan Fairfax

I think the other interesting this is of course solid days for federal business recovery as we see ones falling into the full range. But the mix of business is shifted from the traditional business being highly campus land or in it to much more datacenter. So again one more proof point that the organization across our business gets it bit focused there and that’s where we can, resource is behind their indicatives so that’s going to be positive change.

Rob Eggers

Thank you Jason. Operator we’ll move on to next question please.

Operator

We’ll go to Matt Robison with Wunderlich Securities.

Matt Robison - Wunderlich Securities

Thanks. Two questions, first is one VDX compared to the prior quarter, should we look at this as some business that essentially swift into the joint quarter maybe give a little color what change because certainly was a much different outcome in the July quarter?

Lloyd Carney

Yes, I would say a couple of things have changed, one is we’re seeing larger deals and larger networks and this is part of Jeff’s initiative around going after bigger opportunities and that’s starting to really worked out so for example we saw an uptick in 40 gig adoption of the platform we saw an uptick on the modular chassis to VDX 8770, those things will drive significantly more revenue compared to just selling the topper activities. We hit a new higher watermark in terms of number of customers in a single quarter a number of new customers in the single quarter almost 500 actually. So if there is a number of factors they’re coming together to drive greater strength there but they have to pick up one thing it would probably be larger network, larger deals and really the sales team executing better against existing frontline.

Matt Robison - Wunderlich Securities

Another question is one where I expect to hear a lot more next month but give us a little bit more to work with on the monetization of NFV and you mentioned a big cloud provider that’s been using for a while there aren’t a whole lot of big cloud providers so if you’re going to monetize you’ve already got one of those, why isn’t it moving a needle yet a little bit?

Lloyd Carney

Well I think one of the things that we see that can move the needle is a number of these cloud service providers. When they got, when they began with us in the virtualized platform it was really the sort of the utility model where people would come in with their credit card and spin up in instance a lot of this card providers are moving up market. If you look at Amazon and I’d say SoftLayer, they are starting to build a campaign to go penetrate the enterprise market which is, which will we think drive larger opportunities for us in terms of the run rate of the business. The other thing I would say that there is an agreement that sort of those guys represent the lion’s share of the utilization of NFV. But we’ve identified a fairly large number globally of emerging cloud service providers they won’t be like them in terms of scale but there are hundreds of them and there are new ones every day. So one of our key to do is really for next year is to kind of automate our ability to engage and win similar platforms with large number of albeit smaller but a large number of cloud service providers. And then on the sort of the tier 1 carrier side, I think that model looks like different and I think those organizations are big tier 1 as they start to leverage NFV to kind of rearchitect their service edge platform, the kind of the numbers of instances of software that they are talking about are pretty significant deployments. And so I think there is opportunity to go upscale enterprise with the existing large cloud providers, there is an opportunity to expand that model into additional cloud service providers beyond them. And then I think one of the big opportunity without these tier 1 carriers update their service platform that becomes a very significant opportunity.

Matt Robison - Wunderlich Securities

So a lot of this takes to get these guys to step up and start paying some maintenance fees evolving into a more critical application.

Dan Fairfax

Well yeah I think as they move into the enterprise the expectations on support are going to go up for their customers and so they are going to need to start thinking about how to scale that experience for those enterprise customers. And certainly the tier 1 carriers who are looking to again kind of redesign their service edge, the will want support from the vendors that provide those software platforms.

Operator

Our next question comes from Alex Kurtz with Sterne Agee.

Alex Kurtz - Sterne Agee

Lloyd just back to IP networking business gross margins they have been obviously pretty stable here for a while. And given that there is going to be some changes in how customers deploy new kinds of fabrics over the next couple of years, it seems like there is great opportunity to potentially accelerate share in that market and maybe go below your comfort zone on margin and just sort of set yourself up for the next couple of years because there’s just a lot of different vendors obviously coming to market with new SDN and FV technology. So are you guys looking for that conversation or is it pretty just -- pretty much I want to set a certain P&L on that business and don’t want to deviate from that.

Lloyd Carney

The message to the team and our marching orders are it’s a land grab right now. If you grab as many customers are as possible get as many trials going as possible and insure that we exposing to as broad of audience as possible our portfolio of SDN products because we have a superior products from a performance standpoint. They did the test lastly with Telefónica 80 gig coming out a x86 (Ph) based platform, its unheard of that kind of performance out of x86 based platform. So our big issue is not the pricing of it, it’s just scaling up our teams, our sales teams, our product management teams, our customer facing teams to handle all the incoming request we have right now. So you will notice again someone mentioned that the hiring we are doing a lot of these target awards meeting their needs. So we are not confused it is about getting much market share in this place as is humanly possible. We have with over 100 million downloads to date, the biggest deployed NFV solution to marketplace today and we plan to build on that. So now where we are confident that we will be able to get the right margin eventually in this space, right now it’s a land grab, get as many as customers possible.

Operator

From Citi, we will go to Kim Watkins.

Kim Watkins - Citi.

Hi, thanks so much for letting me in. This might be long shot but you’ve talked now about SSP, SSP attached being a big driver for the SAN and fiber channel business. This quarter I think I saw them back again. Do you have the sense of what percentage of your SAN revenue now this represents?

Dan Fairfax

We don’t Kim. We do know that it’s growing fast anecdotally both as a result of the existing OEMs that we work will all of whom who are delivering flash-based products now as well as number of startups in this space that every one of them we’ve got relationship with. We do know from those relationships that about 90% of the time those arrays are connected to a fiber channel network. And so we see a lot of good signs there but we actually don’t track our director and switch revenue as a function of the type of array that we’re passing to. But I can’t provide any more insight there. But you pointed out correctly and that is SSD is going to continue to be a strong driver for fiber channel because fiber channel is unique in its ability to provide very low latency in determining the performance against that technology. So we’re confident that will continue to drive good business for us.

Kim Watkins - Citi.

Okay, thanks. And then one other quick question on the VDX that was obviously very strong sequentially this quarter you said it also up sequentially. Is that a coincidence I mean is that a significant customer to the VDX and if not kind of whether the pockets of growth on a vertical basis we are seeing to that product?

Lloyd Carney

Yes, so we do see some government wins on the VDX side. And again VDX in the value prop around automation and efficiency is very horizontal and plays in just about every vertical. If you look at the top verticals for the platform and the product line kind of inception to-date it would be service providers, cloud providers, financial services, technology companies because they’re often early adopter of new technology like this and then government state and local government as well as the Fed so that’s where we got the strength today. But we do see the technology appealing across the write down of the segments because it is a horizontal value proposition.

Kim Watkins - Citi.

And which side up disproportionately this quarter?

Lloyd Carney

I would say disproportionately I’d say we saw the recoveries as here that we saw on the campus side and the other product lines. Again I’d point back to the cloud and service provider’s financial services and technology companies as continuing to lead the pack.

Rob Eggers

Thank you, Kim. Operator, we’ll take one final question from next caller.

Operator

Thank you. From Summit Research we’ll go to Srini Nandury.

Srini Nandury - Summit Research Partners

Thank you guys for taking my call I have a question on server virtualization and what it does to your mix of your stitches in directors. Now obviously you saw virtualization as give the sort of account and you would need to approach to connect to your network and so forth so how should we’d be looking at SAN versus I mean the stitches versus directed shipments?

Lloyd Carney

So server virtualization continues I think to place in favor of fiber channel and the reason for that is now fiber channel is more affordable right the more VMs you can amortize against the connectivity having fiber channel SAN the more attractive it is from that point of view. I don’t know that it’s highly influential with respect to directive versus switch that typically a function of customer scale and the size of their storage environment. We’re much more sensitive to the number of storage ports than we are the server ports in terms of fiber channel SAN technology. But by-enlarge server virtualization continues to favor not only a shared storage infrastructure but fiber channel technology in particular.

Srini Nandury - Summit Research Partners

Okay. And how much of your current installed base in fiber channel has been upgraded to first generation?

Lloyd Carney

So we are at approximately 46% of the installed base on the director side and approximately 26% of the switch installed base in terms of Gen 5 so far.

Srini Nandury - Summit Research Partners

Thank you, Gentlemen.

Lloyd Carney

This is Lloyd again. And so in closing I’d like to thank our customers and partners for their continued support. Thank our employees for their hard work and dedication. Thank you again for your time and thank you on call today. We look forward to reviewing our strategy and business outlook with you at our Investor Day in September 24th New York City. Good bye.

Operator

And ladies and gentlemen, that does conclude today’s presentation. We thank you for your participation.

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