Brocade Communications Systems' CEO Discusses Q2 2011 Results - Earnings Call Transcript

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

Brocade Communications Systems (NASDAQ:BRCD)

Q2 2011 Earnings Call

May 19, 2011 5:30 pm ET

Executives

John McHugh - Chief Marketing Officer and Vice President

Dave Stevens -

Ian Whiting - Senior Vice President of Worldwide Sales and Marketing

Richard Deranleau - Chief Financial Officer, Principal Accounting Officer and Vice President of Finance

Michael Klayko - Chief Executive Officer, Director and Chairman of Corporate Development Committee

Robert Eggers -

Jason Nolet -

Analysts

Nikos Theodosopoulos - UBS Investment Bank

Brian Marshall - Gleacher & Company, Inc.

Mark Sue - RBC Capital Markets, LLC

John Slack - Citigroup Inc

Keith Bachman - BMO Capital Markets U.S.

Shelby Seyrafi - Caris

Jess Lubert - Wells Fargo Securities, LLC

Aaron Rakers - Stifel, Nicolaus & Co., Inc.

Kent Schofield - Citi

Jayson Noland - Robert W. Baird & Co. Incorporated

Glenn Hanus - Needham & Company, LLC

Paul Mansky - Canaccord Genuity

Brent Bracelin - Pacific Crest Securities, Inc.

Mark Moskowitz - JP Morgan Chase & Co

Douglas Ireland - JMP Securities LLC

Vijay Bhagavath - Deutsche Bank AG

Katy Huberty - Morgan Stanley

Ittai Kidron - Oppenheimer & Co. Inc.

Operator

Good day, everyone, and welcome to the Brocade Communications Systems Inc. Second Quarter 2011 Earnings Conference Call. Today's call is being recorded. At this time, I would like to turn the call over to Mr. Rob Eggers, Vice President of Investor Relations. Please go ahead, sir.

Robert Eggers

Thanks, Rebecca. Good afternoon, and welcome to Brocade's Q2 Earnings Question-and-Answer Conference Call. By now, you should have seen our press release and prepared comments, which are available on our website at brcd.com. The press release is also distributed by Marketwire and furnished to the SEC.

Before we take your questions, investors should note our comments today may include forward-looking statements regarding Brocade's financial results, cash and debt positions, plans, market opportunities and business outlook, 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-Q for the fiscal quarter ended January 9, 2011 and our Form 10-K for the fiscal year ended October 30, 2010. 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. In addition, this presentation may include various third-party estimates regarding the total available market for SAN and Ethernet as well as other measures which do not necessarily reflect the view 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 2011 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 you questions are Mike Klayko, Brocade's CEO; Richard Deranleau, CFO; John McHugh, CMO; Dave Stevens, CTO; Jason Nolet, VP Data Center and Enterprise and Networking; and Ian Whiting, Senior Vice President of Worldwide Sales. I will now turn the call over to CEO, Michael Klayko. Mike?

Michael Klayko

Thanks, Rob. And as Rob mentioned, please refer to the comments and slides for full details of our Q2 financial results. Now I'd like to take a few minutes to briefly summarize several key developments this quarter.

Brocade executed well in Q2, delivering solid results with stronger-than-expected performance in our SAN business and strength from the Enterprise and Service Provider segments of our Ethernet business. Improvements in Ethernet and SAN product non-GAAP gross margins helped us achieve overall gross margin and operating margins above our guidance, and we delivered non-GAAP earnings per share of $0.13, beating our EPS guidance of $0.10.

Looking forward, I'm excited about the opportunities that we are seeing in our marketplace today as we discussed in our recently held technology day summit, we believe that the networking industry is entering a new innovation cycle driven by the IT imperatives of virtualization and cloud computing. In fact, we're seeing opportunities emerge in this industry that we haven't seen in the previous decade.

Brocade has established a clear leadership position and first-to-market advantage by out-innovating the rest of the industry and delivering purposeful solutions to customers.

An example of this is our announcement of our full "16 gigabit per second" Fibre Channel portfolio that we expect to deliver through our partners later this year. By offering both Ethernet fabric solutions which we began shipping in our fiscal Q1 quarter as well as the latest Fibre Channel fabric solutions, Brocade is helping to ensure that customers have the options in determining the networking technologies that best suit their data center and IT requirements. In summary, we continue to execute well to our FY '11 playbook. I have confidence that Brocade has the right strategy, technologies and offerings to capitalize on this new and exciting era of innovation.

With that, I'd like to open up the conference call for your questions. Rebecca?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question will come from Paul Mansky with Canaccord Adams.

Paul Mansky - Canaccord Genuity

Actually, couple of questions, then a housekeeping item. On the latter, I didn't see headcount mentioned anywhere in any of the supporting materials. It may be in there; I just missed it. I wonder if you can provide that and maybe tell us what your thoughts are relative to where we are exiting the fiscal year.

Michael Klayko

Yes, Paul. It's Mike. It's actually, I believe, if you take a look in the press release, we have it highlighted in there. I think we exited 4,762, which is up from -- looks like it's up about 41 people quarter-on-quarter.

Paul Mansky - Canaccord Genuity

How do you think that looks by the time you exit October?

Michael Klayko

I think we got a pretty optimized model right now, Paul.

Paul Mansky - Canaccord Genuity

On the Federal business, there's a couple of references in there to some normalized revenue contributions as we go through the balance of the fiscal year. I just want to make sure I understand when you mention normalize, we're talking upper 30s to low 40s in the Ethernet business that you saw Q2 through Q4 of last year?

Michael Klayko

Are you talking the revenue statement, Paul?

Paul Mansky - Canaccord Genuity

I apologize. Yes, I am.

Richard Deranleau

Yes. Paul, this is Richard. You might if you look at the prepared remarks, we've broken out the Federal for you. Based on the dynamics of our deferrals last year versus this year in the Federal budget, I think if you look at Q3 of '10 that was a fairly normalized kind of on a plus-or-minus basis.

Paul Mansky - Canaccord Genuity

And then lastly, it looks like to 2.5 weeks of OEM inventory, that's tracked on the low end of your traditional range. I'm a little curious about the 16 gig transition, however. And when is it or what quarter do you think those products will be available through your OEMs? And B, are you going to need HBAs out from your 2 primary HBA competitors at 16 gig to support a full ecosystem there? I mean, how are you thinking about how that transition occurs?

Michael Klayko

This is Mike again. So 16 gig, we'll start shipping that out this quarter, and it will be qualified in different stages by our different partners, and so you'll see them coming out. One is already announced. They'll have product available. Others will follow behind that as they qual the product. In terms of HBAs, I fully believe that some of the providers of HBAs will have 16 gig at some point. But we don't need to wait for them, because we also announced a fabric adapter that is fully 16-gig capable, and so there is a full ecosystem of products available now.

Operator

From Stifel Nicolaus, we'll go to Aaron Rakers.

Aaron Rakers - Stifel, Nicolaus & Co., Inc.

A couple of questions as well. First, on the guidance, you guys talk about 3% to 5% I think it's year-over-year growth in your Storage business. And by my math, that would imply about down 8% sequentially. I think in the past you've talked about a much better seasonal trend in fiscal third quarter, I think down 2% sequentially to flat. So can you help us bridge the gap? Is that a sense of conservatism there? Is there a sense of transition in front of 16 gig? Just help me understand why down that much at the midpoint.

Richard Deranleau

Yes, this is Richard. If you think back to our Analyst Day, we talked about growth in the TAM, 4% to 6%. And so when we compare on a year-to-year basis, we're looking, again, as you said, pretty close to that for a year-over-year compare. Now we did have a pretty strong Q2, the SAN business, but we're really comparing things over a year-over-year basis, and we're basically being very consistent with what we shared at Analyst Day.

Aaron Rakers - Stifel, Nicolaus & Co., Inc.

Okay, so it's more of a strong denominator in that number more so than any burn-down of inventory, any kind of adjustments in front of 16 gig, just to be clear?

Richard Deranleau

Yes, principally, you're correct. Although we did point out that, as Mike indicated, we have a big advantage on 16 gig. The ramp for that is really going to be accelerating in our fiscal 2012. So we'll be making sure that the OEMs have a clear capability to transition, and we're very excited about being able to have execution on that technological lead.

Aaron Rakers - Stifel, Nicolaus & Co., Inc.

And then as it relates to these type of transitions going on to your Storage business, one of the impressive things is that you've been very consistently above your stated long-term target gross margin on your Storage segment. Why should we not think of that as being a sustainable trend, and how do we think about, at least initially, 16 gig ramp and what it looks to be a leadership position for you guys not benefiting your gross margin?

Richard Deranleau

Yes, I think if you look at some of our guidance, I think you would see that we are, from a SAN perspective, when you do your miles, you're going to see a relatively consistent quarter-over-quarter gross margin in the SAN business. And there will be a little bit of an adverse mix on SAN gross margin, principally product-related, but we're not expecting a massive change in profitability. We did lay out a 2-year model. We're trying to be consistent with that, but we're pleased that we're able to over-deliver in the SAN business.

Aaron Rakers - Stifel, Nicolaus & Co., Inc.

And the final question for me is on the Ethernet side of the business. I think, obviously, we can understand the budgetary issues in the Federal side. I think Federal is a little bit weaker than what you guys had kind of laid out as far as your guidance last quarter. Can you talk about the demand dynamics there? What gives you comfort and visibility in those frontiers as we look into this next quarter?

Ian Whiting

This is Ian Whiting. Let me answer that. So I think as the comments that we prepared indicate, there was obviously some compression in the Federal business, primarily due to the budget issues. That fundamentally translates into a push of a number of projects that we had expected to happen in Q2 but are now looking like pushes into Q3 and Q4. So fundamentally, we think those opportunities are intact and that they will materialize over the next couple of quarters. And that was really the primary factor in the Federal number. Conversely, as you've seen, we had really strong growth in both the Enterprise and the Service Provider business, which was collectively up 24%. So the fundamentals, I think, are strong, but the Federal was a phenomenon that I think we'll recover from in the out quarters here.

Aaron Rakers - Stifel, Nicolaus & Co., Inc.

Is it fair to say that without those pushes, you would have been up mid-single-digits, high single-digits sequentially?

Richard Deranleau

Well, yes, if you think about the Federal business, as Ian indicated, the Enterprise in terms of that are very strong. We would have expected to have delivered more in Federal for sure.

Operator

That comes from Jess Lubert with Wells Fargo Securities.

Jess Lubert - Wells Fargo Securities, LLC

A couple of questions, actually. First, on the operating margins, you suggested that your hiring plans would start to moderate going forward. And previously, you've suggested that we will see sales growing faster than expenses during the second half. So I guess I wanted to understand the sequential decline in Q3 operating margins was solely a function of the expected gross margin decline or if there was some other reason why operating margins would be down sequentially, especially if sales were flat to up.

Richard Deranleau

Yes, you're exactly right. If you look at the relative gross margins of the 2 businesses, obviously, SAN is very, very strong. So it's really mix around products. And as we get some of the continued growth that Ian had alluded to, particularly in Federal, it's really just a mix shift.

Jess Lubert - Wells Fargo Securities, LLC

And then I was hoping you could touch on your International revenues, which were strong year-over-year but down about 6% sequentially. So first, I was hoping you could discuss what impact Japan had on the business and how you would categorize business in Japan in the days and weeks following the earthquake. And then secondly, I was hoping you could talk about how the business in Europe trended sequentially and whether or not you saw any regional softening there and how you were thinking about Europe going forward.

Richard Deranleau

Well, in the days after the earthquake, the first thing we did is we reached out to all of our partners and asked how we can help, more than anything else. And so, we were in contact with all the partners over there. Interesting enough for us, I can't blame or gain anything from this, and I don't view tragedies as an opportunity to gain. But from our standpoint, our business is relatively what we expected out of Japan. The majority of our business is in the Tokyo region, which was not highly affected. And so some of the offsets that we may have had in the Ethernet space were actually offset in the positive side in the Storage space on planned projects. And so Japan was relatively benign for us, and I believe that would be the case going forward. From Europe's perspective, Europe -- Ian just came back.

Ian Whiting

Yes, I mean the European business is looking very strong, very healthy. I mean, it's been an area of investment for us over the last year or so, particularly on the IP side. We are definitely seeing the results in that. That's reflected in our strength, primarily in the Enterprise and Service Provider numbers that we've already talked about. So we're feeling good about our organization there and our competitiveness. And I think you'll see EMEA and, indeed, APAC continue to perform well over the coming quarters.

Jess Lubert - Wells Fargo Securities, LLC

And then lastly on the Ethernet side, obviously, there's a lot of new products coming out within the industry, a lot of buzz surrounding Ethernet fabric. There's a lot of buzz on the VDX. And some of your competitors have noted that there's been some freezing in the market in anticipation of these new platforms coming to market. I'm curious if you've seen any of that and if you expect any of that as we work through the second half of the year?

Michael Klayko

Well, we may be the cause of the freeze, because we're actually delivering product to the marketplace right now. Just as -- when you think about it, we've got more than 100 accounts already today in production. Other people have lots of slide presentations and so forth and talk about what's going to come. And we're -- we've just announced, even at our Technology Day, what is the next phase of Ethernet fabrics and a whole list of new products that we'll be announcing, or we actually will be delivering, I should say, beginning in the second half of this year or so. Dave, do you have any other comments about our competitors?

Dave Stevens

Yes, we have spent a lot of time. This is Dave Stevens. We, I think as you pointed out, the industry has really validated this move within data center architectures to fabric-based technology. So there's a lot of discussion around that. I think, as Mike pointed out, we're happy to be a couple quarters into shipping real products into real customers, where many of the other folks are still talking about products on PowerPoint. As for delay, I don't think we're really seeing any delay in some of the deals, partly because the fabric technology that we're shipping solves real problems today, gets rid of Spanning Tree, it's great for virtualization, it's great for cloud data centers. We have a very elegant growth pattern for those products, where you can buy them as 12- or 24-port systems today and then expand those very gradually over time. And because of the standard-based interfaces on them, you can connect those into your existing infrastructure, even if that infrastructure doesn't come from Brocade. So they're solving problems today. They're shipping today, and they're extensions of both existing and new data centers. So the answer is no, we're not really seeing any delay.

Operator

Next we'll go to Ittai Kidron with Oppenheimer.

Ittai Kidron - Oppenheimer & Co. Inc.

Maybe we can talk -- I wanted to ask John McHugh. John, it looks like you're doing a good job in kind of growing your ex Federal business, and you've done that consistently now for, I guess, for a full year now. And that's great and very important, but can you give us a little bit more color on VDX? How much revenue you actually had in this past quarter? I know it's just the beginning. And how do you expect that ramp to go from here? And also, I know you've talked about the Federal being delayed, but given that there's only 2 fiscal quarters kind of left in the year here for you, is there a chance that you're actually not going to be able to get all of the Federal Government business that you were hoping to get for this year, that some either gets leaked out into next year or actually gets postponed or deleted, eliminated altogether?

John McHugh

Well, so let me, first of all, react. We don't break out individual product revenues, so I can't talk in detail about that. But one of the things that -- just to the general acceptance and excitement about VDX and the Ethernet fabric architectures is one of the things that I'm not sure everybody caught was we rolled out an architectural vision known as CloudPlex, which is really very unique in the industry around VDX. And the reason I highlight this in answer to your question is that VDX is more than just the ability to kind of take an existing data center and cloud-enable it. It also is a framework to allow our partners throughout the industry, and frankly, anyone can build these multi-vendor cloud architectures, which really nobody is touting those or leading with the same focus that Brocade is. And I think that's what unique and kind of differentiated about our value proposition and giving us very good momentum on the product. With regards to Federal, I'd probably kick that one back to Ian.

Ian Whiting

Well, yes, I think as I mentioned earlier, the push from Federal was really a function of a relatively small number of deals which we fully expect to capture in Q3 and Q4. And obviously, Q4, seasonally is a strong quarter for everybody in Federal, and we don't expect to see any fundamental differences this year to prior years.

Ittai Kidron - Oppenheimer & Co. Inc.

Very good, and I guess the second question, if I may, John, back to you, maybe I can try and get this out of you in a different way. Can you talk about the pipeline for VDX? How broad it is? Do you think it's going to enable you to deliver on work? Is it progressing in the way you expected it to progress? And also, it's really hard to get very good sales engineers right now in support of customers. Is this an area where you're having some challenges, or do you think you are appropriately staffed to ramp this?

John McHugh

Let me make -- let me kind of put a perspective on some of the things that we think are critical elements of this. There's a lot of customers out there who are looking for guidance and better understanding of what are the first steps to take to embrace the cloud. And to answer your question about the pipeline and pipeline development, we actually feel it's going very well. We've been thought leaders, and setting the whole industry discussion around Ethernet fabrics and data center fabrics, I think, has played to the fact that a lot of customers are coming toward us and looking for advice and guidance. And we intend to essentially monetize that, to build a lot of marketing programs and demand GEN activities to make sure that customers know that there's a supplier who has answers today, who understands the problem today and is looking at a multi-vendor integrated solution today.

Michael Klayko

Yes, this is Mike. 2 comments. Pipeline is just fine. It is what we anticipated when we began talking about this category. And in regard to sales engineers, the nice part in the last 2 quarters, we were named one of the Best 100 Places to Work in America and one of the Top 10 Places to Work in the Bay Area. And with this exciting new technology, we are actually drawing a lot of very, very smart people into the organization, and we're attracting a lot of good sales engineers. And so, we're in a fortunate spot where it's a good place to work, a great place to work in a country as well as has a very exciting technology. So we're doing pretty well in attracting the right people.

Operator

That will come from Mark Sue with RBC Capital Markets.

Mark Sue - RBC Capital Markets, LLC

On 16 gig, the rate of adoption is really driven by what you guys do with pricing. So should we reflect back to what happened with the 4- to 8-gig ramp in the past? Or is there some thought to kind of keep it as a premium product a little bit longer this time around?

Michael Klayko

Mark, this is Mike. You're spot on in terms of the adoption rate and so forth, and we expect that it'll be similar to 8 gig. There are customers right now that want the functionality, the ability in highly virtualized data centers, and they need that functionality and will pay a premium that we're going to go ahead and get on that architecture. So...

Mark Sue - RBC Capital Markets, LLC

And now on the Ethernet side, with all the new products, does it feel like this is a market-growth year for Brocade or does it feel more like a market share gain? And the share gains with the new products and the pricing that you have done in the past, is that eliciting a competitive response, or is it more status quo in the Ethernet switch market?

Ian Whiting

Let me, this is Ian, let me take the first part of that. I think one of the leading indicators that we discussed in prior calls recently has been new account acquisition in IP. And as we've disclosed in some of the comments earlier on and in the prepared materials, last quarter was actually a record for us in terms of new customers. We actually hit just on 400 net new IP customers, which means that we are tracking to our stated goal of 1,000 new customers for the year. In fact, we're slightly ahead of the track right now. So if that's an indicator of growth, which we think it is, then obviously, we feel very good about that. And it's a function of product. It's a function of customers looking for alternatives in both the data center and in the service provider and campus space. So we're very pleased with our progress in terms of new customer acquisition. And obviously, that's leading to the kind of numbers that you've heard from us in our outlook for the rest of the year.

Mark Sue - RBC Capital Markets, LLC

Underneath the trend of new customer acquisitions, are you also starting to see a slight improvement in closure rates and deal sizes as well?

Ian Whiting

Yes, we're very much within our expected model when it comes to -- particularly deal sizes. I don't think we break that out, although I suspect that next Analyst Day, we will be looking to give you some more color on that. But yes, we're within plan, and the closure rates and win rates are what we expected them to be.

Operator

That will come from Brian Marshall, Gleacher and Company.

Brian Marshall - Gleacher & Company, Inc.

I was wondering if you could talk a little bit about the relative opportunity between the ramp of the VDX that you're seeing currently as well as the kind of the ramp with the MLX, MLXe new products that you've introduced over the past several quarters and qualitatively would be great.

Jason Nolet

Brian, this is Jason Nolet. I'll take that one. So the ramp of both products, I think, is quite good, as the guys have commented on here this morning. VDX in particular, Ian mentioned a number of new accounts this past quarter, and a fair number of those, I think, 20% or 25% are, in fact, VCS or VDX accounts. So we're seeing good ramp there, and I think the capacity, the density, the performance of the MLX and the MLXe more recently introduced is appealing certainly to the service provider community, but also to high-end data centers and even in some portions of the high-end campus. So I think we're pretty happy with both product lines in terms of the momentum we're seeing and pretty bullish going forward on those 2 technologies.

Brian Marshall - Gleacher & Company, Inc.

And just on a relative basis, I mean, care to comment on what's going to see better tractions there in the near-term or...

Jason Nolet

Between the 2?

Brian Marshall - Gleacher & Company, Inc.

Correct.

Jason Nolet

Yes, I mean, it's hard to compare. I mean, the MLXe appeals to a different audience and it has a different buying dynamic, especially with the focus on server provider, where the sales cycle's a little longer. The VDX we're targeting primarily to enterprise data centers today, we're gaining traction Service Provider and public cloud infrastructure going forward. It's so hard to compare the 2. I guess I would just leave it at we're pretty happy with the achievement in both product spaces. We think we have a leadership position in both product spaces, and those are essentially the flagship products for us going forward in those categories.

Brian Marshall - Gleacher & Company, Inc.

And I guess my last question is with respect to the Ethernet business, I mean, clearly, over the past couple of quarters, you've seen sort of a migration more towards stackables as opposed to chassis. And I was wondering how that kind of coincides with the ramp that we've seen on the enterprise data center side. So if you can talk a little bit about what's going on, obviously, would expect the opposite to be happening.

Ian Whiting

Well, I think what you're seeing -- this is Ian. I think what you're seeing within stackables, which, as you've pointed out, has been on a steady ramp, it's a function of the growth of our channel programs and the expansion of our channel partners globally. That is a product set that speaks very well to and fits very well with classical Ethernet data networking channel partners. So that we are starting to see good momentum and good leverage from our investments in the channel. I would anticipate that continue with a steady ramp over the coming quarters. The channel partners are segmented into volume channel partners and value channel partners. We feel we have a good mix of both now.

Operator

From Citigroup, we'll hear from John Slack.

John Slack - Citigroup Inc

I was hoping you can help me triangulate sort of the outlook a little bit here. If I kind of back into the 3% to 5% year-over-year for SAN, that makes me look at -- it looks like almost a 20% sequential in the IP business. So I'm wondering how much of that move is predicated on the Fed business coming through this quarter. Or is it a combination of the ramp of new products in the SAN business? If you can give any clarity around that.

Michael Klayko

Sure. I think as you look about your model, if you think about the non-Federal business being kind of market rate growth, and then you can look to our Analyst Day for that, and then what you see is that, that indicates nice recovery of the Federal business for the reasons Ian outlined.

John Slack - Citigroup Inc

So does that mean, you said, the 38-plus kind of is normal for Fed and we did 15-ish this quarter. Is the incremental 20 all come through this quarter? Or should we balance it over the next couple of quarters? I'm just trying to think about how big of a bump do we take this quarter on the Fed side.

Michael Klayko

Yes, if you -- you laid out the structure right, which we talked about a year-over-year growth in SAN. We talked at Analyst Day about kind of Ethernet market rate growth ex Federal, and then the balance would be Federal Services will be relatively stable, it always has been. I think that gets your model to where you need to be.

John Slack - Citigroup Inc

And maybe if I can follow up on the IP gross margin, great progress this quarter. How should we look at that going forward, kind of getting back to the longer-term model as these new products ramp? Will it -- should the new products be accretive right away? Or is it going to be take time as volume ramp on those?

Michael Klayko

Well, the new products, and it's not just the VDX. VDX is particularly special, because it's an ASIC architecture, but even on our other flagship products, like the MLX and the MLXe, there have been cost improvements. So what you're seeing in the current, because the volume is relatively low on the VDX compared to the MLX and the MLXes, you're seeing the benefit from the products that we are shipping in volume. And we would expect to continue to see progress on a sequential basis in our Ethernet gross margins.

Operator

We'll hear from Glenn Hanus with Needham.

Glenn Hanus - Needham & Company, LLC

Can I just revisit the implied sequential guidance again for the SAN business? I understand your comment, Richard, about year-over-year. But I mean, normal seasonality is kind of maybe down 2% to flat. Is there -- are there some things you're seeing out there? Or does it have to do maybe with a little inventory? Or can you give any more color about why you're being cautious in that sequential guide?

Richard Deranleau

Sure, it's pretty straightforward. When you look at Analyst Day, when you look at the market, you've looked at what the analysts were seeing, where Federal or Infonetics, they talked about SAN being a market that grew kind of in the mid-single-digits, and they had pegged 4% to 6%. And we've achieved that. We had a strong Q2. But when you look at the growth rates, year-over-year growth rates against Q3 of last year, if we just -- given some of the macro concerning things we talked about in February and March, I think we're comfortable staying with the year-over-year growth rate that we shared with you at Analyst Day.

Glenn Hanus - Needham & Company, LLC

And how about on the server products? Does it look like pretty good growth again? Can you give some color around your outlook there and what are you seeing in terms of FCoE adoption? Is that still fairly slow?

Jason Nolet

This is Jason. So on the Server Products, the embedded switch products for us has always been a strong component of the portfolio, and that continued this quarter, but that's, I think, that's just goodness. So to the introduction of new products, though, what we announced at Technology Day, we did introduce and announce a new universal adapter, we're calling it the fabric adapter, that essentially can, with a single hardware form factor and a single software driver, take on the personality of an HBA for fiber channel connectivity, a CNA with fully converged FCoE or an Ethernet NIC. And we're very, very excited about that product because we think the combination of all that functionality, it will end up being an aggressive price point relative to adapter technology today. It's going to give us a real leg up in the market. On your question around FCoE, I think I might echo the comments I think I made last time around, and that is the take-up has been modest. I think customers are seeing some advantage relative to convergence from server to top-of-rack to deal with consolidation of I/O on the server side, but still very little uptake in the notion of end-to-end FCoE. There's still some componentry missing there. And so we remain ready to serve the customer all the products that we're shipping or convergence ready, including VDX and the Ethernet fabric. But we're trying to be genuine with respect to the customers' requirements and where they are seeing demand. And so the focus of our portfolio thus far has primarily been at top-of-rack for FCoE. And we're going to continue that focus, as we announced at Tech Day just a few weeks ago, with the introduction of a version of the VDX that supports FCoE to top-of-rack, where the customer can then split out to classic Ethernet and FC SAN. So we remain committed to that technology, but we're trying to be conscious of how quickly the customer will want to take that up.

Operator

From Morgan Stanley, we'll go to Katy Huberty.

Katy Huberty - Morgan Stanley

How linear do you expect the Federal revenue this quarter? In other words, will be more back-end loaded as you get closer to the September timeframe? Or have you already seen a nice uptick in orders in the month of May?

Ian Whiting

So this is Ian. Well, I think we always see a strong "end of Federal year" uptick. That's fairly normal from a seasonal perspective. I would say at this point in where we are in the quarter and looking out to Q4, we're where we would expect to be in terms of seeing some of those orders beginning to come through that pushed out. Some of them will take a little bit longer. But as I said, we're not expecting anything to push to go outside of the current fiscal year. So in that respect, I think we're on track. And there will be a big push at the end of September as there always is, but nothing unusual or unseasonal about that.

Katy Huberty - Morgan Stanley

And then it looks like HDS drove a nice uptick in the Storage business this quarter. Was that a function of you expanding the partnership or taking share within that account? Or was that company-specific trend? And then do you expect HDS to be a 10% customer going forward?

Michael Klayko

Well, I think it's all true, Katy, this is Mike. I think that they have a strong portfolio. We had some emphasis programs with them. They see the value of the relationship long term and the value of technology. And then frankly, it's how well they also compete on the world stage whether they'll be a 10% customer on an ongoing basis. But right now, they seem to be doing quite well on the areas that they serve.

Operator

From UBS, we'll hear from Nikos Theodosopoulos.

Nikos Theodosopoulos - UBS Investment Bank

A couple of questions. On the share count, it seems that in the last 2, 3 quarters here, it's been ticking up about $10 million a quarter, if I'm doing my math right. Can you elaborate on that? And is that a trend that will continue? Or is there something that drove this recent uptick that's not likely to continue?

Michael Klayko

The principal driver on this has been the uptick in the stock price. And so from a -- we hope that would continue. From an actual shares that are being issued, new shares being issued, there is -- that's going to be decelerating as we work through the Foundry acquisition, which we'd talked about in the past. And as we are -- clearly, the amount of equity that we issue will be in line with ISS's [ph] guidelines. So from that perspective, you're going to see quite a deceleration relative to what happened with the Foundry shares.

Nikos Theodosopoulos - UBS Investment Bank

And then I know it's a small part of your business, but you mentioned in the discussion that the Layer 4-7 ADX family was up 30%. Is there something new you've done to that product to gain momentum there? Is that something you think is sustainable? Can you talk about that segment of the business a little bit?

Jason Nolet

This is Jason. Let me take a crack at that. So I'd say there's really 2 things there. One is I think we think we have converged on a focus area for that product line and a strategy relative to where we can have the greatest value proposition, and that is largely focused at service providers and other customers and other segments that value performance scalability and low latency, which is kind of the key DNA of that product line. So I think we have a better focus, perhaps, now than we had last year. And then we've also added sales capacity to that product line, right? And Ian's talked about that in terms of aggregate sales capacity in the past. But that was inclusive of adding to our sales force, overlay team members that are focused on this technology and replicating in other geography some of the success that we had seen historically in North America.

Nikos Theodosopoulos - UBS Investment Bank

And then just lastly, I don't recall a discussion on how the Dell relationship is doing in IP. Is that -- I mean, obviously, the Federal piece is going to rebound in the third quarter for you, driving some of the business, but are you seeing -- how would you characterize the business momentum through Dell?

Ian Whiting

This is Ian. I would characterize Dell as a very strong and important partner for us across the spectrum of the market that we address. I think we've figured out some ways in which to really complement Dell's own product offerings, and that's both in the IP and in the SAN space as well. So we anticipate continued traction and momentum with Dell at the product level but also in the field level, where, frankly, our engagement continues to grow from strength to strength. So definitely a strategic and important partner for us across the whole spectrum of products.

Operator

From Robert Baird, we'll go to Jayson Noland.

Jayson Noland - Robert W. Baird & Co. Incorporated

Richard, a couple of questions on gross margin. Within the SAN business, you've been above the target model now for a while. And with the fiscal '12 transition to 16 gig, would you expect to see much of a change there at the gross margin line?

Richard Deranleau

Yes, I think we generally would take a look at our business model at Analyst Day. And so right now, we acknowledge the over-performance in SAN gross margins. But in terms of changes in model, I think we tend to want to do that at Analyst Day.

Jayson Noland - Robert W. Baird & Co. Incorporated

And then a similar question on the services side, you've been below model for a couple quarters. What's the driver there? And should we see a rebound there in the near term?

Richard Deranleau

One of the things that we've been doing as we've increased our performance in the Ethernet business is really scaling up the professional services and support organizations. So I think that will be a little better over time, but I think it's also a way for us to make sure that we have accelerators to our Ethernet business.

Operator

We'll go to Keith Bachman with Bank of Montréal.

Keith Bachman - BMO Capital Markets U.S.

I had 2 also, if I could. Richard, for you, the OEM business was 53% of your revenues. I just want to understand how that changes the 10% customers, which includes OEM, how that changes over the next couple of quarters? Will there be the inventory or I think in the slide back, you mentioned kind of ramping down in anticipation of the 16 gig. I just want to understand how that number changes a little bit.

Richard Deranleau

The reality is it's never really going to change much because what's happening is that as HDS turned into a 10% customer, that increased that percentage, but they were always a very strong performer in either case. So it's really just a shift from a non-10% to a 10% customer. I really don't see that changing, and I really don't think that has any real effect as we ramp into the 16 gig. The good news is that we can see...go ahead.

Keith Bachman - BMO Capital Markets U.S.

Excuse me for interrupting, please proceed.

Richard Deranleau

No, I just want to make sure people understood that it's really just a shift from one customer being a non-10% to a 10%. But overall, the business continues to be strong.

Keith Bachman - BMO Capital Markets U.S.

Yes, and that's really what I was asking, just if you [indiscernible] at these levels in the [indiscernible]. My second question, then, is on the free cash flow generation in Q1 and Q2 was actually very strong. Is there any color or comments you can give us on Q3 and Q4 on free cash flow, where you think you'll be in the second half of the calendar year? What about the levels of increase? Any color there would be great.

Richard Deranleau

Sure, there is more detail in the prepared remarks. From an operating cash flow for Q3, we're giving $60 million to $75 million. Capital expenditures, $30 million to $33 million, that gets you free cash flow $30 million to $42 million. The big driver from a sequential basis is we have the $600 million in bonds, those pay interest rates -- those pay on the interest twice a year every 6 months. That's hitting us in Q3. That's the biggest driver. Q4 tends to be a strong cash flow quarter, again, and we would see it increasing. We would expect to see it larger than the guidance we're giving in Q3.

Operator

From JPMorgan, we'll go to Mark Moskowitz.

Mark Moskowitz - JP Morgan Chase & Co

I guess I'm just trying to get a greater sense in terms of what gives you guys confidence around the government snapping back here. Is this more than just budgetary constraints? Are you seeing new business opportunities that are being captured? And then the other question is coming back to the Storage piece, it just seems like we're having a material falloff year in terms of the sales velocity or, clearly, run rate in the Storage business. Was there any sort pre-buys that took place on the product from these larger OEMs that's not going to be there in the next few months? It just seems a little odd here, this lack of consistency.

Michael Klayko

So the Federal business, Mark, these are projects, as we've talked on previous calls, that are not one-off projects. They're projects that many times are -- the lifespan of these things are 7 to 10 years. And so these are projects that we continue, to go ahead and supply technology to that have to get annual funding. And so when these funds get released, and it's the absorption factor of how fast this product can go ahead and get absorbed into the operations into the build out. So ours are, once you get past the funding, which always has to get done, then it's a matter of how fast they're going to get absorbed back in. So that's the difference in confidence, where last time, it was challenging, because we went past deadlines in terms of almost shutting down the country and funding, and so it became difficult to make predictions. We have a little bit more confidence this time, because that seems to be a little behind us.

Richard Deranleau

Sure, Mark, I'll just repeat the answer to the prior question. When you look at our storage growth, we'd start back with Analyst Day, and at Analyst Day, we shared with you that we thought the SAN market was going to grow 4% to 6%. And when we look at our year-over-year, if you look at the implied guidance, where the implied guidance is that revenue in the SAN business will grow in that range. Now we acknowledge, we had a pretty strong Q2. But at this stage, we're comfortable with the guidance we shared back at Analyst Day, which is 4% to 6% growth year-over-year, and that's what we're guiding to.

Operator

We'll go to Shelby Seyrafi with SBM Securities.

Shelby Seyrafi - Caris

Like others on this call, I'm just surprised by the forecasted decline of the SAN revenue in the July quarter. Typically, when you have a new cycle, you would actually grow better than the typical growth rate. So I guess my first question is when do you think 16 gig will result in better than 4% to 6% growth as you look out over the next year? And maybe you could tie in when you expect the fabric switches to kick in as well.

Michael Klayko

This is Mike. If you look back and look at history, we went from 2 to 4, 4 to 8, I think it's relatively the same. 16's going to be probably follow the 8-gig trend. We've always said and we said clearly at Tech Day, it's in 2012. That's when 16 gig becomes very, very -- it becomes adopted because it has moved through the OEM quals. It gets built into their portfolio. And as you're building out these large customer builds, they don't flip on quarter-to-quarter cycles. They take periods of time. So I think it's -- from our standpoint, we're very comfortable, because we now have an architecture that's not just a 16 gig, it's the entire portfolio of offerings of what the product does, the whole management system, how it fits in the existing architectures, that this becomes a foundational product that, frankly, our customers can use to build out for the next 5 years. And so we've always said 16 gig would be the mainstay product in 2012, the transitionary product between '11 and '12.

Shelby Seyrafi - Caris

And my next question relates to Paul Mansky's earlier question, where I think you replied that the Federal segment will be like it was a year ago in Q3, which was roughly in the high 30s. That would imply roughly $20 million sequential growth, like others have indicated. Can you talk about the margin implications there? How does your Federal Ethernet margin compare to your Service Provider and Enterprise margins? And how does that play into your outlook for the Ethernet gross margin in the third quarter?

Richard Deranleau

This is Richard. We are -- as we said earlier in the call, we would expect to see sequential improvement in gross margins in our Ethernet business.

Shelby Seyrafi - Caris

Right. But can you compare the Ethernet gross margin -- I mean, the Federal Ethernet gross margin to the other categories?

Richard Deranleau

What we've said publicly before is that the Federal business has a better gross margin profile than the standalone Ethernet, other Ethernet businesses. We haven't quantified it, but it's a lumpy business, but on the other hand, it is a profitable business and a nice business. And it's a core competency that Foundry had that we've maintained. So we like the business, but it is more variable than the rest of the business.

Operator

From Deutsche Bank, we'll go to Brian Modoff.

Vijay Bhagavath - Deutsche Bank AG

This is Vijay Bhagavath on behalf of Brian Modoff. I have 2 questions. I mean, one is I'm looking at the data center fabric, and 10 gig is kind of 2 major product cycle opportunities for switching both later this year and into next year. Like to hear kind of your go-to-market strategy to capture your share of wallet in those opportunities.

Ian Whiting

This is Ian. Maybe I can take a stab at that. So I think what you heard from us a year ago was, we were committed to building out the sales organization to capture that opportunity, knowing that the 10-gig transition was upon us and that we had a product cycle ahead of us that was very exciting. So we have essentially completed that expansion of the sales organization in order to give us the maximum exposure in those key marketplaces. And we feel that the sales model that we've consistently talked about and executed against is bearing fruit. As we get into in some cases longer sales cycles and in some cases shorter sales cycles, the pipeline, as we have alluded to earlier on, for VDX is healthy and growing. Some of the new account metrics that we talked about, I think, are also indicative of that expansion. And as I've mentioned a couple of times, we are starting to see some very healthy traction through our efforts in the channel, which has always been a cornerstone of the sales strategy and go-to-market model for all of our Ethernet and data center products. So when you take it all together, I think it paints a very consistent and confident model that we feel we have the right pieces in place to take advantage of those cycles that we're in.

Vijay Bhagavath - Deutsche Bank AG

And then in terms of a follow-up in single out of [ph] switches come out from the Broadcom ecosystem based on Dune and Trident and Trident Plus. Any thoughts on how do your switches stack up or compete versus kind of the Broadcom switch ecosystem?

Jason Nolet

This is Jason. Let me answer that. So I think one of the kind of differentiators that we have and one of the contrast positions is a deep understanding and history of developing our own ASIC technology, and this comes out of 10 to 15 years of Fibre Channel innovation and market leadership. And we're now applying all that same ASIC expertise and technology, in fact, much of the same technology itself, to Ethernet fabrics. So we think we've got an advantage there and are not going to suffer the, what I call the commonality, that all of the other vendors who are banking on one source of technology are likely to see in their products over time. So we believe it's a contrasting position. It's a differentiator for us. It is a clear core competency for the company based on what we've done in the Fibre Channel space over those many years. And we're going to continue to leverage that ASIC-based strategy for select products in the portfolio, notably the VDX product with virtual cluster switching.

Operator

From Pacific Crest Securities, we'll hear from Brent Bracelin.

Brent Bracelin - Pacific Crest Securities, Inc.

2 questions, one for Richard, one for Ian. I guess Richard, I'll start with you. I want to attack kind of the Storage business a little differently here. If you look at the current quarter, biggest surprise in our model was the upside from Storage. Clearly more than offset kind of the weakness in Federal. I can understand and appreciate your conservatism and not willing to kind of really change or update the full year model based on kind of SAN growth, but what drove upside in kind of Storage? What were you surprised by relative to strength in Storage in the current quarter? 17% growth year-over-year, I think, is the highest in 2 or 3 years. What drove that? And what were you most surprised by? And was there some deals that were in the pipeline for next quarter that maybe fell into this quarter?

Michael Klayko

Let me start, Richard, and give you all the details. This is Mike. I think there's 2 trends. One is virtualization is driving a lot, Brent. It is frankly, everywhere we go, most of the fabrics are still built on Fibre Channel, but they're highly virtualized. And so as virtualization becomes more and more prevalent, there's more and more requirements for Fibre Channel SANs behind that. The second is the strength of HDS, frankly, drove that also. So that's the 2 primary drivers from my perspective. Anybody other? I think that's good.

Brent Bracelin - Pacific Crest Securities, Inc.

And relative to Ian, obviously, you are coming out of EMC World Event. I imagine you met with a lot of customers last week. Could you give us a little maybe be an update on customer interest in Storage right now, interest in 16 gig Fibre Channel? Any sort of color that you learned relative to customer interest in the Storage SAN market will be helpful.

Ian Whiting

Yes, lots and lots of good things came out of EMC World. 7,000 customers attending itself, I think, is a statement that the storage industry is alive and well. Yes, I think we had some great meetings with many of our largest customers and many of our competitive customers around their interest in building out new data centers. And clearly, the combination of the SAN, our product cycle that we're in now, plus some of the great products from our storage partners and, obviously, EMC being a key one there, is giving a lot of confidence to customers that it's time to move forward. And as Mike said, the compelling reason is, frankly, all around virtualization. So the mood is, I think, very positive. Customers are starting to look to spend and take advantage of these technologies. Our partnership with EMC is very, very strong and continues to grow. In fact, it's growing in some new areas, as we announced last week at that event. We're also seeing some good uptake in standard Ethernet switching with EMC built around some of their core solutions, most notably in the area of their Greenplum acquisition around data analytics but also off the back of their launch of Isilon products. So there's a number of other advantages and other opportunities that we are exploring with our big storage partners beyond just the traditional Fibre Channel space as well.

Operator

Your next question will come from Kent Schofield with Goldman Sachs.

Kent Schofield - Citi

Could you give us an update on the sales count investments that you've made in terms of the ramp-up relative to what you were expecting?

Ian Whiting

Yes, this is Ian. As I said, I think we have essentially completed the build-out of the sales organization, as we had forecasted a year or so ago. At that time, we talked about a 5-quarter ramp to full productivity. And that is still very much what we expect to see and are seeing. Those investments in sales headcount, which includes, by the way, systems engineering or sales engineers, not just sales reps, is across the whole organization. It's not just end-user-facing sales people, but it's also in our global accounts, our channel, our Systems Integrated business as well. So we feel that we've completed the model build-out. We'd expect to grow in line with SG&A models that we've already communicated. But we are happy with the sales productivity ramp that we've been seeing, and it is very much in line with what we laid out just about a year ago.

Operator

And your final question will come from Douglas Ireland with JMP Securities.

Douglas Ireland - JMP Securities LLC

One of your competitors, HP, released their FlexFabric products at the -- and also OEM partner, sorry -- released their FlexFabric products at Interop. And I was wondering how would you feel like that might affect your ability to sell through them as an OEM going forward. They've also acquired a bit of a reputation for going sort of scorched-earth on the lower-end switching and really lowering the bar on ASPs in this space. And I wonder if you can talk a little bit about how that's affecting the competitive landscape.

Michael Klayko

I think everybody, this is Mike, I think everybody has got a product offering that's going to be unique to their own brand. I will tell you that HP is a very good partner on the Storage business for us, has been for more than a decade, and I don't see that changing for a long period of time. We compete in the Ethernet segments. We do, but we compete in different segments of the Ethernet marketplace, and so we are very, very data-center focused. We're getting great traction there. More importantly, we just announced a whole new architecture of products around our VCS and VDX product line, which is getting equally great traction around the world. So I think that the market itself is going through a transition. And now, it's a matter of an opportunity to go out and execute and capture those customers that are part of that transition.

Douglas Ireland - JMP Securities LLC

And on the VCX [VCS] and VDX, it seems to me that the shift to fabrics is an architectural shift that may make buyers reevaluate their vendors altogether, because you almost have to go with a single vendor to get all the benefits of the fabric. Do you think that this move to fabrics may lower the benefits of incumbency and create opportunity for challenger vendors?

Michael Klayko

Actually, that's what they were saying and what we had hoped for, because it does take -- customers do take a step back, and they say, "Well, let me take a look at all the different opportunities I have within my data center to re-architect." And so what you described is exactly what we're seeing in the marketplace.

Okay, again, this is Mike. I'd like to thank all of you for joining us today. We hope to see you at one of our upcoming investor conferences in June, which we will be presenting at the BofA Merrill Lynch and Cowen Group Technology Conferences in New York, RBC's Communication Technology Event in Boston and the NASDAQ Piper Jaffray Investor Program in London. You can go to our website for more information on these events. And with that, Operator, we would like to conclude today's conference call.

Operator

Ladies and gentlemen, that does conclude today's presentation. We do thank everyone for your participation.

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