Brocade Communications Systems F1Q07 (Qtr End 1/27/07) Earnings Call Transcript

Feb.26.07 | About: Brocade Communications (BRCD)
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Brocade Communications Systems, Inc. (NASDAQ:BRCD)

F1Q07 Earnings Call

February 26, 2007 5:00 pm ET

Executives

Shirley Stacy - Director of IR

Michael Klayko - CEO

Richard Deranleau - CFO

Tom Buiocchi - VP of Marketing

Analysts

Mark Moskowitz - J.P. Morgan

Dan Renouard - Robert W. Baird

Laura Conigliaro - Goldman Sachs

Samuel Wilson - JMP Securities

Brent Bracelin - Pacific Crest Securities

Aaron Rakers - A.G. Edwards

Tom Curlin - RBC Capital Markets

Glenn Hanus - Needham & Company

Presentation

Operator

Good afternoon. My name is Laurie and I'll be your conference operator today. At this time, I would like to welcome everyone to the Brocade First Quarter 2007 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions).

At this time, I would like to turn the conference over to the Director of Investor Relations, Ms. Shirley Stacy. Please go ahead.

Shirley Stacy

Thank you. Good afternoon, everyone. I am Shirley Stacy, Brocade's Director of Investor Relations. Joining me today are Michael Klayko, Brocade's CEO; Richard Deranleau, Brocade's CFO; and Tom Buiocchi, Vice President of Marketing.

Before we begin, let me cover some housekeeping items. Brocade issued a press release today detailing its first quarter fiscal 2007 financial results via PR Newswire and FirstCall. The Q1 press release along with the corresponding slide presentation is available on our website at www.brocade.com.

This conference call is being audio webcast and will be archived on our website for approximately 12 months. In addition, a telephone replay will be available at approximately 5 pm Pacific Time tonight. To access the telephone replay, dial 800-642-1687 or 706-645-9291, the pass code is 7485740.

As a reminder, the information the presenters discuss today will include forward-looking statements, including without limitation, statements about Brocade's financial results, business outlook, and guidance. These forward-looking statements 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 28, 2006. These forward-looking statements reflect beliefs, estimates and predictions as of today, and Brocade expressly assumes no obligation to update any such forward-looking statements.

Certain financial information that we reveal on today's conference call is presented on a non-GAAP basis. The most directly comparable GAAP information and a reconciliation between non-GAAP and GAAP figures is provided in our Q1 '07 press release, which has been furnished to the SEC on Form 8-K and in the corresponding Q1 '07 slide presentation posted on our website at www.brocade.com/investors.

In addition, the presenters will discuss sell-through information which provides a measure of OEM and channel partners' sales to end-users. Brocade does not record revenue based upon OEM sell-through information, and this measure is not intended to be viewed as a substitute for reported GAAP revenue. Sell-through is a measure of demand, but is not a GAAP measurement of revenue and therefore is not subject to the same level of internal controls as reported GAAP revenue.

Finally, our reported financial results for the first quarter of 2007 are for Brocade standalone and do not include McDATA's results. We will include consideration for McDATA's historical financial performance in our forward-looking guidance.

I will now turn the call over to Mike.

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Michael Klayko

Thanks, Shirley. Good afternoon, everyone and thank you for joining us. Today, I will briefly discuss results for Q1 '07, highlight our performance across our product lines and growth initiatives and share some thoughts on our recently closed acquisition of McDATA. Following my remarks, Richard will review our Q1 results in more detail, share our outlook for the second quarter of fiscal 2007 and provide more detail on our combined financial model for the company.

We have lots to cover today and I want to ask you for your patience as we go through the material.

The first fiscal quarter of 2007 was very strong and represented Brocade's fifth consecutive quarter of record revenues and sixth consecutive quarter of increased profitability. Q1 revenue was a record $224.2 million. Revenues increased 7% sequentially from Q4 and 32% year-over-year.

Our product sell-through for the first quarter was also a record at $227 million, representing an increase of 11% sequentially and 31% year-over-year. Q1 non-GAAP gross margin of 63.7% was stronger than expected and higher than our long-term model, primarily due to increased volume, favorable product mix and a better than expected pricing environment.

As a result, non-GAAP operating margin increased to 26.1%, once again reflecting the powerful leverage in our financial model. Q1 non-GAAP diluted EPS was $0.17 as compared to $0.14 in Q4 '06 and $0.10 in Q1 '06.

Now let's look at some of the details of our Q1 performance. We had a record quarter in Directors with very strong sequential growth of 23% and again, we gained share during the quarter. Year-over-year, our Director revenue grew 15%. The 48K remains the industry leader in the Director category in terms of value, performance and total cost of ownership.

One example of a significant total cost of ownership savings that makes the 48K appealing to enterprise buyers is that it delivers the highest performance in the market, yet requires one-third the power and cooling to operate compared to our competitors' high density 4-gig Directors. Power efficiency is a critical issue facing IT executives today and is part of the overall buying decision. Our customers have told us that the 48K can save a significant amount in lifetime energy and cooling cost when compared to the competition.

Our total Switch revenue was relatively unchanged from a record Q4 '06, and grew a healthy 44% year-over-year. Within total switches, Embedded Fan Switches had another outstanding record quarter, growing 14% sequentially and 69% year-over-year reflecting the strength of our product offering, our partnerships with the leading providers of bladed servers, and the growing acceptance of bladed server solutions in the marketplace. Overall, we maintained our number one position in a healthy and growing SAN market in Q1.

I am also pleased to report a record revenue quarter in our File Area Networking business, which is predominantly software. FAN revenue grew 5% from Q4 '06 and over 2000% year-over-year. We also increased bookings by nearly 180% sequentially. The bookings are important metric in this portion of our business. Its ongoing Software Maintenance and Services are key components of our FAN solutions.

In Q1, we booked several large FAN opportunities including a multimillion dollar FAN project that contains a significant amount of ongoing services which will be delivered over several years. In Q1, there were numerous Marquee Customers, who selected Brocade FAN solutions to help them better manage their enterprise file data, including GE Healthcare, British Telecom and HSBC Bank.

With well over 500 customers to-date we've taken the lead in this emerging and growing segment, and are very excited about the opportunities for continued growth by bringing new efficiencies to enterprise file management.

In Q1, our Services revenue increased 5% sequentially and 33% year-over-year. More importantly, Service Bookings increased 84% year-over-year. Much like our FAN business, bookings are an important metric for our Services business where projects often span multiple quarters.

We also signed Master Service Agreements with IBM and Network Appliance to resell Brocade's professional services globally. The challenge is associated with unprecedented data growth are not subsiding. And our value proposition to provide the industry's deepest expertise in storage, networking and data management continues to resonate strongly with both partners and end-user customers.

In Q1, as in Q4 '06, Software and Services continue to represent approximately 10% of our business, and this continues to be weighted more toward services. As described at our last Analyst Meeting in September, we stated that our objective is to grow FAN Software and Services to represent approximately 20% each of our total revenue over the next 3 to 5 years. These businesses are each growing rapidly, and are enabling us to diversify our revenue streams and grow our total revenues faster than the core FAN infrastructure market.

Before I turn the call over to Richard, I'd like to share some thoughts on our recent acquisition of McDATA. We are only a month into it, and I can tell you that we are more excited and committed than ever. By all early indications, we are off to a great start. One of the most important goals was to immediately provide clarity. First, to our customers and partners, so they are clear on our strategy, our offerings and our product roadmap. I am delighted to report that this was done within the first week.

Next, to our employees, so they would understand our vision and goals and specifically what their roles, responsibilities and their expected contributions. Again, I am delighted to report that this was done on day one. During the first hours and days following the close of the transaction, there was a wide range of very focused and effective communication to help achieve this, and we were able to hit the ground running. We reached out to over 30,000 customers and 10,000 partners in the first day alone. A key finding from our outreach is that fewer than 300 of those customers overlap from the Brocade McDATA merged customer list. This demonstrates the added synergies of a respective installed base.

Our consolidated product offering and roadmap was available and downloaded by thousands of these customers on January 29. And within the first 48 hours of the acquisition, our executive team personally met with nearly 2,000 employees in San Jose, Colorado and Minnesota. Our pre-closing planning has paid off in other ways as well. The rollout of our new brand has been extremely well received by the market and is serving as a rallying point for all of our employees.

Our new employee base is very excited and motivated. In fact, we just had the new sales team in for training last week and the atmosphere was energetic and optimistic. In addition to the talent and expertise we acquired in the engineering and development areas, we've also strengthened our sales, service and support organization with the industry's foremost experts in the areas of mainframe, FICON connectivity and Distance Extension solutions for both mainframe and open system environments. These skills are rare and in high demand from our largest customers. The vast majority of McDATA's end-user sales organization was retained, thus ensuring continuity and a smooth transition of account management for large customers, many of whom have 10 plus year relationships with specific sales and support executives from McDATA.

All in all, we are delighted with the additions to our organization which now represents the largest, the most focused and the most experienced sales, services and support team in the network storage solutions industry. As a part of our ongoing integration plans, we are all very focused on maintaining our momentum, continuing our execution and meeting our commitments. We will not take our eye off the ball. One of the most important commitments we've made to the McDATA customer base was to protect and extend their investment with continuing product supply, customer support and bring new innovation to their current environment.

In the first two weeks following the close, we introduced new capabilities to provide interoperability with our bladed SAN modules. We also recently announced the industry's first and only truly inner operable switch platform, the Brocade 5000, which supports mission critical SANs that are based on either Brocade or McDATA technology. We will continue to innovate to deliver the best value proposition to our customers, and ongoing investor protection is a key element to this commitment.

We have an incredibly efficient and powerful supply chain operation. In Q1, we continued to enhance and optimize our global supply chain by expanding the capacity of our Asia-based manufacturing and moving our operations to a new and larger location with zero disruptions to our customers. While completing this manufacturing expansion and while preparing for the integration of the McDATA supply chain, we achieved all of our operational metrics, world-class quality, on-time shipments for our current products and outstanding new product introduction into volume production.

In January, we also completed preparations to comply with phase 1 requirements of the China RoHS directive. This was well ahead of the March 1 deadline and demonstrates our continuing commitment and leadership in environmental compliance. We continue to meet and exceed our milestones in operational efficiency and we'll apply our expertise and processes to the inefficiencies that existed in McDATA. Our ability to execute in this area will be a key driver for the ongoing integration synergies.

Finally, during the quarter, we also acquired and integrated Silverback Systems, a small private company which brings its valuable expertise and technology to accelerate our product plans and vision related to the next generation data center solutions, and more specifically 10-gig Ethernet technology. We are continuing to execute on our strategy, whether it's following through on product in our interoperability commitments, continuing our acquisition of new technologies, improving our operational and supply chain performance are one of many other examples. We are maintaining our focus on stellar execution of the business plan.

I will now turn the call over to Richard to provide more detail on our Q1 results and our outlook for the combined company.

Richard Deranleau

Thank you, Mike. Now let's review our Q1 results for Brocade, standalone, beginning with the income statement. In Q1, revenues were a record $224.2 million. This represented an increase of 7% sequentially from $208.8 million in Q4 and 32% year-over-year from $170.1 million reported in the year ago quarter. Q1 sell-through was also a record and exceeded reported revenue at approximately $227 million. This represented an increase of 11% sequentially from the sell-through of approximately $204 million in Q4 and an increase of 31% year-over-year from the sell-through of approximately $174 million in the year ago quarter.

As a percent of sales in Q1, OEM revenue remained relatively constant at 92% compared to 91% in Q4 and 92% in the year ago quarter. From a customer perspective, our top three OEM partners, EMC, HP and IBM were relatively unchanged at approximately 72% of Q1 revenue as compared to 74% in Q4 and 72% in Q1 of '06.

On a geographic basis, as a percent of sales, domestic revenue was 59% and international was 41%. This compares to 63% and 37% respectively in Q4 and 63% and 37% respectively in Q1 of '06. This reflected strength in both Europe and Asia.

Cumulative port shipped were approximately $8.9 million, an increase of approximately 9% from Q4.

In Q1, non-GAAP diluted EPS was $0.17. This compares to non-GAAP diluted EPS of $0.14 in Q4 and non-GAAP diluted EPS of $0.10 in Q1 of '06. This strong performance is the direct result of the powerful leverage in our financial model.

Reporting on a GAAP basis, Q1 EPS was $0.12. This compares to GAAP EPS of $0.07 in Q4 and GAAP EPS of $0.04 in Q1 of '06.

Non-GAAP net income for Q1 excludes charges of approximately $7.4 million in expenses associated with the acquisition and integration planning activities with McDATA, $5.2 million in expenses related to the SEC investigation and other related costs, of which $3.9 million represented legal and related expenses, associated with our indemnification obligations related to various ongoing legal proceedings against certain former employees, $5.5 million for stock-based compensation, $0.9 million for amortization of acquired intangibles and the related net income tax adjustments.

Our effective non-GAAP tax rate in Q1 was 25%, lower than our expected rate of 26% to 27%. A lower than expected non-GAAP tax rate is primarily due to the extension of the federal R&D tax credit by the Congress.

In Q1, our net stock-based compensation expense was $6.7 million, of which $5.5 million is due to the impact of FAS 123R and has been excluded from our non-GAAP results. The difference between the total net stock-based compensation expense and the amount excluded from our non-GAAP results is primarily due to $1.2 million in charges related to the restricted stock compensation.

Non-GAAP gross margins for Q1 was 63.7%, above our guidance of 60% to 61% and above the high end of our target model of 55% to 58%, reflecting increased volume, a favorable product mix and a better than expected pricing environment. This compares to non-GAAP gross margin of 62.1% in Q4 and 60.2% in Q1 of '06.

In the quarter, ASP declines were again in the low-single digits.

Q1 non-GAAP operating expenses, excluding the items referred to previously, were $84.3 million. This compares to non-GAAP operating expenses of $84.9 million in Q4 and $73 million in Q1 of '06. Non-GAAP operating margin for Q1 was 26.1% above our long-term model of 15% to 20% of sales. This compares to non-GAAP operating margin of 21.5% in Q4 and 17.3% in Q1 of '06. Again, the strong increase demonstrates the powerful leverage in our financial model.

Now let's turn to our balance sheet. Our cash and investments balance at the end of the quarter was $631.7 million. This compares to cash and investments of $582.6 million at the end of Q4. In cash and investments at the end of Q1 of '06 is $510.2 million, which includes restricted short-term investments, and is net of the company's convertible debt.

As previously announced, during the quarter, we acquired Silverback Systems for less than $10 million in cash. Cash flow from operations in the quarter was a healthy $33.3 million above our expected range of $20 million to $30 million, during what has historically been a seasonally weaker cash flow quarter. This compares to cash flow from operations of $52.8 million in Q4 and $32 million in Q1 of '06. Day sales outstanding in Q1 was 38 days and was below our target range of 40 to 50 days, and reflected greater linearity in the quarter. This compares to 43 days in Q4 and 41 days in Q1 of '06.

Our on-hand inventory in Q1 was $10 million and in line with our range of $8 million to $10 million as projected last quarter. This compares to $9 million in Q4 and $8 million in Q1 of '06.

Capital expenditures in the quarter were $13.4 million, above our target range of $6 million to $8 million per quarter. This compares to $7.5 million in Q4 and $8.2 million in Q1 of '06. The increase in capital expenditures primarily reflects costs associated with integration-related system upgrades.

And finally, deferred revenue increased to $69.2 million in Q1 compared to $60.9 million in Q4 and $45.5 million in Q1 of '06.

Now, let me turn to our expected outlook for Q2, which reflects the addition of McDATA. As we go through our outlook, please keep in mind that as a result of the acquisition there are a lot of moving parts and new elements factored into our combined guidance, which requires some explanation. I would encourage you to follow along with our Q1 slide presentation that is posted in the IR section of our website. These charts should make it easier to follow the various assumptions and elements that add clarity to the combined outlook. Note, that this is our first combined quarter outlook and our visibility is not as clear as it had been in the past.

First, here is a base line for McDATA's business. For our quarter Q1 ending January 27, 2007 McDATA had revenue of approximately $136 million.

Now, let's look at the factors that we have considered for this combined company outlook for Q2.

Seasonality: Historically, fiscal Q1 is traditionally the strongest quarter of the year. Q2 is generally the weakest, with revenues down approximately 5% to 8% sequentially. Our outlook for Q2 assumes the economy and demand for our solutions will continue to be healthy. And while we are expecting to experience some historical seasonality, our leadership position and our strength in a healthy market may reduce the typical seasonality of a 5% to 8% sequential decline.

Competition: We believe that our competitive position is strong and we will continue to execute on our strategy and business plans. Nevertheless, the market remains extremely competitive and we've seen our competitors announce and begin to deliver several new products to market, particularly in the switch and bladed SAN module market segments.

Pricing: The pricing environment for the past four quarters has been more favorable than historical norms. While we believe ASP declines will eventually return to mid single-digits per quarter, as competitors ramp their new products throughout year, we are planning for a relatively benign pricing environment in Q2, with ASP declines in the low single-digits.

Purchase accounting: As required in accounting for an acquisition, we will have to make purchase accounting adjustments to reduce McDATA's deferred service revenue at the time of acquisition. This will reduce the combined company's revenue run rate by approximately $5 million to $8 million per quarter.

McDATA third-party product revenue: Historically, McDATA had approximately 6% to 14% of revenue from third-party product sales. We are discontinuing the resale of low margin third-party products because they are not strategic to our core business, and they do not support our financial model. Therefore, in Q2, we expect sales from third-party products to decline substantially.

When we take all of these factors into consideration, our outlook for Q2 is as follows:

We expect our reported revenue in Q2 to be in the range of $335 million to $350 million. Again, this assumes some historical seasonality, a significant reduction in third-party product sales for McDATA and a purchase accounting adjustment that reduces McDATA deferred service revenue.

We expect non-GAAP Q2 gross margins to be in the range of 53% to 55%, again reflecting a combination of strong gross margins from classic Brocade products and lower gross margins on McDATA products and services, as well as the reductions in third party product sales and purchase accounting adjustments.

For Q2, we expect total non-GAAP operating expenses to be in the range of $135 million to $140 million. For Q2, we expect other income, other expense net, to be approximately $7 million. We expect our Q2 non-GAAP effective tax rate to be approximately 29% to 30%, reflecting the tax profile of the combined company which is higher than Brocades standalone weight and reflects the less efficient tax structure of McDATA.

We expect diluted shares outstanding to be in the range of 410 million to 415 million shares. We expect Q2 non-GAAP EPS in the range of $0.08 to $0.10. We expect Q2 GAAP EPS in the range of breakeven to $0.02. The difference between non-GAAP and GAAP EPS in Q2 consists primarily of integration charges, including acquisition related compensation and severances, amortization of acquired intangibles and an increase in our GAAP tax rate due to non-deducibility of acquired intangibles. In addition to the items excluded in our Q1 non-GAAP results, we expect Q2 non-GAAP operating margin range of 13% to 15%.

We expect capital investments in Q2 to be in the $14 million to $16 million range. This reflects another planned major systems upgrade in Q2 related to the integration of our IT systems. After Q2, we expect our CapEx will grow in net dollars but will return to historical levels as a percent of revenue. We expect DSOs in Q2 to be in the range of 45 days to 55 days, reflecting the lack of linearity in McDATA's business. We would expect to return to our historical range of 40 days to 50 days over the course of the year, as we return the combined company to our linearity model.

We expect on-hand inventory in Q2 to be in the range of $30 million to $40 million. The increase reflects absorption of McDATA's product inventory. Again, we will apply our expertise and strength in operations to McDATA's less efficient model. And therefore, we would expect this inventory level to decline and return to our historical inventory turns by the end of the year. Q2 is historically a strong cash flow quarter, and we expect to generate cash from operations in the quarter of approximately $30 million to $40 million.

In Q2, we have paid off CNT convertible debt of $122.1 million, and we have assumed McDATA convertible debt of $172.5 million which will remain outstanding. As a remainder, the company has an additional $200 million share repurchase program that would add to be approximately $52.7 million remaining under the prior announced $100 million stock repurchase program. We expect to be active in the market in Q2.

Looking at fiscal 2007 in total, we plan on providing a more detailed outlook and model for you at our Analyst Day in San Jose on March 29. Today, however, I wanted to update you on some key factors that you may want to consider in your combined business models for Brocade full year 2007 outlook.

First, let me reiterate our commitment to our long-term financial model. This has not changed with the acquisition of McDATA. Our target model includes a gross margin range of 55% to 58%, non-GAAP operating expense range of 38% to 40% and non-GAAP operating margin range of 15% to 20%. As a result of the significant pre-integration planning and work completed and information obtained after the close of the transaction, we have greater confidence in the synergies of the combined companies and have moved up some of the key milestones we first set when we announced the acquisition.

We now expect to achieve approximately $113 million to $115 million in annualized synergies by the third quarter of combined operations. This represents an increase of $13 million to $15 million in annualized savings one full quarter earlier than previously expected. We now expect the transactions to be accretive by the third quarter of combined operations. Again, one full quarter earlier than previously expected. These improvements are relative to the expectations set out at our analyst meeting in September 2006.

Finally, we now expect to operate within our target model by the second quarter of combined operations significantly earlier than previously discussed at the September analyst meeting.

Now, please refer to our slide presentation, as we go through our full year outlook. Here are the assumptions you should include in your combined fiscal 2007 model, the Q1 '07 reported results for Brocade on a standalone basis, the Q2 '07 guidance for the combined company. For the second half of fiscal 2007, I am comfortable with the current analyst consensus estimates on FirstCall for both revenues of approximately $705 million and EPS of $0.22.

Once you have compiled your model, you will find that our expected outlook for fiscal 2007 is a significant improvement over the combined model that we shared with you in September at our analyst meeting.

Again, we will provide you with much more detail at our analyst meeting on March 29 in San Jose, when we have the benefit of another month of operations as a combined company.

With that, I will turn the call back over to Mike.

Michael Klayko

Thank you, Richard. Overall, we had a phenomenal quarter which culminated with shareholder approval of the McDATA acquisition. As you can see from our Q1 results and outlook for fiscal 2007, we are continuing to execute to our strategy for growth and diversification. We've made tremendous progress in integration planning and are tracking ahead of our key milestones.

We are operating our company from a position of strength with many opportunities to extend our leadership position in core SAN switching and to continue broadening our innovative solutions in the enterprise data center. It's an exciting time for Brocade and for our customers who'll benefit significantly as we continue to deliver these innovative solutions.

To close, let me once again reiterate the key points of our ongoing strategy. First and foremost, we are focused on continuing to execute very well in our Base SAN business. Second, Brocade will continue to drive our strategy for growth and diversification. Third, our belief in strategy is that shared storage will have an increasingly important role in driving next generation efficiencies across the enterprise and Brocade will be a leading supplier of these solutions. And finally, our team is focused and committed to delivering exceptional results for customers, partners and our shareholders.

We have passed the integration planning phase and are well into execution. I look forward to updating you on our continued progress at our analyst meeting in San Jose on March 29.

Thank you for your time. Operator, please open the call for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question is from Mark Moskowitz with J.P. Morgan.

Mark Moskowitz - J.P. Morgan

Yes. Thank you. A few questions, if I may. Mike, can you share with us of maybe what you are seeing from a market perspective in terms of the multiples which Brocade is growing right now? Are you considerably outgrowing the market when you say that you are taking the share or is the whole market growing, because you are just talking a lot more shares than people have anticipated previously?

Michael Klayko

Okay. Mark, what's the part because I will get them all at once here?

Mark Moskowitz - J.P. Morgan

Okay, great. The other piece that I may have missed it, but kind of a piggy bag stuff question, have you guys truncated your revenue attrition target of 30% given some of your commentary on your progress in the marketplace with McDATA?

Michael Klayko

Okay. All right.

Mark Moskowitz - J.P. Morgan

And then lastly, before I see the fall, are you seeing any positive or negative effects from the up-tick in the server virtualization right now? That seems to be having some impact on the server units or some would say that when servers are virtual that are consolidated and optimize through virtualization that people actually are willing to connect those servers to a SAN-type of environments, so actually it will benefit a switch maker. I know it's kind of a loaded question, but maybe Tom could help there.

Michael Klayko

Okay. All right. So, here is what I will do. In the three questions, in terms of market, I am going to have Tom go through, because actually it's the SAN market. It's a FAN market. It's the services market as well as a new market that we are starting to exploit in logistics extension. And so, we are going to look at it in a combination. So, we will talk about the market growth because we are seeing growth in all of those segments, but at different rates.

In terms of revenue, I will let Richard go through because we are still going to be within our long-term model. In fact, we have got some more data. We've got now a month of data to work with. And so, we'll tell you where we are out there. And in server virtualization, actually if you take a look, we had another records in terms of blades, bladed server opportunities and I think part of that is being driven by the virtualization move from consolidation and so forth. We are actually benefiting from this quite nicely here. But Tom, why don't you add a little color on the market?

Tom Buiocchi

Sure. Hi, Mark. So, first of all just in general demand, the fundamental is driving the need for better data communication and management solution just haven't subsided. So, overall demands are very, very strong.

Talking of where we participate, Mike mentioned it's not just the Fibre Channel SAN market any more. Obviously, in the SAN space, we gained significant share this quarter in the Director space and maintained share else where. So, we did pretty well this quarter, particularly at the high end. So, we are growing faster than the market there.

In the FAN marketplace, which is a much smaller but a higher growth segment, our growth exceeds dramatically the growth in the SAN marketplace, and that's kind of a still small marketplace. It's tough to tell market rates but we grew 24% year-over-year and our bookings I think grew 180% quarter-on-quarter in FAN. So, I would say, we are outdoing the market there as well.

Distance Extension, we have very high shares there. We are just beginning to track that on a quarter-on-quarter basis. But from market standpoint, that's being driven by the need for better disaster recovery and business continuity and remote backup solutions, both in open systems and mainframes. We have very strong share positions there as well. So, I would say we are doing better than the market there.

And then in services, the need for the focused expertise here is just outstripping the supply. And so, both from a partner and a customer standpoint and we mentioned IBM and NetApp today, the need for those services is very, very strong, and we are one of the predominant suppliers of those particular services.

I don't know if that answers your question specifically enough, but --

Mark Moskowitz - J.P. Morgan

No, that's helpful.

Michael Klayko

Okay. Thanks Mark.

Richard Deranleau

Yeah. So, a little bit around the revenue attrition. When we announced the deal, we announced that we had provision in our modeling at the time for up to a 30% reduction in McDATA's revenue and still have an accretive deal. Through the significant amount of work that we have done in the planning between that date and when the transaction closed. We are reducing the amount of attrition that we are expecting. Probably more importantly is that, the components of that attrition are now changed, where the 30% may have been around allowance per share loss, when we look at the attrition right now, we are looking at a smaller number and the components of it are related to third-party product revenue that McDATA used to sell. That's really not strategic for us and its very low margin. So, we are planning and getting to reducing or eliminating that type of revenue.

The second really deals with the accounting adjustments for the purchase accounting, where we have to take a haircut on the amount of service revenue that was in their run rates. So, to sum up, less attrition and attrition is really third-party low margin stuff we want to get rid of or accounting adjustments, and we are not at this point planning on any significant share loss.

Mark Moskowitz - J.P. Morgan

Okay. Thanks Richard.

Michael Klayko

Yeah, let me just touch on that quickly, Mark. So, VMware and server virtualization we believe is a boost to our market acceptance in SAN in particular. Because if you think about it, in the past high-end severs were first connected to SANs and a very small percentage of entry level servers, Wintel servers and then Linux servers were originally attached to SAN. And speaking to some VMware folks that I know very well, they said that over 90% of installations connect to SAN at some point in time. So, what server virtualization is doing basically is driving connectivity of lower-end servers to Storage Area Network, which is a bonus for us.

Mark Moskowitz - J.P. Morgan

Okay, thanks for the three-prong attack to my question.

Richard Deranleau

Sure, sure.

Michael Klayko

Thanks Mark. Next question please?

Operator

Our next question is from Dan Renouard with Robert W. Baird.

Dan Renouard - Robert W. Baird

Hi, thanks. My question is on the McDATA revenue for the January quarter. You referenced 6% to 14% typically from third-party or historically from third-party? What percent was it in, the January quarter? And it sounded like you didn't expect that's equal to zero immediately, does that go to zero over a couple of quarters or does it go away this quarter? How should we think about that? Thanks.

Michael Klayko

Sure. We are not breaking out the detail of the 136 between its components, because that's the company really combined into Q2, it will become less meaningful. But to answer your second part of your question, what we would expect to see is that amount of third-party revenue to decline over the next several quarters, and we would also expect for it. It's not equal to zero, but to be focused more on solution sales that where we can have a strategic impact in the account as opposed to just chasing revenue numbers. So, we will continue to sell a smaller amount when it helps us to provide a 4-gig solution. So, we are really not going to be taking revenue for revenue sake.

Dan Renouard - Robert W. Baird

Yes. Thanks.

Shirley Stacy

Thank you. Then next question?

Operator

Our next question is from Laura Conigliaro with Goldman Sachs.

Richard Deranleau

Hello Laura.

Shirley Stacy

Laura, are you there?

Laura Conigliaro - Goldman Sachs

Yeah, I think the questions really have been answered.

Richard Deranleau

Okay. Thank you, Laura.

Operator

Our next question is from Samuel Wilson with JMP Securities.

Samuel Wilson - JMP Securities

Good afternoon, just one question. Can you give us update on the competitive environment, now as you've got McDATA in-house, so you'll get a chance to see what's going on there vis-à-vis the other competitors in this space and what's happening? Thank you.

Tom Buiocchi

Yeah Sam, this is Tom. So, again, I am going to come back to different segments. I will talk about SAN first and FAN extension service. But in the SAN space in particular, as they are products coming to marketplace right now. But then we never underestimate the competition, but our products, we believe are still leadership. The demand is still there and we are competing very, very well head-to-head in the Director space and in the switch space and in the blade space.

So, there are new products but most of those products, quite frankly, bring to the market feature sets that we've been shipping for over two years right now. So, we feel very confident in that space. In the FAN marketplace today, much of the leadership positions, both of our StorageX products for data centers and our WAFS products for remote offices and so forth. In the extension business, we have very strong market share and position there. So, not a lot of new competition there.

Samuel Wilson - JMP Securities

Tom, if I may just ask one follow-up. When you are going into bid? Are you basically bidding right now, mainly Brocade products or you bidding sort of McDATA products, so should you have some McDATA customers and Brocade products to everybody else?

Tom Buiocchi

Actually Sam, what we're doing is, we're going in and we're seeing what the customer requires. And we've just got a larger portfolio now of products to offer to the customer. So, whether they had a history of buying McDATA products or Brocade products, we're continuing that sales process. We don't want to cause any outages or disruptions at that customer.

Samuel Wilson - JMP Securities

Got it. Thank you so much.

Tom Buiocchi

You're welcome.

Operator

Our next question is from Brent Bracelin with Pacific Crest Securities.

Brent Bracelin - Pacific Crest Securities

Thank you, Richard. I was wondering if you could just talk a little bit about your greater confidence in the cost synergies here. I know you're the only one into it, but clearly feeling a little bit better. Could you target specific areas? Where you are you feeling those cost synergies are going to come from now versus about one month ago, is it manufacturing, employee attrition? Just give us a little more color on where that's coming from and then I have a follow-up as well.

Richard Deranleau

Sure Brent. What we did was we had worked with McDATA in anticipation of the close and had done a lot of planning to identify the headcount activity that was going to happen at the point of the close. So the reason we feel more comfortable today is because the vast majority of that headcount action has been both either implemented and is done or the folks who are working in transitionary roles know their roles and that information has been communicated. So, the headcount aspect of our synergies is much more clear to us at this point.

Brent Bracelin - Pacific Crest Securities

Okay. So, it sounds like the primary delta there is on the headcount side?

Richard Deranleau

The timing of the headcount.

Brent Bracelin - Pacific Crest Securities

Okay perfect.

Richard Deranleau

And then the certainty around it.

Brent Bracelin - Pacific Crest Securities

Okay perfect. Then my follow-up question is more on demand side. Obviously, you had very strong bookings on software and services, much stronger than what the actual revenue growth was in the quarter. As you look at layering some of the software and services functionalities from McDATA, how should we look at that segment? What are the general targets on software and services overall do you expect out of those product segment family?

Michael Klayko

Brent, this is Mike. I'll take the first part. Some of the contracts that we are engaged in now as a part of the acquisitions have in the services arena, have are licensed three plus years. And so there are some long contracts that have componentry around SAN components, FAN components, services. There is a variety of pieces there. So they are much longer periods of times versus just quarterly transaction. And so, again, as we learn more and we have more of these more offerings to bring to the customer base, I think you will see us have much longer-term contracts in some of the pieces.

Other areas that looks as real interesting is there is some anonymous demand for the skill sets that we have around distance, around mainframe connectivity. And there are just not a lot of resources out there in the marketplace that can supply that. So, we are getting stretched pretty thin. And so, it's a good balance. We have a lot of short-term opportunities, but we also have that nice balance of long-term engagements with customers.

Richard Deranleau

And Brent, just from a modeling point of view, they follow pretty much the model we would have expected to see and we shared when we started looking at our model between software products, which are primarily in SAN area versus services versus the traditional hardware. And they fall really into that. So, their software components they bring to the table will again provide upside to our gross margin or upward pressure on our gross margin. Their services again will provide a counter balance to that to the extent that they grow in a combined company. Then we are looking at the gross margins to really neutralize those two things grow together.

Brent Bracelin - Pacific Crest Securities

Okay. Great. That's helpful. My last question and I'll hop off here. You have talked about pricing and your expectation that pricing will be benign this quarter, but really didn't talk about beyond that, as you look at the market we are now, what, four quarters of stable pricing. If you look at the HBA market, pricing has been stable for four years with only a couple of competitors got a control in that market. Is there something unique about the switch market where you do expect longer-term pricing to be competitive or is that just tied to from the trends that you have seen over the last four years, and do expect more normalization based on what you have seen in the last four years?

Michael Klayko

Tom, why don't you answer one of the market questions? Why don't you take that?

Tom Buiocchi

Yeah. So, couple of things, Brent. One is that, thus far this quarter, we have seen a continuation of the trend. You mentioned, for the last four quarters, which is a fairly benign environment. However, competitors are introducing products in our traditional switch and bladed segments and we are planning for it to return to historical levels because of their participation in those segments.

Brent Bracelin - Pacific Crest Securities

Okay. So, relative to your high share in the switch side of the market, you do expect the switch pricing specifically to get more aggressive on the Director side. Any color there?

Tom Buiocchi

No. Overall, I think as competitors continue to introduce products into segments where we have a strong share and strong participation, you can expect it to return to historical levels, I think.

Brent Bracelin - Pacific Crest Securities

Okay. Fair enough. Thank you.

Tom Buiocchi

Thanks, Brent.

Operator

Our next question is from Aaron Rakers with A.G. Edwards.

Aaron Rakers - A.G. Edwards

Yeah. I have got a couple of questions. I apologize, if I missed it, but I think there was a question asked in regard to the contract manufacturing relationships between Brocade and then legacy McDATA. I just wanted to understand is the new target for operating synergy is reflective of the consolidation of that contract manufacturing or is that something that we think about going into the 2008 timeframe?

Michael Klayko

Yeah. So, the decision on what we are going to do from a supply chain, those decisions have been made. But obviously, when you are dealing with supply change, it takes time to bring those into effect. So, the impacts are getting in the supply chain optimization or later on in the calendar year.

Aaron Rakers - A.G. Edwards

Okay. And the next question is in regard to the deferred revenue. It looks like you broke out current and non-current significant growth in the non-current line. Can you just give us, I would assume that services and software maintenance-type contracts, any color on what that line item includes, it will be helpful? And may be how we should view that going forward?

Richard Deranleau

At this stage, what you are finding is that the company is getting into more multi-year deals. And that's kind of a reflection of the more strategic place we play into the data center. But as we have more of these multi-year deals, then obviously the impact will be to see the long-term deferred revenue to grow. Now, how the exact mix of that is? I think we are going to need more time dealing with the consolidation of the McDATA services before we can give you lots more modeling to do. But that's what's driving it.

Aaron Rakers - A.G. Edwards

And then final thing, if I can. I know there have been conversations about the competitive landscape and specifically in regard to the blade switch market. I think there are some interesting things going on there. Can you help us understand, are you guys positioned for what HP is doing in terms of Virtual Connect Architectures? Just any thoughts there Tom, on what that might mean?

Tom Buiocchi

Just to point out, one of the announcements we made in February, soon after the acquisition close was, something we call Access Gateway or NPIV, which is an industry-standard mechanism to virtually connect our switches to fabrics. And what that does is, it allows greater scalability, easier manageability and probably, most importantly, interoperability. So, we will be able to connect our blades to directors or switches from any other vendor that support that NPIV standard. So, that NPIV standard is fairly common in the industry and fairly new and that's going to create a new level of connectivity I think. So, yeah, I think the answer to your question directly is, yes.

Aaron Rakers - A.G. Edwards

And you guys are positioned there?

Tom Buiocchi

Yes.

Michael Klayko

Yeah, quiet well. Thanks Aaron.

Operator

Our next question is from Tom Curlin with RBC Capital Markets.

Tom Curlin - RBC Capital Markets

Hey, good afternoon.

Michael Klayko

Good afternoon.

Tom Curlin - RBC Capital Markets

On the embedded side, there is a particular OEM that's being rolling out of what appears to be very well accepted blade platform. And without naming names, do you feel like that fuel adoption process within that OEM is still in the early stages or is passed up, I guess, will pass the inflection point, if you will in terms of adoption or is there more to go with that in terms of helping year-over-year comps?

Richard Deranleau

Not exactly. What we are talking about, we do have relationships with all the major server manufacturers in that regard. So, clearly HP where the C-class blades would have to be helping the trend.

Michael Klayko

Yeah, I think that we've also, Tom, we are the seven of the largest server manufacturers right now and supplying them product, all of them are different stages, all of that different market acceptance depending upon the region that they participate in the world. Obviously, all of our OEMs are critically important and we are working with each of them on current, as well as, next-gen. And so, we're pretty comfortable right now, what we are doing in the bladed market, not only currently but what we have planned.

Tom Curlin - RBC Capital Markets

Okay. On the Director side, have you guys commented yet on what the 8-gig architecture will look like, is it primarily a continuation of the traditional Brocade architecture or some, if you will blend of the Brocade and McDATA architectures as you get out to 8-gig?

Michael Klayko

We've had an opportunity to meet with all of our partner OEMs and some very, very select customers that have investments in both McDATA as well as our Directors, and it's given them kind of an advance here of what we're going to be doing and why and when. And what we plan on doing is adding a little bit more color at our Analyst Day, because it's not, as you can imagine not a very simple topic to go through on a call like this. So, we are maybe adding some more color at the Analyst Day on that one, Tom.

Tom Curlin - RBC Capital Markets

Is it a blend versus just a straight forward extension of the existing architecture?

Michael Klayko

You can imagine that customers from both the classic environments want their particular feature sets. Tom, so I think it's important we make sure, we have the features that appeals the classic McDATA customers, both in the mainframe and open distance space, as well as the classic Brocade customers. So, architecturally and in feature-wise again, Mike said, we will go into more color on it. But it's going to accommodate all of the installed base requirements.

Richard Deranleau

I think our customer base is going to be very pleased.

Tom Curlin - RBC Capital Markets

Okay. Thank you very much.

Michael Klayko

Thanks Tom.

Shirley Stacy

Operator, we'll take one more question, please.

Operator

Okay. Then our final question is from Glenn Hanus with Needham & Company.

Glenn Hanus - Needham & Company

I know you are not going to break out McDATA specifically, just on the Director side there today have sort of a weak quarter or down quarter, and with that, you had such strong growth. And can you give us some color on just kind of what the ups and downs were in the McDATA revenue stream?

Richard Deranleau

I think the way to really look at it from a Director point of view, is in the last quarter specifically, you need to think about both company's performance together. And therefore splitting one out as strong or weaker, the other stronger or weaker, I think isn't the right way to look at it and I think if you looked at the combined company, however, would have confirmed if we would have closed the quarter earlier. I think it would have been a strong quarter for both companies. There is some migration that has been from McDATA over to Brocade. But if you look at them both together, I think both companies did very well.

Michael Klayko

Glenn, this is Mike. One last comment on that. What I was very, very pleased with is when we did our first day reach-out we sent an e-mail and letters of to over 30,000 customers. And when we did merging of the two databases between the Brocade and the McDATA database, we had less than 300 names overlapped. So that to me was very, in fact, we'd talk about a pleasant surprise. It was outstanding to go ahead and see that. And so, I think it's a positive sign going forward for us also in that space.

Glenn Hanus - Needham & Company

On the balance sheet then, what is your net cash position now post deal coming into the second quarter?

Richard Deranleau

From a net just really round numbers and you probably would've been looking at something on the magnitude of $680 million to $700 million net. And that would be net of all of their debt. Remember that two levels of debt one was with CNT which was paid off in middle of February. The other one was the McDATA convertibles and those will be outstanding through 2010. So, on a net basis, somewhere between $680 million and $700 million.

Glenn Hanus - Needham & Company

Okay. So, that's as of the end of January?

Richard Deranleau

Yeah, it's at the end of January just rough numbers.

Glenn Hanus - Needham & Company

Okay thank you.

Shirley Stacy

Thanks Glenn.

Richard Deranleau

Thanks Glenn.

Shirley Stacy

Well, thank you everyone again for joining us today. This concludes our Q1 fiscal 2007 conference call. We look forward to seeing you at our upcoming conferences including Goldman Sachs Conference, tomorrow February 27 in Las Vegas, the Morgan Stanley conference on March 7 in San Francisco, The Citigroup Conference on March 13 in Las Vegas and the Brocade Analyst Meeting on March 29 in San Jose.

As always, our presentation and breakouts will be audio webcast on our website. And if you have any further questions, please call Brocade Investor Relations. Thank you. Bye-bye.

Operator

This concludes today's teleconference. We thank you for your participation. You may now disconnect.

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