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Brocade Communications Systems (NASDAQ:BRCD)

Q3 2011 Earnings Call

August 18, 2011 5:30 pm ET

Executives

Daniel Fairfax - Chief Financial officer

Dave Stevens -

Ian Whiting - Senior Vice President of Worldwide Sales and Marketing

Robert Eggers -

Jason Nolet -

Michael Klayko - Chief Executive Officer, Director And Chairman Of Corporate Development Committee

Analysts

Mark Sue - RBC Capital Markets, LLC

John Slack - Citigroup Inc

Kaushik Roy - Merriman Capital, Inc.

Matthew Robison - Wunderlich Securities Inc.

Jess Lubert - Wells Fargo Securities, LLC

Jason Ader - William Blair & Company L.L.C.

Stephen Patel - Gleacher & Company, Inc.

Operator

Good day, everyone, and welcome to the Brocade Communications Systems Inc. Third 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. Please go ahead, sir.

Robert Eggers

Thank you. Good afternoon and welcome to Brocade's Q3 Earnings Conference Call. By now you should have seen our press release that has been distributed by Marketwire and furnished to the SEC. Today's presentation including slides and prepared comments will be available on our website at www.brcd.com following the call. We thought it would be helpful to change the format of our call this quarter from the last several quarters. We will begin with some prepared comments from CEO, Mike Klayko, who will provide a summary of Q3 as well as an assessment of the company's strategies and key business initiatives. He will be followed by CFO, Dan Fairfax, who will review the financial results in more detail and provide guidance for our fiscal fourth quarter. After the management presentation, Mike and Dan will be joined by Dave Stevens, CTO; Ian Whiting, Senior Vice President of Worldwide Sales; John McHugh, CMO; and Jason Nolet, VP Data Center Enterprise Networking to answer your questions.

Before we begin, investors should note our comments today may include forward-looking statements regarding Brocade's financial results, IT spending and macroeconomic conditions, cash and debt positions, strategic 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 April 30, 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 market for Storage 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 Q3 2011 press release, which has been furnished to the SEC on Form 8-K and on our slide presentation and prepared comments that we will be posted on our website at www.brcd.com later today.

I will now turn the call over to CEO, Mike Klayko. Mike?

Michael Klayko

Thanks, Rob. Brocade ended Q3 with revenues of $503 million, generating a non-GAAP EPS of $0.09 on a diluted basis. A key highlight of our Q3 was our Ethernet product revenue, which was up 14% year-over-year and 8% quarter-over-quarter. However, as we announced in our preliminary results earlier in the month, in terms of overall company performance, we were not able to drive growth across all of our segments and geographies to meet our original expectations for the quarter. In particular, performance in our Storage business was lower than expected with product revenue down 6% year-over-year. Headwinds in the IT market, Federal spending and the overall global economy made for a challenging quarter for the company.

However, we're confident that we've got the right strategy and business initiatives in place to set us up for long-term success in the networking industry. We believe that Enterprise IT organizations and service providers are continuing to look at their networks as strategic assets that differentiates them from the competitors to provide greater value to their customers. This is particularly due to the major growth drivers fueling demand for networking products such as server virtualization, enterprise mobility, video and the migration to next-generation architectures.

As we look at our own performance, Brocade has always monitored its business and operations to ensure we're delivering growth and value and we'll be taking additional steps to improve and optimize performance. The following topics I'll be covering today: An overview of the health of our business, what we see as drivers for continued growth and the actions we've already taken, and those we will be implementing to improve performance. I will discuss an overview of the Storage business and why I believe it will continue to remain a viable and key part of our strategy, our well-positioned products for cloud computing, which is an important growth driver for networking overall. Our Ethernet business, the successes we have seen and why we expect to continue to grow this business, the steps we're taking on business optimization and expense controls and finally, I'll conclude with some summary remarks and a quick review of our 2011 Playbook, which defines our high-level strategy.

In Q3, our Storage business reported lower-than-expected revenues primarily due to 2 factors. OEMs reducing more inventory than we had expected and weaker-than-anticipated demand among end users. The Storage business is not immune to macro IT factors. Fluctuation in demand levels is normal and to be expected particularly in this period of heightened economic uncertainty.

We look to the future of our Storage business with optimism we believe will continue to be a source of strength for the company for a number of reasons: One, the total addressable market for storage switching has been on an upswing for more than a year, rebounding from the recessionary conditions we managed through in 2009. As an industry leader, Brocade has benefited from the higher demand and we've maintained our healthy lead in market share, both measured in revenue and imports.

Two, our customers are telling us that they will continue to spend and invest in storage. In our recently completed annual customer survey, 80% of our Storage customers said they expected to either grow or maintain their Fibre Channel switching spending over the next 3 years. Finally, Brocade is again leading the Storage industry and transitioning to the next-generation 16 gigabit per second technology, which bodes well for our long-term Storage business.

I'm excited to report that we're making excellent traction among our OEM partners in terms of qualifications and general availability. As of today, we have qualified and made 16 gig products generally available through HP, IBM, EMC, HDS and Fujitsu Technology Systems. We're also making great progress with qualifying our 16-gig products with our other key OEMs. Message is clear. We believe with that Fiber Channel Storage Switching business is healthy and will continue to be healthy based on real data from our customers and partners.

Another driver of the Brocade's long-term success is our positioning related to the tremendous opportunities in cloud-based IT spending. I believe that Brocade can capitalize and execute on these emerging opportunities as demonstrated by our pioneering work and market leadership and Ethernet fabrics through our VDX switches and VCS fabric technology. Customers are deploying our technology now to evolve their traditional data center networks to better support virtualization and facilitate the move to cloud architectures.

Ethernet fabrics have been an area of high interest from customers, partners and investors. And as the only company, we believe, that is actually deploying Ethernet fabrics in production data centers today, we're starting to see some interesting trends emerge in customer adoption.

For example, we're seeing good traction among customers who are further along in their virtualization maturity cycle. These customers are no longer using virtualization just for server consolidation and cost saving. They're optimizing the virtualization for migration to agile cloud architectures. This is a sweet-spot for Brocade's Ethernet fabric, specifically, our ability to support the growing number of virtual machines in a higher degree of VM mobility across distributed data centers. A simple and highly agile network architecture is essential to operating in these environments.

We're also seeing both strong interest in adoption from public cloud data center hosting service providers and software-as-a-service company. We saw this trend contribute to strengthening our business among service providers who view cloud-based services as a major revenue stream. In addition, Ethernet fabrics fit nicely into their data center strategies. This trend, along with our investment in sales, propelled us to generating record revenue with our service provider customers in Q3.

Brocade has a highly differentiated Ethernet fabric offering and our grow-as-you-go architecture resonates well with our customers as it cost effectively aligns with their own IT evolution strategy. We look forward to sharing and announcing other exciting cloud innovation across both technology and business sectors at the VMworld at the end of this month.

Our success of our Ethernet fabric solutions is an important part of our overall Ethernet business but it is only one of our key market differentiators. We're continuing to see increased traction in our Ethernet business and Q3 represented the second highest Ethernet business revenue quarter in the history of Brocade, going back to the Foundry days.

I believe several factors account for Brocade's improving position in the Ethernet market. The first factor is our strategic positioning in the high-growth 10-gigabit Ethernet segment, especially in data center deployments. From a macro view, we saw 10-gig revenues across the industry outpace 1-gig sales for the first time ever, according to recent industry research from Gartner. In Q3, we were able to highlight some exciting 10-gig Ethernet wins such as the end-to-end deployment at the U.S. Army base at Fort Carson as well as a FleetCor, which manages millions of credit card transactions a month for more than 500,000 commercial accounts globally.

The second factor is our highly innovative and evolutionary approach. We're helping customers migrate to IPv6 networks through our complete portfolio of IPv6-ready products. This practical approach is appreciated by our customers including Hurricane Electric, the operator of the world's largest IPv6 backbone.

The third factor is we have a compelling offering for 100-gigabit Ethernet product that we are shipping to large enterprises and service providers who are deploying them to upgrade their networks to terabit scales. Brocade is now shipping 100-gig products for revenue and we're pleased with the high-profile wins we had in Q3.

The final factor is the significant strides Brocade has made over the last 2 years in raising our profile and market acceptance in the Ethernet space. One example is our solid standing as a visionary in the 2011 version of Gartner's Magic Quadrant for Enterprise LAN. We also picked up another important industry validation in Q3 at Tokyo Interop, where our MLX and VDX products won both Best-in-Show Grand Prix awards in a field that included more than 300 competing products.

In addition, a recent Morgan Stanley CIO survey shows that Brocade is gaining momentum in terms of spending intentions for Ethernet switching.

Brocade continuously looks for ways to streamline operations and optimize our business at all levels to promote growth and increase profitability. On the expense management side, in Q3, we implemented aggressive measures to better align our operating costs within our model. In particular, Brocade has focused on controlling headcount, travel and compensation-related expenses. This result was $1 decrease in operating expenses sequentially.

In terms of business optimization, we've implemented measures to place more focus, prioritization and resources in our core strategic businesses, while de-emphasizing those that are becoming non-core to Brocade.

Executing on these go-forward strategies is a primary responsibility for Brocade's management and executive team. Consistent with this objective, we've made some important executive changes: The important appointment of Dan Fairfax as CFO. Among Dan's responsibilities will be working closely with the sales organization and operation to improve the processes around our revenue forecasting. As the former CFO of Foundry, Dan has extensive experience in the Ethernet space and is also focused on increasing profitability and shareholder value.

A larger role for CTO, Dave Stevens, who assumed the additional responsibilities of corporate development to help ensure that Brocade is well-positioned in driving key technology transitions and industry initiatives.

The appointment of Paul Martin as Vice President of Global Services to replace Dan Fairfax. Paul will be in charge of growing our services revenue, maintaining high customer satisfaction and increasing profitability through a focused, strategic approach.

And finally, the hiring of Anthony Robbins as VP of Federal Sales. Anthony brings a wealth of industry experience and insight, especially among the civilian agencies, which offer a number growth opportunities for Brocade in the Federal sector.

We'll discuss these topics in greater detail at our upcoming Analyst Day, where we are hosting in San Jose on September 14.

In summary, we believe that Brocade is well-positioned to take advantage of current and future business opportunities within the networking industry. We're confident in our strategies and our company culture thrives on performance and success. Moreover, we believe that our product innovation allows us to offer our customers a highly differentiated portfolio of solutions.

The overall IT industry is facing a series of challenges, but we believe we will emerge stronger and better positioned to compete in the networking industry.

This will not require wholesale changes to our strategies and we'll remain focused on our strategies as outlined in our 2011 Playbook with the following 5 fundamentals: Differentiating through innovation, growing the Ethernet business and top line profitably, maintaining storage leadership, generating more awareness and being an employer of choice.

With that, I'd like to turn the call over to Dan.

Daniel Fairfax

Thank you, Mike. In Q3, Brocade generated revenue of $503 million, which was essentially flat from Q3 '10 and consistent with the updated guidance that we provided on August 5. Storage product revenue was down 6% year-over-year on lower switch revenues, while Director and Server revenues were up year-over-year. OEM inventory reduced to approximately 2 weeks supply exiting Q3, compared to approximately 2.5 weeks exiting Q2 '11 and Q3 '10, respectively. The reduction of approximately 0.5 week of inventory translates to approximately $24 million for the quarter and was made up of mostly switch and embedded products. From an end-user perspective, storage demand was down approximately 1% sequentially and up approximately 4% compared to Q3 '10. Storage product revenue represented 55% of total revenue in Q3, versus 60% in Q2.

Ethernet product revenue was up 14% year-over-year and up 8% quarter-over-quarter with our Federal and Service Provider segments driving the sequential growth in the quarter. We saw very solid Ethernet growth year-over-year even with the backdrop of software IT spending and we continued to show returns across all geographies, with the exception of Federal, on the sales and marketing investments we have made starting in 2010. While all geographies had double-digit revenue growth year-over-year, in some cases, they did not grow as fast as we originally expected for the quarter. Similar to recent announcements from our peers, the Federal business proved to be a challenging environment and although Federal Ethernet was up sequentially, Q3 performance was lower than our expectations and down compared to Q3 '10. Ethernet product revenue in Q3 represented 28% of total revenue, up from 23% in Q2.

Global service revenue, flat year-over-year and down 3% sequentially, was impacted by fewer new support contracts tied to the lower product revenue and from a modest decline in product shipment linearity during Q3. Our global services revenue represented approximately 17% of total revenue, essentially flat with Q2.

Non-GAAP gross margins were 61.8% in Q3, consistent with the range we provided earlier this month and up 130 basis points from Q3 '10. The margins reflect improved product costs and progress from our Ethernet gross margin initiatives. Operating margins declined to 14% in Q3, as revenues were relatively flat year-over-year and operating expenses increased year-over-year tied to the ramp of the sales headcount and the increased marketing spending over the past year.

Non-GAAP EPS on a diluted basis was $0.09 for Q3 and GAAP EPS was breakeven for the quarter. GAAP EPS included a $25 million one-time charge related to the unamortized original issuance costs and discount on the original term debt, which we refinanced in the quarter. And it also included a one-time benefit of $14 million from a release of reserves for pre-acquisition litigation related to CNT at the time it was acquired by McData in June 2005. Q3 EPS results included a benefit from a lower-than-expected tax rate resulting primarily from lower anticipated U.S. net profit in our full fiscal year 2011 and other one-time benefits. The Q3 effective non-GAAP tax rate was 13.8% and the effective GAAP tax benefit was a favorable 123.2%. Other income and expense in the quarter was a net expense of $17.1 million, approximately $4 million better than the original guidance for Q3, reflecting the lower interest rate on our term debt and the associated lower amortization of issuance costs and debt discount. Total Q3 diluted shares were 510 million shares.

In Q3, the company identified an error in how we had accounted for certain sales discounts, which when corrected, resulted in immaterial changes to net revenue for the fiscal years prior to and including 2009, 2010 and for the first 6 months of 2011. These changes are reflected in the figures in our earnings release and prepared slides.

Finally, during Q3, we generated $11 million in operating cash flow, repaid $12 million of term debt and repurchased $10 million of stock. Net debt was up $374 million exiting the quarter, a reduction of $20 million from Q2 '11 and $320 million lower than Q3 '10.

Looking at our Ethernet business, including hardware and Ethernet-based support and services, Q3 revenue was $168.5 million, up 13% year-over-year and up 6% from Q2 '11.

From an Ethernet product segment view, stackable products continued to grow as a percentage of our Ethernet revenues to 48% in Q3 compared to 43% in Q2. FastIron CX, FastIron SX and VDX product growth have all contributed to the expanding stackable business over the past year. We also continued to see growth with our ADX layer 4 through 7 product revenue in Q3, which was up over 60% year-over-year and was a record quarter for the company.

Drilling down into the Ethernet business details in Q3, we are pleased with the year-over-year growth in our Service Provider and our Enterprise segments. Revenue from Enterprise and Service Provider businesses collectively were up 28% year-over-year and up nearly 3% sequentially showing continued growth across our product portfolio and customer base. We are pleased to announce that our Service Provider customers generated record revenues for Brocade in Q3. We are also encouraged with the overall growth in the international geographies year-over-year, specifically with regional and international service providers that have helped to expand our customer base. We saw sequential growth in Asia-Pacific and Japan in the quarter. While our EMEA Ethernet business, down 6% compared to Q2, was more impacted by the macroeconomic headwinds in that geography. Americas Ethernet revenue, excluding Federal, was up slightly sequentially and up 18% year-over-year.

Our Federal Ethernet revenue was $24.5 million, up 32% from the previous quarter but down 33% year-over-year, reflecting some improvement in Federal spending in the quarter, although our Federal orders did not improve as much as we had previously anticipated.

Total converged networking product revenue, including the Brocade 8000, FCoE blades for our flagship DCX storage chassis, VDX switches and CNAs, was up more than 390% year-over-year. Our VDX revenue was up over 50% sequentially in Q3 and we saw continued growth in new customers who have ordered our Ethernet fabric solutions. Although VDX does have a longer selling cycle, we are pleased with the growing pipeline of opportunities. We believe that our overall Ethernet and converged product portfolio continues to demonstrate our leadership in new technologies and protocols that are important to customers.

Looking at our Storage business, including hardware and storage-based support and services, Q3 revenue was $334.3 million, down 5% (sic) [ 6% ] from Q3 '10 and down 14% sequentially from a very strong Q2. As I noted earlier, OEM inventories came down by approximately 0.5-week in the quarter. Reported revenue would have been approximately $24 million higher for Q3 if OEM inventory had remained flat sequentially.

Demand for Storage products was weaker than expected and resulted in Storage product revenue at $275.4 million in the quarter. The mix of our Storage product shipments was consistent with the prior quarter.

Our server product group, including embedded switches and server adapter products, HBAs and Mezzanine Cards, posted revenue of $44.2 million, up 12% year-over-year and down 9% from a strong Q2. Embedded switch revenue was up 12% year-over-year while our server adapter product revenue was up 10% year-over-year.

In Q3, Brocade had 3 customers, EMC, HP and IBM, that each contributed revenue of at least 10% of the total company revenue. These 3 customers contributed 43% of revenue in Q3, down slightly from 44% in Q3 '10 when we had the same three 10% customers. You will recall that in Q2, we had four 10% customers that contributed 53% of revenue. Other OEMs represented 18% of revenues in Q3 versus 11% in Q2 when HDS was our fourth 10% customer for the quarter. Channel and Direct were 39% of revenue in Q3, an increase from 36% in Q2, reflecting a mix shift from the OEMs to the channel, consistent with a stronger Ethernet contribution in the quarter.

The mix of business based on ship-to locations was 61% domestic and 39% international in the quarter.

Q3 non-GAAP overall gross margins of 61.8% were consistent with the guidance range of 61% to 62% provided earlier this month. Gross margins came down 160 basis points quarter-over-quarter due to the mix shift from Storage to more Ethernet revenue, as well as slightly lower Ethernet product gross margins in the quarter. Gross margins improved 130 basis points year-over-year driven by expanding Ethernet and Storage gross margins. Q3 Storage non-GAAP gross margins were 72%, down slightly from 72.2% in Q2.

Q3 Ethernet non-GAAP gross margins were 49.7%, down slightly from 51% in Q2 and up 44.4% in Q3 '10. The Ethernet margins came down sequentially as a result of a shift in channel mix and special discounting for a few large transactions in the quarter. The year-over-year improvement Ethernet gross margins, however, reflects good progress on initiatives to improve gross margin that we laid out at our September 2010 Analyst Day. The impact of a lower Ethernet gross margins on overall non-GAAP gross margin was unfavorable by approximately 35 basis points in Q3.

Global Services non-GAAP gross margins were 49.5% in Q3, up versus 49% in Q2, primarily due to spending controls.

The overall segment mix changes, driven by Ethernet revenue growing from 23% of revenue in Q2 to 28% of revenue in Q3, unfavorably impacted the overall company gross margins by 115 basis points.

As Mike mentioned earlier, we have taken a series of steps to manage our spending, including actions in Q3 to more tightly control and effectively manage expenses.

On a non-GAAP basis, total operating expenses were 47.8% of revenues in Q3 versus 45.4% in Q2. However, on a dollar basis, operating expenses decreased $8.5 million sequentially, reflecting the focus on controlling spending, including headcount, travel and compensation-related expenses. As we mentioned previously in Q2, we completed investments in our direct sales and channel organizations that we had launched in the first half of 2010. Near term, we would not expect to grow sales spending further as we optimize on those investments already made in our sales model.

Non-GAAP operating margins were 14% in Q3, a decrease from Q2 driven by the lower revenue and lower gross margins due to segment and product mix.

Cash from operations was $11 million in Q3, down quarter-over-quarter due to the lower revenue and profitability, as well as the typical cash flow pattern for the company, which is seasonally lower in Q3. Total capital expenditures in the quarter were $26 million, versus $27 million in Q2. The company's headquarters campus development has been fully paid as of Q3 '11.

Cash and equivalents grew to $473 million, up $7 million from $466 million in Q2. In Q3, we reduced our term debt principal by $12 million and our term debt loan balances is now down to $240 million. We also repurchased $10 million of stock during the quarter and have $379 million remaining of our Board-authorized stock repurchase program.

Adjusted EBITDA in the quarter was $91.3 million, which was a decrease from the Q2 level of $120.9 million. The senior secured leverage ratio of 1.87 and the fixed charge coverage ratio of 2.3 are both well within the covenant requirements of our term credit agreement.

In Q3, we renegotiated the terms as part of refinancing our term debt and now have more flexibility in our use of cash. With that increased flexibility and current market conditions, we are actively exploring our options to accelerate our stock repurchase program. Going forward, our priorities for cash continue to be paying down the term debt and repurchasing stock opportunistically, as well as strategic M&A opportunities in adjacent businesses or to acquire key technologies.

Looking forward to Q4 '11, here are some things to consider in developing your financial models: The current macroeconomic environment continues to show uncertainty. The IT spending environment including Storage and Ethernet is growing at a slower pace than originally forecasted for this year. The Federal fiscal year ending in September should help in driving sequential growth in U.S. government orders, although this area has become increasingly challenging for us to predict. Exiting Q3, OEM inventory was approximately 2 weeks. For Q4, we would expect OEMs to again drop inventory level as they look to manage assets tighter in the softer economy and actively plan for the transition to our new 16-gig Fibre Channel products.

We expect quarterly ASP declines in our Storage and Ethernet businesses to be in the low-single digits in Q4. We expect to hold operating expense dollar spend relatively flat in Q4 from our Q3 levels. We expect to see the full benefit of the lower interest rate and lower amortization of original issuance costs and discount of our term loan in Q4.

From a tax rate perspective, we expect a slight reduction to our structural rate for planning purposes. Discrete events can impact tax rate from time to time, however, we do not provide guidance on such events due to the inherent uncertainty of their timing.

Given those overall planning assumptions for Q4, we expect overall revenue to be: $520 million to $540 million. Non-GAAP gross margins to be 61% to 62%. Non-GAAP operating expenses to be 45.2% to 46.2%. Non-GAAP operating margins to be 14.8% to 16.8%. Other income and expense net to be an expense of approximately $14 million. Our non-GAAP tax rate to be approximately 24%. Diluted shares outstanding to be in a range of 509 million to 512 million shares excluding any share repurchases in the quarter. Non-GAAP EPS to range from $0.09 to $0.11. Operating cash flow of $85 million to $100 million. Capital expenditures of $20 million to $23 million. And free cash flow of $62 million to $80 million.

That concludes our prepared remarks for today. I'll turn the call back over to Mike now. Thank you.

Michael Klayko

Thanks, Dan. I appreciate that a lot. There's a lot of information that was covered in my prepared remarks as well as Dan's prepared remarks -- a lot of information to absorb. But with that, I'd like to turn the call over to the operator for questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] And we'll take our first question from Brian Marshall with Gleacher & Co.

Stephen Patel - Gleacher & Company, Inc.

This is Stephen Patel calling in for Brian Marshall. In the event that the IT spending environment deteriorates further, can you talk about what kind of levers you have on OpEx to preserve margins and profitability? How should we think about hiring and investments you plan to make over the next year?

Daniel Fairfax

Yes, this is Dan. Let me answer your question. So as you saw from Q3, we do have some significant control over our operating expenses. We were able to bring spending down quarter-over-quarter by $8.5 million and we're serious about our 2-year model guidelines although we fell outside in terms of the expenses in the quarter. Most significantly in terms of our spending, clearly, is our personnel costs. We are quite pleased with the team we've developed within the company and so it would not be our certainly first choice to make any kind of slashing to that investment. But there are other expenses that we have control over including prototype spending and other things and in terms of knobs and dials.

Stephen Patel - Gleacher & Company, Inc.

And then just a follow-up. You showed very good growth in your Ethernet business despite the impact from Federal and lower IT spending. Can you talk about how sustainable you think that growth is and how you view your share gain opportunities with VDX and some of the new products you've launched recently?

Ian Whiting

Yes, this is Ian. Let me take a shot at that. So certainly from a sustainable growth perspective, we do feel that the investments that we've made in sales and marketing over the last year or so are starting to bear fruit. We're certainly not done in terms of driving more productivity in the sales and marketing organizations. But certainly, the key dials for us are the number of new customers that we continue to acquire running at sort of between $300 or $400 a quarter. And the repeat business, the annuity business we're starting to see from those accounts, the leverage we're getting from our investments in both channel and systems integrators, both in the Federal as well as in the broader commercial space. So certainly in terms of the sales model and the investments we feel that we are executing well and that we're starting to see the return on those investments.

Jason Nolet

Yes, and this is Jason. Just to add to that from a product point of view, you mentioned VDX. I think we're very pleased to see that the customer community, the analyst community and all the partners embraced the notion of Ethernet fabrics and they need to think about data center architectures differently than in the past. In Q3, we were able to double our installed base on VDX product from 100 customers to over 200 customers, so we feel very good about that. We're seeing wins in both Enterprise environments for their product cloud initiatives as well as in Service Provider and SaaS provider environment. So we're seeing broad adoption and interest in the technology. And one of the things we're most excited about is announcements we'll make at VMworld in about 2 weeks, where we'll be extending our existing lead in the Ethernet fabric category with a number of new product announcements for the product portfolio. So stay tuned for that. We're very excited to be delivering some more capability there.

Operator

Our next question comes from Mark Sue with RBC Capital Markets.

Mark Sue - RBC Capital Markets, LLC

I just had a question. Do you feel the weak economy is masking some underlying transition away from fibre channel? Does 16 gig still happen with the current state of affairs? Just trying to get a sense, because historically, the Fibre Channel business is a steady business even during tough times, so I'm just trying to get a better sense of the decline.

Dave Stevens

Yes. Hey, Mark, this is Dave Stevens. So let me make some just comments on fibre channel technology in general. I think as Mike mentioned in some of the prepared remarks, all indications that we're having from customers continue to indicate demand for the technology both through personal interactions as well as industry surveys and third-party surveys. The buying dynamic continues to be very strong for Fibre Channel. It continues to be the dominant technology in the data center for pooled storage environments. And then on top of just that, there's some macro things happening within the customers which are continuing to drive the adoption over into the 16-gig space. Applications like virtualization and VDI, drive very high I/O rates and they also drive very high rates of pooled storage attached. Both of those things are favorable for Fibre Channel in general. And also for high-speed Fibre Channel, new devices like solid state disks and caching devices that are being put into networks for analytics and for VDI deployment, also are driving much higher I/O rates in the storage network. And that's getting people to take a hard look at 16-gig Fibre Channel. And then also new capabilities that we've put into the new product beyond just the speed, things like embedded encryption, native extension capabilities, which eliminate the requirements for some other equipment as you extend Fibre Channel between data centers, new diagnostic capabilities that allow you to look at per VM, I/O statistics and things like that. So all those things are in that new 16-gig product set and our expectation is that the transition is going to be about the same as it's been in the past on 2 to 4 and 4 to 8 gig Fibre Channel. So we don't see any reason to believe that, that's not going to occur.

Mark Sue - RBC Capital Markets, LLC

Okay. And then perhaps on Ethernet and specifically on the Federal side, maybe, if you can share your planning assumptions for the upcoming quarter for Federal Ethernet, the type of flush we should be anticipating for the October quarter? And then subsequently, should we anticipate a sharp decline in subsequent quarters? Or how does that moderate overtime?

Ian Whiting

This is Ian. So it's certainly going into the Federal year end, we anticipate seasonal uptick in our Federal business, which will be consistent with our historical growth. The other thing, just a couple things to point out that despite some of the budget tightening that clearly everyone is talking about, we have been in the process of diversifying our base within the Federal business, which gives us a little bit more of a broader base of business to pick from. And we've been investing in some of the channel and systems integrator areas as well that is helping us sort of broaden that base of business. And when you look at where we're strong in Federal business historically, that's been in DoD and Intel, so some of the more critical parts of the Federal government business. So we feel that those are in a broader scheme of things more likely to be areas where budget will be protected and preserved. So all in all, I think looking at Q4, we do expect to see an uptick in Federal business in line with seasonality. And I would anticipate that continuing based on historical trends into the new fiscal year as well.

Operator

Our next question comes from Jess Lubert with Wells Fargo Securities.

Jess Lubert - Wells Fargo Securities, LLC

So first, at the Analyst Day last year, you provided a target financial model which you referenced in the slide deck. Is this still a valid financial model for us to be thinking about after fiscal 2012?

Daniel Fairfax

Jeff, this is Dan. So at this point, we're not changing or to your model, we'll be planning to do any updates against that model on Analyst Day in early September. But at this time, no, we're not making any changes.

Jess Lubert - Wells Fargo Securities, LLC

All right and then could you maybe just a little bit about linearity during the quarter and perhaps when you started to realize that the quarter was tracking below plan, where you saw it first? Was it in Ethernet or Storage? Can you provide us with some additional insight there?

Daniel Fairfax

So I did make a comment in the prepared remarks but we did see a slip in linearity in the quarter. It was modest. We tend to be fairly back-end loaded, the Ethernet business in particular. Ian, any additional color you want to add on that?

Ian Whiting

No, I think in terms of the Ethernet linearity as you said it is historically back-end loaded. That is something we're working on and I think as our repeat customer frequency increases and also leverage in the channel model increases. I would expect that to return to sort of normal industry benchmarks. But we are absolutely in a customer acquisition and aggressive posture in the marketplace. So we do tend to see a lot of activity at the end of the quarter. And I think that's borne out in the IP linearity. I think on the SAN side, we're fairly consistent with historical norms.

Jess Lubert - Wells Fargo Securities, LLC

And then can you give us a sense of how the business has trended during the first few weeks of August? And how is your visibility trended? And what's giving your confidence in guiding for sequential growth?

Ian Whiting

So this is Ian again. So from a pipeline perspective, we feel pretty good about how we've started the quarter and that's reflected in the numbers that Dan gave earlier on. So as always, there are opportunities to carry forward from prior quarters. But certainly, the new business, but also we started to see pick up early in August. It's giving us a reason to provide the guidance that we gave you earlier on. So a positive start, I would say.

Jess Lubert - Wells Fargo Securities, LLC

So just in terms of the outlook, have you made any change in terms of closed rates or assumptions when setting the guidance versus past quarters?

Ian Whiting

No, nothing material. It's all about the total size of the pipeline and maintaining the conversion rates and improving where possible.

Operator

Next we'll hear from Matt Robinson from with Wunderlich Securities.

Matthew Robison - Wunderlich Securities Inc.

A couple of things. First, did you guys see a benefit from broadband stimulus for the service provider sales in the June early in the quarter -- June timeframe? And also can you give us, I know you don't breakout this vertically typically, but can you help us understand what your sensitivity is to financial sector?

Ian Whiting

This is Ian. As far as the broadband stimulus is concerned, I think that is reflected in some of the strength that we saw in subtier 2, tier 3 regional service provider market, where we, as we've called that early on, we saw pretty healthy growth. I think it was 28% in Service Provider business globally and that was certainly affected and impacted by the stimulus. In terms of financial services, certainly in the SAN marketplace that is a strength for us and we have a strong position in the larger financial services companies. On the IP side that is very much an area of focus for us but we're coming from a different starting point obviously. So I'd say our exposure there on the Ethernet side is significantly less. On the SAN side, that is a stronghold for us and we continue to see trends around data center consolidation that point towards a positive reception for our new 16-gig Fibre Channel products.

Matthew Robison - Wunderlich Securities Inc.

Do you think that the fact that stimulus is going to benefit you in the current quarter? Or are you going to need to replace that sort of funding with other types of demand?

Ian Whiting

Well, I think we're certainly not dependent upon that, overly dependent I would say. I think as I've alluded to, our base of business is now pretty broad and it continues to grow. So across all segments of the marketplace, healthcare, education, Federal Service Provider business and other sectors, we are reasonably well spread and represented. And for us, it's more about penetration of those segments where we feel we have the highest probability of success. So not specifically exposed to that marketplace but certainly has been a growth engine for us so far.

Jason Nolet

And this is Jason, to just add to that a little bit, in terms of demand for bandwidth. We started shipping our 100 gig port adapter for the MLXe platform last quarter in volume. And we've completed a number of trials with service providers. We're seeing some pretty broad demand for that. So I think it's a testament as to the bandwidth requirements that service providers are seeing and we expect good adoption of the 100 gig overtime.

Matthew Robison - Wunderlich Securities Inc.

So we correlate the service provider volume pretty much directly with MLXe? Or is there a significant mix of others, which is in that percentage?

Jason Nolet

So MLXe, it's kind of a flagship product in that space, but there are other products. We have our CEO and CES products. We also do some business with our FCX. And as I mentioned earlier, we are seeing adoption with VDX in Ethernet fabrics in service provider environments as well. Because as you know, many Service Provider customers are looking to take advantage of the transition to public cloud infrastructure and VCS and VDX, in particular, fit very nicely in that space. And the last thing I'd highlight is the ADX product line, which still a reasonably small part of our business but as Dan talked about in his prepared comments create year-over-year growth on that product line. And that product is very tightly focused on Service Provider initiatives and IPv6 transition as a primary use case, for example. So I think we've got a number of products that are contributing to the Service Provider results.

Operator

Next we'll hear from John Slack with Citi.

John Slack - Citigroup Inc

Maybe I can first get a clarification on Mark's question about the Fed expectation. Ian, you said Fed should be seasonal. I'm trying to figure out what the seasonal pattern is. You said these days -- because, I mean, if I looked back at the Foundry days, they had 40% sequential quarters in Fed into September, October. These days it doesn't seem like you have that much real sequential trend going on. So if you could clarify that first, and then I have a couple others.

Daniel Fairfax

So Ian, let me make a couple of comments as I move to Foundry days. So there was a distinct seasonal pattern beginning of the year, lower revenues, and then effectively more of a flush in the back half of the year. And our timing and our fiscal calendar is different from the Foundry calendar, so we see slightly different patterns there. And again, I believe that we wouldn't say that in more normal times, we would see any difference in that pattern. At this point in time, things have been made more complex by wrangling around the lifting of the debt ceiling. Things that we certainly never expected to take as much time to wrangle out within Congress and the White House. But overall, I think the one thing we would like to maybe kind of wrap some of the other questions together is we think we looked very carefully through the pipeline. We understand that we missed expectations for Q3. We believe we have a conservative forecast in front of you right now.

John Slack - Citigroup Inc

Great. And then kind of, I guess, dove-tailing with that on the service provider side, clearly good traction there. We've got conflicting comments of, out of, a number of different vendors, out of kind of the service provider CapEx environment in the back half of this year. I mean, do you guys think your product cycle with 100 gig in the MLXe, you can grow through that? Any sort of kind of back half Service Provider slowdown? Or what's your take on the Service Provider CapEx environment, I guess?

Michael Klayko

Yes, I guess the comment we'd make is we've seen good strength there so far, and there's no reason to believe that won't continue. I think you're right on, that the 100 gig, the MLXe, the positioning of ADX for the Service Provider space in solving very, very discrete problems like transition IPv6, I think, are all very supportive of continued progress in that part of the market. So I think we're optimistic there.

John Slack - Citigroup Inc

And the last one for me, just on the SAN side. You said linearity is relatively normal on the SAN side. Was just it one particular event -- OEM that was short? I'm just trying to jot where that actually that other $25 million came from? Was it broad based? Any sort of color, incremental color you can give on that would be great.

Daniel Fairfax

Yes. So this is Dan. Are you ask specifically around the change in inventory position?

John Slack - Citigroup Inc

Both the inventory and the overall. The other half of the miss just on demand being later, if you could kind of clarify between the 2.

Daniel Fairfax

Let me first -- so from an inventory position it was across multiple OEMs, it wasn't a single company. And then within the book of business that came in, I don't think we'd reflect that there was anything unusual there for a quarter like this. We, in fact, that when we put guidance together at the beginning of the quarter, we all felt very, very good about the strong Q2. TheStreet actually took consensus above the numbers we guided to, so everyone was feeling strong about the business.

Ian Whiting

Yes, I think if you look at our seasonal trends around end-user demand, we were in line. I think we had expectations that we would do better than that, but I think the headwinds that we've been talking about obviously dampened some of those expectations. But if you look at end-user demand year-over-year, we were up about, I think, roughly 4%. And sequentially, we were kind of in line with what we would have expected to see on a seasonal basis.

Operator

Next question comes from Kaushik Roy with Merriman Capital.

Kaushik Roy - Merriman Capital, Inc.

I have one question for Ian and one for Dave. Ian, NetApp said they saw a weakness in the financial services. Did you see any weakness in the financial services in July or in August?

Ian Whiting

Not that I would point to specifically as a reason for any gap between our -- what we achieved and what are our expectations were, no.

Kaushik Roy - Merriman Capital, Inc.

Okay. And on the Federal, what do you think is going to happen? I mean, the miss in July, do you think that those things got deferred and you'll capture 100% of it or maybe 60%, 70%? What happens to those projects?

Ian Whiting

Well, as I said earlier on, we're starting the quarter with a positive outlook and some uptick in the Federal business through a combination of a more diversified revenue stream, more opportunities and also the Federal year-end budget. So overall, I think it's reflected in our guidance, we feel that Federal will be stronger. I think we're all still somewhat cautious about what's going to happen with budgets. But as I said, we're working from a much broader base and many of the places where we expect our revenue to come from are in the category of mission-critical networks. So for that reason, we feel somewhat optimistic that the Federal business will be seasonally strong for us.

Michael Klayko

This is Mike. I actually got on an airplane and went out after the quarter, actually in the end of the quarter. And it's interesting, as Ian just said, the demand is there, the requirements are there. The need is there and the desire is there. And when talking to the actual users of the technology, what they said is politics and budgets are running rampant. And that is trumping right now all the other things that we talked about. It becomes very difficult to forecast that because every time you chat with them, they talk, we're building plans and designing architectures, but it still becomes very, very challenging and predicting. And as Dan said earlier, I think we've taken a more cautionary view in terms of actually a more conservative view in that space because those are soft things that we can't control, the harder things we can.

Kaushik Roy - Merriman Capital, Inc.

And I have a question on Fibre Channel market. Okay, NetApp missed, but if you look at their core revenues, it still grew 14% year-over-year. I mean, EMC, Hitachi they're still growing at, at least high-single digits. Service are growing at high-single digits. But if I look at your storage revenues for the last 12 months, it grew only 2% for the previous 12 months. So the question is, servers are growing, storage is growing much faster than the Fibre Channel market, so why? I mean, what is the growth rate for this Fibre Channel market? Is it flat? Is it negative? Is it low-single digits? Dave, can you help us understand.

Daniel Fairfax

So I think that the macro trend that we see in the customers. As I said before, we don't see a drop in demand. It's hard for me to sit and correlate the server numbers and the other vendors numbers. I don't have them sitting in front of me but the demand that we see from customers continues to be strong. The indication that we get from the customers in excess as Mike said of 80% are continuing to buy the technology, expand the existing SANs that they have. We're shipping the next generation of technology that has some very significant capabilities. And as like I mentioned before, the encryption, the native extension that's applicable to macro application trends that we see like the adoption of virtualization and VDI. All those things point to the continued growth and the use of cold storage, and Fibre Channel continues to be the technology of choice in large data centers worldwide and I don't see any change to that trend.

Kaushik Roy - Merriman Capital, Inc.

So is it like MLX came and said, it's a flat market, the Fibre Channel. What's your best guess at this point? Is it low single digit, flat, negative?

Daniel Fairfax

Well, I think what we've said consistently, publicly is that it was low single digits, it's been 3%, 4%, 5% up. 4%, I think, is the median that we've talked about. Some of the analyst community has been higher than that. Some of them have been lower than that. But I think we've consistently said about 4%.

Operator

Our final question comes from Jason Ader with William Blair.

Jason Ader - William Blair & Company L.L.C.

I got 2 quick questions. First, I believe you alluded to deemphasizing some businesses that you said were noncore to Brocade, I was hoping you can elaborate on that? And then secondly, Dave, have you guys thought about at a management level, at a Board level, changing the way you did the whole channel inventory situation? I remember in McData days, there was a time when they actually recognized on sell in and then they changed it to recognize on sell-through. And it just made things a lot more transparent. You don't get this sort of volatility around inventory moving up and down. Have you guys thought about making that change? And if so, if not, why not?

Michael Klayko

Jason, this is Mike. So in terms of core and noncore, what we do is we have to look at each piece of the business and the long-term growth and profitability and we bucketed it into looking at it around data center technologies, Service Provider technologies and campus technology. Where the highest potential in terms of revenue as well as profit, anything and then we have to make trade-offs based on our long-term business plan. That's what we're referencing in terms of strategic, or what I call it, maybe it's not as core as some of the long-term strategic businesses. But we hope to give you a little update on that at the Analyst Day, because we're about through that exercise and you'll see we're surgically, we're going to go after each one of those. In terms of the sell in and sell-through and so forth, and there's different ways to look at it. But essentially, for many years, it had been relatively benign. The sell in and the sell-through is the same. And we have reported it that way. We actually reported in sell in and sell-through, but because they had pretty much ran the same, we just stopped reporting it a couple years ago. Back in 2009, we had thought we had experienced the trough in terms of inventory at the OEMs, because in the years past, it had been the high 3s and even into the 4's and it dropped to 1.5 weeks in 2009 during the recessionary time. In fact, if you look at our business alone, we took $15 million out of our supply chain to coming into us this quarter, and that just backs up in the whole supply chain. That's the first thing people will do when they see macroenvironment or things that cause cautionary look, so just stop buying some of the inventory. It's very simple to do and push off, and so we actually did that ourselves. So up until the last couple of quarters, it's been benign per se. And so why we're telling you about this is because it has dropped fairly significantly but it hasn't affected the end-user demand, so we were trying to be as transparent saying, the end-user demand is this, but for the last many years, it hasn't been -- it hasn't even been immaterial.

Jason Ader - William Blair & Company L.L.C.

I understand. My question really is how come you can't restructure the way you recognize the revenue? So I understand giving us information on sell in and sell-through but why can't you restructure it, just the way that McData did? I think it was in 2005 or something when they moved from a model, where they were recognizing and selling to the OEMs to a model where they were recognizing on sell-through?

Daniel Fairfax

Jason, this is Dan. I actually think Michael was at McData when that change took place. To be honest, to answer your question I've only been in this chair for literally a few weeks now. Clearly, other things have taken precedence to this, but your comments are understood and we'll certainly take that into consideration.

Michael Klayko

Okay, thank you very much and for participating today, we look forward to speaking to you at our upcoming Analyst Day in September. Watch for additional announcements. Thank you.

Operator

And that does conclude today's call. Thank you all for your participation.

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