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Brocade Communications Systems (NASDAQ:BRCD)

Q4 2011 Earnings Call

November 21, 2011 5:30 pm ET

Executives

Daniel W. Fairfax - Chief Financial officer

Ian Whiting - Senior Vice President of Worldwide Sales and Marketing

Dave Stevens - Former Chief Technology Officer

Robert Eggers -

Jason Nolet -

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

Analysts

Jung Pak

Andrew J. Nowinski - Piper Jaffray Companies, Research Division

John Slack - Citigroup Inc, Research Division

Scott Schmitz - Morgan Stanley, Research Division

Nikos Theodosopoulos - UBS Investment Bank, Research Division

Rajesh Ghai - ThinkEquity LLC, Research Division

Kent Schofield - Goldman Sachs Group Inc., Research Division

Brian T. Modoff - Deutsche Bank AG, Research Division

Matthew S. Robison - Wunderlich Securities Inc., Research Division

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

William H. Choi - Janney Montgomery Scott LLC, Research Division

Glenn Hanus - Needham & Company, LLC, Research Division

Erik Suppiger - JMP Securities LLC, Research Division

Stephen Patel - ISI Group Inc., Research Division

Mark Sue - RBC Capital Markets, LLC, Research Division

Jess L. Lubert - Wells Fargo Securities, LLC, Research Division

Operator

Good day, ladies and gentlemen. Thank you for standing by, and welcome to Brocade's Fourth Quarter 2011 Earnings Question-and-Answer Conference Call. As a reminder, this conference is being recorded. And now, I would turn the program over to our speaker, Bob Eggers, Vice President of Investor Relations with Brocade. Sir, please go ahead.

Robert Eggers

Thank you, Melanie. Good afternoon, and welcome to Brocade's Q4 earnings question-and-answer conference call. By now, you should have seen our press release and prepared comments, which are available on our website, www.brcd.com. The press release was also distributed by MarketWire and furnished to the SEC.

Before we take your questions, investors should note our comments today may include forward-looking statements regarding Brocade's financial results, 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 July 30, 2011, and in our Form 10-K for the fiscal year ended October 30, 2010. These forward-looking statements reflect beliefs, assumptions, outlook, estimates and predictions as of today, and Brocade expressly assumes no obligation to update any such forward-looking statements.

In addition, this presentation may include various third party estimates regarding the total available market for SAN and Ethernet as well as other measures, which do not necessarily reflect the view of Brocade. Further, Brocade does not guarantee the accuracy or reliability of any such information or forecast.

This presentation includes non-GAAP financial measures. The most directly comparable GAAP information and a reconciliation between the non-GAAP and GAAP figures are provided in our Q4 2011 press release, which has been furnished to the SEC on Form 8-K and in our slide presentation and prepared comments on our website, www.brcd.com.

Here to take your questions today are Mike Klayko, Brocade's CEO; Dan Fairfax, CFO; John McHugh, CMO; Dave Stevens, CTO and VP of Corporate Development; Jason Nolet, VP Data Center and Enterprise Networking; and Ian Whiting, Senior Vice President of Worldwide Sales.

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

Michael Klayko

Thank you, Rob. I am extremely pleased with Brocade's performance in Q4 and for the full 2011 fiscal year, which broke a number of records and positioned us quite well for FY '12. I'm especially gratified by some of the bold steps we took in the quarter to increase our financial and market position. The repurchase of approximately $200 million of Brocade's stock in the quarter equaling roughly 9% of the shares outstanding at the -- in the Q3 is a testament to the confidence we have in our strategy.

We are beginning to reap the benefits of the investments we made in FY '11, which also drove the introduction and adoption of our highly differentiation through our products and solutions such as Ethernet Fabrics, well ahead of the other players in our market. These actions combined with careful expense and margin controls resulted in a Q4 EPS of $0.16 on a non-GAAP basis and nearly 8% increase quarter-on-quarter.

In terms of revenue, Brocade had a record Q4 and full year generating $550 million in Q4 and $2.15 billion for full year '11. And we've not led up on our strategy to grow our Ethernet business faster in the market, and so it's no surprise that we saw a 14% growth quarter-on-quarter in our Ethernet product revenue.

There are other notable trends in our Ethernet business that are worth mentioning. One, Q4 was a record quarter in terms of revenue in both our Americas and EMEA geographies. In fact, EMEA improved its business nearly 60% year-over-year. Two, we're seeing some very positive customer trend data such as Brocade acquiring more and more new Ethernet customers in Q4 than any quarter before. In addition, we're seeing great traction in our top 100 accounts, which are foundational for this business. We're very pleased to see that 95 out of these top 100 accounts made purchases in Q4, and the average deal size per account was up nearly 20% quarter-on-quarter.

We were also making great progress in being able to sell Ethernet solutions into our top SAN accounts. At the end of Q4, we can now point to 60% penetration of Ethernet sales into our top 100 SAN account, with more than half of those customers purchasing Brocade Ethernet products in the quarter. This demonstrates majority of our large SAN customers trust Brocade as a complete networking solutions provider.

In our Storage business, we saw a faster-than-expected ramp of our 16-gig portfolio of products. As many of you know, I've been in the networking business for a long time, and in my recollection this is perhaps the fastest and smoothest qualification process of any new product portfolio among our key OEMs. All of our major OEMs have now qualified our next-generation storage portfolio.

We've been speaking about wholesale upgrade of the entire network for a few years now. It's real, it's happening, and we believe we have a distinct advantage with our considerable first-to-market leadership in many of the networking market segments. Most exciting for me is this next fiscal year that we just started.

Brocade had its Annual Sales Meeting, where we gave a brief preview of what's coming from a product and program perspective. Even more exciting is that the sales team is armed and ready to go with a very broad and competitive product and services portfolio that truly meets the needs of our customers.

The sales team is also excited about our new business model such as Brocade Network Subscription, which is enabling them to penetrate accounts that have traditionally blend on lockdown with the incumbents. It just makes too much sense to be able to pay as you grow, not to give Brocade the opportunity [Audio Gap] to bid. It's one thing to offer all the features and functionality that customer needs to run the network. It's another to offer them an affordable way to pay for it. We're surrounding the customers, and they're waiting us in.

I think you can tell that I'm very excited about this year that's coming up with the products, the people and the pool of the projected forward in FY '12 and I really look forward to a great year.

With that, operator, I'd like now to turn the call over to you for questions.

Question-and-Answer Session

Operator

[Operator Instructions] We will take our first question from Jess Lubert with Wells Fargo Securities.

Jess L. Lubert - Wells Fargo Securities, LLC, Research Division

A couple of questions. First off, typically, the January quarter is up sequentially. So I guess I wanted to start off by getting a better understanding of what's behind the flat to down sequential guidance. Are you being conservative? Or has the business deteriorated in certain area? Are you trying to capture Q1 seasonality? I just wanted to better understand how come you're guiding flat to down quarter-over-quarter when typically, the January quarter is up?

Michael Klayko

Jess, let me again, I'll this -- this is Mike. Let me give start with the macro view down, and get a little more granular. The macro view, I can tell you why, with all the stuff that's going on and where the economies and so forth, and there's quite a bit of uncertainty out there. Even in our own super committee right now, it's very, very difficult to figure out where that's going to land, plus what's going on in Europe. And so there's that element of a global uncertain economy that we all have to go ahead and just look at straight in the face and say, "What's going to happen there."

Ian Whiting

Yes, Jess, so just to give a little more color on that, so as Mike said, we're looking at Eurozone issues in the macro, the super committee impact on the U.S. economy. And then more specifically, we did complete the divestiture of our SBS services subsidiary. They accounted for about $20 million of annualized revenues that won't be in our business next year. The full first quarter will reflect that. And then we also have some normal Federal government seasonality in our IP business. So we're taking all those factors into account when we set guidance fully for the first quarter.

Jess L. Lubert - Wells Fargo Securities, LLC, Research Division

All right, that's helpful. And then on the Ethernet gross margins, they ticked sequentially a bit in the quarter. Can you maybe talk a little bit about what you're seeing with respect to Ethernet pricing? Has it gotten any more aggressive? Are you still confident you can get to the low end of your 54% to 59% range exiting the fiscal year?

Ian Whiting

Yes. So just on the quarter-to-quarter comparison, it would reflect in kind of the same comments we've made last quarter that the larger opportunities tend to be more price competitive. The good news is we're seeing significantly more large IP opportunities than we have traditionally and winning better than our fair share of those opportunities. Other than that, pricing has been relatively stable. Our position in terms of how the prices have changed in the marketplace.

Jess L. Lubert - Wells Fargo Securities, LLC, Research Division

And then my last one is on the 16-gig Fibre Channel, it sounds like demand there really picked up in the quarter. Can you discuss how much of the revenue there was channel fill versus end-market demand? And how do you expect that to progressively ramp to fiscal 2012? Is it likely to be steady sequential improvement? Or do you think that's going to be lumpy going forward?

Ian Whiting

This is Ian. Let me take a strike of that. I think first of all, the growth that we saw in the 16-gig Fibre Channel business is all about end-user demand. There's considerable growth I think, and we're seeing strong demand across the board in Fibre Channel. Given the strength of that platform, we were out of the game very quickly winning a number of very large transactions both here domestically, but also interestingly, something we've been talking about for a while is the growth we see internationally in a number of high-growth markets as well. So that all goes well for the -- with the market for Fibre Channel SAN, and I think with the 16-gig platform, we've hit it right at the right time with a very strong product offering. So we expect to see continued strength in that business going forward into FY '12.

Operator

Our next question comes from John Slack with Citigroup.

John Slack - Citigroup Inc, Research Division

A handful for me as well. Maybe just following up on Jess' question, relative to the seasonality into January, could you rank order the macro and SBS and the kind of the Federal seasonality in terms of the impact and how you think about that?

Ian Whiting

All right. You know what, it's not quite as simple as prioritizing that. We -- somewhat we achieved it when you booked our models we build them. There's an echo, the different impacts and then after all, that -- so it will be very hard to give you any kind of guidance. Again, I'll reiterate that the SBS number will be -- will impact from our normal run rate and services about $5 million.

John Slack - Citigroup Inc, Research Division

Fair enough. Fair enough. Then kind of shifting over to product point of view a little. With the good wins recently 800-gig for you guys, and then also strength in 16-gig, first, maybe if you could talk a little bit about 100-gigabit business for you guys, quantify that all if you can. And then how do the 16- and 100-gig businesses impact gross margin? Because of OpEx are still pretty expensive on those platforms.

Dave Stevens

Yes. John, this is Dave. So I'll just make a little bit of a comment about the higher-gig business. The place that we're seeing big demand there is obviously, in the service provider market, where those guys are struggling with trying to make ends meet carrying lots more traffic and trying to take cost out of the infrastructure. So very good demand in transit carriers and Internet exchange points other places like that. We obviously -- we're also actually seeing pretty reasonable demand in the Enterprise space, believe it or not, for 100-gig and things like medical imaging and in research and development. And I think -- and Ian can correct me, but I think our largest 100-gig installation today is actually in Enterprise customer, not a service provider. So pretty good demand for that across both. The cost of the OpEx are continuing to come down a little bit with more volume. And so I think our expectation is that, that will all continue to gain strength over the years as the problems persist and the cost becomes more cost effective. And then we'll, of course, continue to take costs out of that as well going forward.

John Slack - Citigroup Inc, Research Division

Okay and would you characterize them as kind of 100-gig optics being a drag on the margins at this point on the year, overall?

Dave Stevens

I wouldn't characterize it as being a drag on the margins.

John Slack - Citigroup Inc, Research Division

Then maybe last one for me, and I'll free the floor. You mentioned -- Mike, in your comments you mentioned the success in the top 100 SAN accounts with the Ethernet business. Can you talk a little bit more about that? Are they buying top-of-the-rack solutions for kind of future proofing for converge convert or is it across the portfolio? Just any sort of metrics you can give around that would be helpful.

Michael Klayko

I think it's more across the board in terms of the products they're buying. As each customer that we're dealing would have unique request requirements in the network solutions. And so I can't point to just Enterprise or is it just the data center, it's a combination of both. So it's fairly broad.

Operator

We'll take our next question from Mark Sue with RBC Capital Markets.

Mark Sue - RBC Capital Markets, LLC, Research Division

Gentlemen, on 16-gig, do you feel we might be front-loading the benefits of the mature market? Or do you think we might be able to elongate the maturation of the Fibre Channel market before we move to Fibre Channel over Ethernet?

Jason Nolet

Yes. Mark, this is Jason. Let me tackle that. So I think what we're seeing is we're seeing continued and very strong interest in Fibre Channel is the premier storage and networking technology for mission-critical apps. And while we continue to invest in FCoE and have the broadest portfolio really in the industry with respect to FCoE today, we are seeing very modest take up. When we talked about this on, I think, a number of earnings calls and where we're seeing some take up markets in the connectivity from the server to the first top switch to the network. But end-to-end FCoE, the thing that would be mostly likely to present a challenge to Fibre Channel, we're seeing almost no take up. And so because of that Fibre Channel continues to enjoy that kind of premier place in the hierarchy of technologies for storage networking.

Mark Sue - RBC Capital Markets, LLC, Research Division

And recognizing, it's very early and right at the start of 16-gig Fibre Channel, does that go to 32-gig over time? Or do you think maybe 16-gig is the peak of it?

Dave Stevens

Yes, I think what we're hearing back from customers is that 16-gig is going to buy them a fair bit of runway. And the thing that is actually resonating most with the customers about this new generation of technology released is the enhanced manageability, automation and diagnostics that we built directly into these products. And so while they really appreciate the opportunity to future proof their networks with the capacity that 16-gig offers, it's actually some of the manageability features and the scaling of the actual networks themselves, the things that's driving the most interest in the technology. And so from that point of view, pretty much every customer that's a Fibre Channel customer has an interest in driving a greater level of efficiency, automation and simplicity in their networks.

Mark Sue - RBC Capital Markets, LLC, Research Division

Okay, got it. And maybe separately on the VDX, $15 million in VDX revenues, how should we extrapolate this current footprint as a means in terms of future potential? How large can VDX performance get out of a particular site? And does a pull in additional Brocade switches or are you finding that there's still a lot of segmentation in terms of how these switches are deployed out in the field?

Dave Stevens

Mark, this is Dave. We'll make a comment on the fabric thing. So one of the things that I think is very clear is that there is an unmistakable migration to fabric architectures both in the public and the private data centers driven by the adoption of virtualization and cloud technology. And so that's unmistakable, it's pretty early in that migration. I'm happy to say we were first in that market with the VDX back in January. We shipped our second wave of technology this year. We're continuing to innovate in all of the fabric technology through 2012 and 2013. And I think as customers migrate over to this fabric architecture, I think we're in great shape in terms of being able to lead that technology and lead that market. I don't think that we're trying to make any predictions on the speed of that uptake and the speed of that adoption. But the fact that everybody is going to fabric architectures is really almost indisputable in the industry.

Jason Nolet

The only other thing -- this is Jason, I might add to that is I think the first part of your question, we do see a fair bit of pull with respect to our other technologies when we win a fabric deal, I think in that fabric deal in particular. And what I'd highlight for you is the MLX. It's the perfect Layer 3 device to be connecting your fabric to reach the rest of your network. So we do see good synergies there.

Mark Sue - RBC Capital Markets, LLC, Research Division

Got it. So we're trying to see VDX connect to MLX?

Jason Nolet

Correct.

Operator

We will take our next question from Brian Marshall with ISI Group.

Stephen Patel - ISI Group Inc., Research Division

This is Stephen Patel calling in for Brian Marshall. You've made very good progress in the Ethernet business and gained to market early with your fabric solution. Can you talk about the customer feedback and that pace of adoption for VCS now that other fabric products have been in the market and help us compare and contrast the VCS with QFabric and fabric path?

Ian Whiting

Well, this is Ian. I'll start to answer that. I think one of the -- and further to the last question as well, one of the key metrics that we're looking at is really new customer adoption. And while the revenue, obviously, is very important and the drag it has on other products, the thing that we're focused on mainly is placing VCS and as many customers as possible because this is about winning the hearts and minds of the early adopters. And to that extent, we actually exited the year with over 300 customers using VCS in production environment. So for us, that's really the primary way of measuring uptake and adoption of the technology. And we'll continue to be a way that we think about the adoption of our Ethernet fabric implementation.

Stephen Patel - ISI Group Inc., Research Division

Okay. And then a follow-up, if I could, on the Service Provider market, it's down a little bit this quarter, but a very strong year, overall. How diverse is that customer base? What trends did you see in that market this last quarter? And how sustainable do think the growth is there for your Ethernet business and the Service Provider market?

Dave Stevens

I'll just make -- I'll make 2 comments on the technology, and then let Ian add some color on it as well. I think the -- our target in the Service Provider market is people that are building out cloud infrastructure and have big bandwidth demands. And so I think the product set that we have in there is with the MLXe with the CER and CES platforms and the VDX platforms, as well as the ADX load balancers is extremely well received by that environment. We've gone from kind of in the early days of our Ethernet portfolio having something like 150 Service Provider customers, quadrupling that customer base over the last 6 or 8 quarters. So we're seeing good uptake and good adoption of the technology. It's a lumpy business because people tend to buy pretty large quantities. But I think the uptake is going to continue for that product set.

Ian Whiting

Yes, just one thing to add that I think it's important is that we've also -- we said are still out several quarters ago to diversify the revenue stream specifically in our international market. And that's been a focus area for us in terms of where we've been investing in sales and technical resources over the last few quarters. So we're definitely on a mission to expand the SP business outside of our core markets, which has historically been very strong in the U.S. and a few other pockets into the international markets where we're seeing very high growth rates and we certainly want to participate in that.

Operator

We'll take our next question from Kent Schofield with Goldman Sachs.

Kent Schofield - Goldman Sachs Group Inc., Research Division

You've mentioned that the Ethernet business grew 60% year-on-year in the quarter. Can you talk about some of the drivers there? And then as you think about trying to take share in the overall business -- overall Ethernet business during 2012, what do you think will be the key focus points for Brocade to be with cash flow there?

Ian Whiting

This is Ian. So a couple of things on the growth in Ethernet. We talked about this really, just going back to as far as mid-2010 and most recently, at Analyst Day, it's really a little bit about -- it's been about taking the products that we have and some of the new products and becoming more efficient in our go-to-market model. And we've been on a steady course now for about 18 months in terms of focusing sales resources into key market segments. We look at this business through 3 lenses through the Service Provider, the data center and the traditional campus line segment -- segmentation of the market. And we've been focusing resources, sales plays, marketing efforts in those 3 areas of the business. And most recently, we've started to see some significant traction with the other major investment we've been making, which is in the channels. So certainly in the last couple of quarters, we've seen a growing contribution from our channel partners, which we measure in a number of ways for the key metrics for us or a number of new opportunities that are created by our channel partners, and that's reflected in the way that they bring those opportunities to us through deal registration. So it's really all about the execution against the sales model that we outlined several quarters ago, and then combining new products and some renewed marketing effort into those key segments.

Kent Schofield - Goldman Sachs Group Inc., Research Division

And was there any color on EMEA, in particular, during the quarter and the strength there?

Ian Whiting

Well, EMEA, I think, there's a couple things. EMEA has been under new leadership for the last 12 months or so, very early on in our EMEA sales leaders, [indiscernible] invested in new channel partners. So we've seen some good strength in channels in EMEA. But also just execution against the Playbook that we laid out 18 months ago.

Kent Schofield - Goldman Sachs Group Inc., Research Division

All right. And then jumping over to the share buyback, could you give us an update there again with what you have remaining and just what your thoughts are going forward?

Michael Klayko

So in terms of the excess cash and the story for us is really around the balance sheet. So our first and foremost concern is net liquidity and the balance sheet to operate the business effectively. We look at continued focus on -- into the debt that we acquired when we bought on the Foundry business. And then kind of the third of this -- or maybe third and fourth would be share repurchase and any kind of M&A activity. So it would be in that kind of priority order. In the fourth quarter, we generated a record level of operating cash flow. And we looked at the level of debt repayment we've made over the year. We've repaid $160 million on our term debt and we fell with the share price being at an incredibly good buy. It was an opportunistic time to make a significant investment in our own shares. Looking forward, we still have about $178 million left on our Board-authorized share repurchase program.

Operator

We'll take our next question from Brian Modoff with Deutsche Bank.

Brian T. Modoff - Deutsche Bank AG, Research Division

Question. Can you talk about the 10-gig upgrade cycle and how do you see Brocade playing into that wrongly and be certified coming into the market? How do you see you 10-gig benefiting from that trend?

Dave Stevens

Brian, can I ask you to repeat the question? We missed about half of it.

Brian T. Modoff - Deutsche Bank AG, Research Division

Yes. Can you, the 10-gig upgrade cycle, switching. Can you talk about any way you can play that opportunity for the coming -- I know you've got your 16-gig product. But with the Ethernet switching side, is there any way to benefit from that? Did you see the move to 10-gig wrongly? And then VMwares, vSphere 5, how that might drive your business?

Jason Nolet

Yes, absolutely. This is Jason. So the 10-gig upgrade cycle is very real. We see lots of customers investing in that. And we are well-positioned to take advantage of that on the Ethernet side of the portfolio. So whether you look at our VCS fabric technology and our 10-gig top rank switches or you look at our campus technology, they also has 10-gig aggregation capability on our SX platform. And then a number of other platforms that we have including MLX, we have some of the industry's best density at 10-gig as well as price per port. So a fair bit of the growth that we're seeing in terms of new wins and momentum is with respect to that 10-gig upgrade cycle.

Brian T. Modoff - Deutsche Bank AG, Research Division

And what do you see on the pricing side?

Jason Nolet

I'm sorry, we can't understand.

Brian T. Modoff - Deutsche Bank AG, Research Division

What are you seeing on the pricing side of that environment?

Jason Nolet

I think pricing is going to continue to come down a little bit, but it is not dropping super-fast. I don't think it has quite hit that knee in the curve yet. So I think we continue to see good margins here on the 10-gig gear, and I don't expect that to change any time soon.

Brian T. Modoff - Deutsche Bank AG, Research Division

Can you comment at all on a foot-forward basis what are you're seeing out there for 10-gig ports?

Jason Nolet

I won't comment on the cost per port, no. I'll just say it again, I think it's not falling off quickly. I think it's still on the demand side of that ramp, if you will. And so we continue to see that as a good margin opportunity for us.

Operator

We'll take our next question from Nikos Theodosopoulos with UBS.

Nikos Theodosopoulos - UBS Investment Bank, Research Division

Can you comment on the mechanics of the repatriation that you did?

Daniel W. Fairfax

Sure, this is Dan. So we brought back to the U.S, we repatriated $200 million of our offshore cash. We -- and you'll see in our GAAP tax rate for the quarter, we did take provision for the taxes on that. The repatriation is about a $50 million tax impact. All that was noncash as we used significant NOLs, so we have here in the U.S. to offset that. Once we repatriated cash in the form of -- it was done as a company dividend. And we've been into the market in a 10b5-1 trading plan and purchase of shared all within Q4.

Nikos Theodosopoulos - UBS Investment Bank, Research Division

Okay. And is there any -- is that the -- is the cash on your balance sheet now with the split between U.S. and international? And if this opportunity is available, if you have remained international cash to be brought back? Or what's the situation there?

Daniel W. Fairfax

Yes, there's so we would expense and I won't go into all details on the call, some limits in terms of what we can repatriate further from our foreign operations. But we ended the quarter with a total of $200 million of cash on the U.S. balance sheet.

Nikos Theodosopoulos - UBS Investment Bank, Research Division

Over $100 million and the rest is still overseas?

Daniel W. Fairfax

The balance of the oversees.

Nikos Theodosopoulos - UBS Investment Bank, Research Division

I see. Okay, all right. And on the SAN market, this year for the full fiscal year, the business was roughly flat from last year. Would there be any other -- would there be any puts and takes or the 16-gig update that -- or anything else that could make it grow faster than that next year? Or do you envision that being another flat year?

Ian Whiting

This is Ian. So we certainly have a plan to grow the SAN business this year based on the strength of the product cycle that we're in, and also a number of the other dynamics that we see in the marketplace, one being a major check refresh is happening that we're driving. We continue to see, as I've mentioned a few times now, growth in some of the higher growth markets where there's extensive data center build outs, and the opportunity for us also to take share because we are in that position today with a very strong product line. We have an objective to go out and take share particularly in the direct end of the market. So we feel that we're in a good position entering the year with a great product lineup and some win in our sales in terms of OEM support. And we certainly intend to take that business forward in a very aggressive manner this year.

Operator

We'll take our next question from Matt Robison with Wunderlich Securities.

Matthew S. Robison - Wunderlich Securities Inc., Research Division

You had pretty strong increase in percentage mix from Enterprise Ethernet. Was that a factor in the Ethernet margin? And can you give us some sense for the tone of business for Service Provider Ethernet going into the current quarter?

Ian Whiting

Yes, this is Ian again. So I think the strength that we saw in the Ethernet business was really a function of numerous things, one of them was certainly our ability to win more larger deals. In fact, one of the other metrics that we look at is the number of million dollar Ethernet transactions per quarter, and we hit an all-time high in Q4, which means that we're winning not only in the traditional campus LAN space, but also winning in larger Enterprise accounts. And Mike had mentioned this in his opening comments around the number of large Brocade SAN customers that we now count as Brocade Ethernet customers, the number of repeat customers we had in our top 100 Ethernet customer list. So all of these things really point to our ability to sell more upmarket into higher value and typically, therefore, higher margin Ethernet opportunities. That's true in the Enterprise space. It's similar in the Service Provider space, but they really all comes down to our ability to expand as well as penetrate deeper into our existing accounts.

Matthew S. Robison - Wunderlich Securities Inc., Research Division

So would that -- that would imply a sequential increase in Ethernet margin? How does that -- what was the sequential decrease?

Ian Whiting

Well, our Ethernet margins are -- they are a function of our aggressive stance in the market. We've been saying for some time that will we continue to be aggressive to win new footprint. Obviously, as volume goes up, margin will follow. But right now, the current course of status that we'll continue to be aggressive in winning new footprint in the broader campus LAN space. We're also increasing in the larger accounts, which do typically become more competitive. But that's really what we have to do, and that's where we started to see some success.

Matthew S. Robison - Wunderlich Securities Inc., Research Division

So is it correlated with your share gain and then -- and on the Service Provider outlook?

Ian Whiting

Well, as I said, our Service Provider business has historically been strong, but somewhat concentrated in the U.S. and in some key customers internationally. But we have made investments now, well, some time ago 2 to 3 quarters ago in building out dedicated Service Provider sales teams with dedicated marketing and other infrastructure to build that base of customers internationally, particularly in Asia, but also in other parts of Europe. So we do expect to reap the benefits of that throughout FY '12 and going forward to diversify the customer base.

Matthew S. Robison - Wunderlich Securities Inc., Research Division

So we don't really -- we shouldn't really think of any real change in the first quarter? Or how should we look at that in the near term?

Michael Klayko

I think some from a guidance standpoint, it would be evolutionary from where we are right now and through the first quarter. And taking into account that there is some lumpiness. We are investing still in the Service Provider marketing and sales, and starting to see some execution there in Europe and Asia Pac.

Operator

We'll go next to Bill Choi with Janney Montgomery Scott.

William H. Choi - Janney Montgomery Scott LLC, Research Division

So first on VDX, last quarter, you guys were good enough to give out a sequential growth rate. I'm wondering if you guys could go back to that for this quarter just a rough sense for that. And you guys have noted that of the 300 customers, about 20% are returning or repeat customers. And I just want to understand kind of how big these repeat deployments are in terms of scale and where we are seeing in terms of inflection point and deal size as going up for VDX? And I have a couple more questions.

Jason Nolet

Yes. Let me take a crack at that. This is Jason. So on the repeat buys for VDX, what we typically see is customers starting out with either a new project or a greenfield deployment of some kind. They'll take VDX into lab. Do a proof of concept, kick the tires a bit, and usually, that's somewhere between 2 and 6 switches. Then when they go to production, they'll deploy beyond that. But again, it's typically on a per project basis rather than a wholesale rip and replace of the existing infrastructure or a brand new data center kind of end-to-end. So again, I would I guess suggest that the fabric sizes are anywhere between 2 and maybe 10 switches on average. And we had about 20% quarter-over-quarter growth on VDX in Q4. And I think the number of customers was 320 approximately.

Michael Klayko

Correct.

William H. Choi - Janney Montgomery Scott LLC, Research Division

Okay, that's helpful. Also, I think you guys have devised a new comp plan that you've entitled Rev It Up and I guess I just want to understand what may be you could talk to in terms of any adjustments to go-to-market sales force and anything that could help us think about what this new comp plan would do?

Michael Klayko

It focuses people on things that are very important to grow the top line profitably, and make you rewarded for doing that.

William H. Choi - Janney Montgomery Scott LLC, Research Division

And are there any meaningful adjustments in the way you have looked at go-to-market here?

Michael Klayko

No, there's not.

Operator

We'll go next to Erik Suppiger with JMP Securities.

Erik Suppiger - JMP Securities LLC, Research Division

First off, just on the headcount. What was the headcount at the end of the quarter?

Michael Klayko

So in the quarter, and it's in the slide, it was about 4,500 employees. A little bit quarter-over-quarter, the bulk of which was related to the divestiture of SBS, that at the time of the close, had 120 employees.

Erik Suppiger - JMP Securities LLC, Research Division

Your OpEx in the quarter came down as well sequentially. Is there a reason why OpEx came down in spite of the nice uptick on revenues?

Michael Klayko

I think it still reflects, and we will go back and say in the third quarter, we started to bring our OpEx down as much as anything because we were concerned about the macro. And we started making some adjustments in spending in the third quarter. We continued that into the fourth quarter, just out of an abundance of caution. And we'll release incremental spending as we get more confidence about that. The other thing I think that will reflect there is that we have made significant investments in the business since about the mid-2010 time frame. And we're kind of at the point of being able to execute on those investments.

Erik Suppiger - JMP Securities LLC, Research Division

Did you say that the OpEx would continue to come down into -- in Q1?

Michael Klayko

No, I didn't say that. Actually, as we look into Q1, we go through our normal employee focal process. So we'll have salary adjustments be reflected in the first quarter. What I would say is that we continue to watch the business very closely, and we are expecting a prudent management team to do in this economy.

Erik Suppiger - JMP Securities LLC, Research Division

And where would you expect headcount to go in Q1?

Michael Klayko

I don't think we've given any specific guidance around headcount right now. I guess what I would say is that we continue to hire. We don't have any kind of hiring freeze on the business. And -- but we're very selective on the individuals that we do hire and where we're placing them in the business.

Erik Suppiger - JMP Securities LLC, Research Division

Okay. The FCX had a nice uptick. Was there any particular discounting in the quarter, any deals associated with that?

Jason Nolet

Yes, this is Jason. Now, I think it's a reflection of what Ian talked about before in terms of the execution of all the sales resources that we've deployed as well as increased emphasis on the channel. And you'll continue to see us invest in the leveraged channel for reach and scalability. The different thing I'd mention is that this year in particular, FY '12 is the year where we're focused more heavily on the campus network in particular. It's an area we've been a little quiet in, but have a very, very strong pipeline of products early on in FY '12. In fact, if you caught the news, you saw us release a few of them just a few weeks ago in the new access level kind of a high-end switch for the -- your campus access network as well as enhancements to our SX platform for 10-gig aggregation. And that's just the start of it. You're going to see us get more aggressive with additional product in the pipeline in just the next quarter or 2. So campus is going to be an area where we invest heavily in FY '12 and FCX is a core part of that.

Erik Suppiger - JMP Securities LLC, Research Division

Does the FCX carry similar margins to your data center products?

Jason Nolet

For the campus space is slightly more, I guess, price-challenged, if you will. So it depends on which product you compare it to in the data center. But we're comfortable that all the campus products on a blended margin basis, are going to be supportive of the model that we have.

Erik Suppiger - JMP Securities LLC, Research Division

Good. And finally, on the pay-as-you-grow initiative, what kind of revenues are you doing there?

Daniel W. Fairfax

So Erik, this is Dan. Right now, the revenues are still very, very modest. And I think if you go back to Analyst Day, we've made some specific comments about what you could think about in terms of modeling. It's really been an enabler for us to give us ourselves and started into accounts that we otherwise wouldn't be competing for. Customers rarely want all of their business to that form of acquisition model. And so I'd say it's really helping us in terms of just the overall attractiveness of the Brocade model to the end customers versus anything material right now on the revenue side.

Erik Suppiger - JMP Securities LLC, Research Division

But that will remain a pretty modest revenue contributor?

Dave Stevens

I would expect so over the next couple of quarters. And as it builds momentum, we'll soon be reporting that to you.

Operator

We'll go next to Rajesh Ghai with ThinkEquity.

Rajesh Ghai - ThinkEquity LLC, Research Division

A couple questions on the Ethernet business, which is pretty strong through fiscal '11 despite the decline in U.S. Federal. My question is that although this has now come to the lower dependence on the Federal business on the Ethernet side, is there any chance that you could see that business rebound from virtual fiscal '11, which is bottoms outs down to 28% year-on-year?

Ian Whiting

I think if you're referring specifically to the Federal business, obviously entering Q1, we are expecting -- we called out in a normal seasonality. I would repeat some of the comments I made earlier on around diversification. The Federal business for us has been extremely strong, but it has been somewhat concentrated. We've set out a few quarters ago to diversify in the Federal business looking specifically in areas such as the civilian agencies. We put on new leadership there, and also put in some new challenge as well. So our expectation is that we we'll continue to see strength where we've historically been strong in the Federal business, namely in the DoD and in intelligence agencies, but also increasingly so in some of the civilian agencies where we've made discrete investments over the last 12 months or so.

Rajesh Ghai - ThinkEquity LLC, Research Division

Okay. And following up on your last comment about the network the subscription services model, the question that keep you going for Investor Day is around the -- is there a possibility that this model could lead to a different revenues from the cloud Service Provider vertical, as some customers might replace product business with the subscription model? And would it possibly smooth out your Service Provider revenue views kind of that going forward?

Michael Klayko

Well, actually what's happening is customers who want to try Brocade, this is an excellent opportunity for them to try Brocade product sets as they exist in their current infrastructure. And so it allows them the flexibility to try the product with very minimal risk. It also helps us get into these accounts engaged and have other discussions were they will talk about capital projects. And so it's just a fabulous tool right now that we've been able to go ahead and deploy with our sales teams and our customers seem to resonate it in. So I don't think it's going to go ahead and effect our current revenue streams. If anything, it actually could help with some of the acceleration of new opportunities.

Rajesh Ghai - ThinkEquity LLC, Research Division

And the last question on the 16-gig ramp switch, which is obviously faster than the 4-gig, 8-gig ramp in the past. Does that change your expectations for gross margins going forward? And to what extent video games share on the SAN side this quarter?

Ian Whiting

I'll take the second question first. We've seen some preliminary share information from analysts that suggest that in the direct space in the calendar quarter, we did see some share gains, some very good share gains in the direct space. I think there's reports that either or we've got short leads to support of that. I think overall, the Fibre Channel business is extremely healthy. The margin profile is strong, and given the leadership position we've had and continue to have with 16-gig products, we expect to continue to be very competitive not only in refreshing our install base, which is the majority of the market, but also to the extent that we have opportunities to replace our competitors' install base we will or pursuing that very actively this year.

Operator

Our next question comes from Scott Schmitz with Morgan Stanley.

Scott Schmitz - Morgan Stanley, Research Division

Just on VDX, another question. Are you seeing any pent-up demand as customers wait for the larger chassis product next year? Or is it still just strong adoption of the current top-of-rack switch?

Jason Nolet

Scott, this is Jason. No, we're not seeing any pent-up demand or orders being deferred in anticipation of the modular chassis. Lots of customers show a lot of interest in the deploying fabrics that top-of-rack. And in September, we doubled the scalability of the fabric to 24 switches. It's 60 ports each of 10-gig, so there's plenty of scalability there for customers to build out those fabrics. So we don't believe we're constrained in any way on the timing of that modular chassis.

Scott Schmitz - Morgan Stanley, Research Division

Okay. And then just on the -- I think you gave a stand at the 60% penetration in Ethernet and Ethernet customers with SAN accounts. Have you -- can you remind us what that was historically and how much helped drive that growth this quarter?

Ian Whiting

Yes. So just to be clear, so we -- that statistic is based on our top 100 SAN accounts, 60% of them are now account as Ethernet customers. We've been calling that number out, I think, the last 2 or 3 calls. And from memory, I don't have the number in front of me. I think we started the fiscal year at less than 30%. So we've kind of doubled the number of what I would call typically large global 1,000 SAN customers to become Ethernet customers in the fiscal year. And that's obviously a metric we'll stay very focused on.

Operator

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

Andrew J. Nowinski - Piper Jaffray Companies, Research Division

I just wanted to get a quick clarification on your Service Provider segment. Growth in revenues are down 12% sequentially, Juniper just reported down 6% in that segment. But they said it's a shift in carrier spending from Q4 out to Q1. I'm just wondering if you saw similar a shift in Service Provider CapEx for the January quarter.

Ian Whiting

This is Ian. I certainly don't recognize that trend. I mean, we're continuing again to be an aggressor and to take share. So our objective is to continue to grow on our install base account, but also to win these many new footprints as we can. So our dynamic is all different, but that's not a trend that we recognize.

Andrew J. Nowinski - Piper Jaffray Companies, Research Division

Okay, very good. And then moving on to Storage margins, I just had a question regarding our FY '12 targets of 69% to 71% for Storage, and then as it relates to pricing strategy of 16-gig, I think this has been asked, but I just want to get a clarification as well. With regard -- when you had 8-gig Fibre Channel and you have the first mover advantage over Cisco, can you price modestly above 4-gig? Just wondering how your pricing 16-gig. And then as it relates to your targets, how do we take a material step down from the current levels to get to within that range for FY '12?

Michael Klayko

Let me take the pricing part of that. So consistent with what we did on 8 over 4, we do have a modest pricing premium on 16 over a [Technical Difficulty] Yes, sorry, what was the first part of your question?

Andrew J. Nowinski - Piper Jaffray Companies, Research Division

You got cut off there. So yes, just had a question regarding the pricing of your 16-gig. I know on 8-gig, you only priced it modestly above 4 in order to gain market share. The 16-gig, are you adapting the same strategy on that? And then as a follow-up, how does your stores gross margins grow from the current levels? How do we get down into that 69% to 71% range for FY '12? What were the takes on that?

Michael Klayko

So let me answer the first part of your question. I'll have Dan answer the second part. So on first part of your question, consistent with what we did when we introduced 8-gig over 4-gig, 16-gig does had a modest premium on the price. Again to gain share and to leverage the advantage that we've got in the market with the technology.

Daniel W. Fairfax

And the gross margin numbers, this is a multi-quarter forecast out, so we're taking into account the fact that the pricing will not stay out at the this premium level. We'll be bringing those prices down, and then it takes into account what we think the mix of product will be later in the year.

Andrew J. Nowinski - Piper Jaffray Companies, Research Division

Okay, very good. And then finally, on the storage revenue, I'm just wondering, do you view the PCIe flash storage trend as a headwind to your Storage networking growth?

Dave Stevens

This is Dave. I would say it's exactly the opposite. I think that the PCI flash, whether it's embedded in the server or whether it's embedded into the network in the form of flash-based arrays tends to drive the performance requirements in the SAN up and actually drive 16-gig adoption faster.

Operator

We'll go next to Jung Pak with BMO Capital Markets.

Jung Pak

I want to ask about the revenue guidance. You indicated Federal is going to be down sequentially with normal seasonality. How should we think about the non-Federal Ethernet business? Do we expect that to be up sequentially?

Michael Klayko

Yes. So we would normally see some expansion of our Enterprise Ethernet business as we come into the end of the calendar year. We're an October year end company, so we'd expect to see that kind of rebound in the calendar fourth quarter.

Jung Pak

Okay. And then with the Ethernet and the services expected to be down sequentially, should we expect the SAN revenues to be about seasonal growth for the January quarter?

Michael Klayko

So in terms of the kind of modeling guidance, we would expect to see the SAN business expanding with normal seasonality in the fourth quarter.

Jung Pak

What kind of normal seasonality?

Michael Klayko

Fourth calendar quarter -- first fiscal quarter for ourselves.

Jung Pak

Okay, good. And in -- on the 16-gig, you guys had a significant lead in 8-gig relative to your competitor. How far ahead do you guys -- are you guys in terms of 16-gig to your nearest competitor?

Dave Stevens

So this is Dave. I think I would make 2 comments. One on, as Jason made before, one of the attracting -- that's part of attractiveness from the product portfolio is the speed bump, obviously. But the thing that is, even really more attractive to customers are building large stable Enterprise SAN fabrics. And so to that end, some of the manageability, and the encryption, the extension capabilities and the virtual machine monitoring capabilities and device monitoring capabilities that we've been in the equipment is maybe even more significant than the 16-gig speed bump. And I think our expectation is that we're probably 18 months to 2 years out in front of any of the competition catching up to those capabilities in that speed jump.

Operator

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

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Just a follow-up to that last question. Dave, when would we'd expect to see 16-gig products from Cisco, at least some time late next year?

Dave Stevens

I can't tell. I have enough trouble keeping track of our product portfolio.

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Okay. Another follow-up for Ian. We were told that Cisco Storage business was up 20% year-on-year and sequentially. Is that not accurate for the market share data you've seen?

Ian Whiting

I think it may well be. I believe they stopped actually announcing their storage results. At least we don't see them publicly. But I think we have heard that. And I think there's 2 things I would say. One is we know that Cisco's business in this space is concentrated in a small number of large customers. That's been the case for some time. But I think more importantly, it's sort of validation of the marketplace for Fibre Channel SAN. And we've been saying this for some time that customers of both teams, Fibre Channel over competing technologies because it is the most stable high-performance reliable choice for anything data center deployment. So I think it's good news that the market, overall, has expanded. I think our competitors' results are a function of a lumpy success in a small number of traditional house accounts.

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Okay. And last question for me on expectations around competitive dynamics in the Ethernet LAN market going into next year specifically, if you've seen much of Juniper QFabric products so far.

Jason Nolet

This is Jason. No, we really haven't. In fact, we haven't lost a single VDX opportunity to Juniper and QFabric. So we'll be interested to see if and when that product starts to get some lags, but not an issue for us so far.

Operator

Our last question will come from Glenn Hanus with Needham.

Glenn Hanus - Needham & Company, LLC, Research Division

Just in light of your operating margin out-performance this quarter. Any update to the targets you gave at your Analyst Day fiscal '12 in terms of the gross margin or operating targets as we update our models?

Michael Klayko

No. I think we're comfortable with the modeling we gave you. Certainly, every quarter has its own dynamics in terms of some volume and expense controls. And so we're not going to dig into guidance at this time.

Glenn Hanus - Needham & Company, LLC, Research Division

And on the Ethernet side, I think you talked about sort of 6% to 8%, at least, for a TAM growth rate. Is that the general vicinity we should think about in the Ethernet growth for next year?

Michael Klayko

Yes, I think we're still good with that range. We were certainly pleased with the performance of the business over the last year. But again taking into account the macroeconomic kind of the clouds over the world economy is -- we don't feel comfortable changing those ranges at this point in time.

Robert Eggers

Thanks, Glenn. And this includes Brocade's Q4 2011 conference call. Thank you for your time.

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