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Brocade Communications Systems, Inc. (NASDAQ:BRCD)

F2Q07 Earnings Call

May 31, 2007 4:30 pm ET

Executives

Shirley Stacy - Director of IR

Michael Klayko - CEO

Richard Deranleau - CFO

Tom Buiocchi - VP of Marketing

Yin Cantor - Manager of IR

Analysts

Mark Moskowitz - J.P. Morgan

Tom Curlin - RBC Capital Markets

Laura Conigliaro - Goldman Sachs

Aaron Rakers - A.G. Edwards

Shebly Seyrafi - Caris & Co.

Samuel Wilson - JMP Securities

Glenn Hanus - Needham & Co.

Joel Inman - Robert W. Baird

Presentation

Operator

Good afternoon. My name is Bill, and I will be your conference facilitator. I would like to welcome everyone to Brocade's Second Quarter Fiscal 2007 Financial Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period (Operator Instructions).

Ms. Stacy, you may begin.

Shirley Stacy

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

Before we begin, I would like to cover some housekeeping items. Brocade issued a press release today detailing its second quarter fiscal 2007 financial results via PR Newswire and First Call. The Q2 press release, along with the corresponding slide presentation, is available on our website at, www.brocade.com.

This conference call is being webcast, and will be archived on our website for approximately 12 months. In addition, a telephone replay will be available approximately 6 pm Pacific Time today, May 31st, through 6:30 pm Pacific Time June 7th. To access the telephone replay, dial 888-286-8010, or 617-801-6888. The passcode is 5542-2585.

As a reminder, the information the presenters discuss today will include forward-looking statements, including without limitation statements about Brocade's financial results, business outlook and guidance.

These forward-looking statements are only predictions and involve risks and uncertainties, such that actual results may vary significantly. These and other risks are set forth in more detail in our Form 10-Q for the fiscal quarter ended January 27th, 2007 and Form 10-K for the fiscal year ended October 28th, 2006.

These forward-looking statements reflect beliefs, estimates and predictions as of today, and Brocade expressly assumes no obligation to update any such forward-looking statements. Certain financial information that we review on today's conference call is presented on a non-GAAP basis.

The most directly comparable GAAP information, and reconciliation between the non-GAAP and GAAP figures, is provided in our Q2 '07 press release, which has been furnished to the SEC on Form 8-K, and in the corresponding Q2 '07 slide presentation on our website.

Note that beginning this quarter, the slides will be automatically advanced as part of the webcast presentation, and a PDF version will be posted just after the call concludes. In addition, the presenters will discuss sell-through information, which provides a measure of OEM and channel partners' sales to end-users.

Brocade does not record revenue based upon OEM sell-through information, and this measure is not intended to be viewed as a substitute for reported GAAP revenue. Sell-through is a measure of demand, but is not a GAAP measurement of revenue, and therefore, is not subject to the same level of internal controls as reported GAAP revenue.

The second quarter of fiscal 2007 is the first combined quarter for Brocade and McDATA. In accordance with purchase accounting, we have not restated prior quarter financials to include McDATA, and therefore, the comparisons we will refer to in this presentation do not reflect McDATA's historical results.

Finally, in Q2, Brocade service revenue was greater than 10% of total Company revenue for the first time. As a result, we have broken out service revenue in accordance with segment reporting requirements.

I will now turn the call over to Mike.

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Michael Klayko

Thank you, Shirley. Good afternoon, everyone, and thanks for joining us. Today, I will briefly discuss Q2 results, and update you on our growth initiatives. Following my remarks, Richard will review the Q2 financials in detail, provide an update on the McDATA integration, and share our outlook for the third quarter of fiscal 2007.

I am very pleased with our second-quarter performance. We were able to deliver strong results in our first quarter of combined operations, despite it being historically a seasonally soft quarter.

We successfully integrated two large organizations, and rationalized our product and service offerings. We also met with thousands of customers to communicate our strategy roadmap, both of which have been very positively received.

Our combined employee base is very energized and focused. We were able to achieve and surpass many of our internal milestones this quarter, including IT consolidation, product interoperability, and the reduction of non-strategic and unprofitable offerings from our portfolio.

From a shareholder value perspective, I am delighted to report that we have far exceeded the commitments that we made when we first announced the McDATA acquisition last August. As you will hear from Richard in a few minutes, our Q2 results reflect achievement of higher annualized synergies.

Q2 non-GAAP operating margins are comfortably within our target model, and non-GAAP earnings per share that our accretive to the acquisition model in the first quarter of combined operations. Our results this quarter validate the strategic rationale of the acquisition to expand our installed base, and further grow and diversify our business.

As you can see, the McDATA integration is well ahead of schedule. The integration milestones I have referred to were all accomplished significantly earlier than originally projected. And I am extremely proud of our employees for these exceptional results.

Now let's look at our Q2 results. We performed very well across each of our three core business segments, SAN, FAN and Services, which led to the overall strong and balanced results. Overall, we maintained our number one position in the SAN infrastructure market in Q2.

We had a strong quarter in switches and embedded switches for Bladed servers. Directors also grew with the addition of the classic McDATA directors to our director offerings. Our Q2 is traditionally a stronger switch quarter and a seasonally softer quarter for directors, and our results reflected this seasonal mix.

In addition, we had very strong growth in SAN extension and routing solutions, again, buoyed by the addition of the classic McDATA extension product. We continue to focus on rapid innovation in our SAN business, and earlier this week further bolstered our SAN offering with a number of enhancements that were detailed in our May 29 press release.

In addition, in Q2, we began to deliver on our comprehensive commitment to interoperability. We announced and began shipping the Brocade 5000 Switch, the industry's first and only platform that can operate seamlessly in a classic McDATA or Brocade environment.

We also announced the general availability of Brocade Access Gateway, which allows embedded Brocade switches, or Bladed server environment, to connect seamlessly to classic McDATA and other Director products. These two introductions have been very well received by our partners and customers, and are indicative of our continued ability to execute very well in our core SAN business.

Before I leave the SAN discussion, I want to reemphasize that our SAN business is being driven by a number of market factors. Traditionally, these factors have always included new storage and server shipments, but increasingly the trend of server virtualization and consolidation initiatives are becoming the drivers of network storage.

A number of analysts and market sources have recently highlighted that server virtualization, predominantly VMware, fundamentally requires storage network connectivity for successful and efficient deployment. This market is still in its early stages of adoption, and we will continue to ensure that Brocade is the preferred solution for these environments as server virtualization continues to grow.

Also, there are very few customers who are not considering, or are not in the middle of, data center consolidation projects. These initiatives also typically require a storage network to connect and more efficiently share server and storage resources. By our estimates this is a multibillion-dollar opportunity for SAN refreshes and consolidations. And we are in a unique position to capitalize on this dynamic.

A critical aspect and important driver of many of these consolidation initiatives is an absolute requirement to save energy via reduced power, space and cooling needs. According to IEC, data centers consume approximately 2% of the world's electricity.

We are uniquely equipped to help enterprise customers along these lines, as our products have been demonstrated to be two to three times more efficient than our competitors'. And we have developed tools and programs to help our customers to model, architect and realize these important efficiencies.

This is an important focus of Brocade, as it addresses a critical customer need, differentiates our solution from the competitor, and contributes to a heightened social responsibility.

We expect these macro factors, server virtualization, the need for consolidation, and the reduction of power consumption to continue to be important driving factors for the SAN market. And we will continue to invest in solutions that uniquely align with these market realities.

In our file area network business, our revenue nearly doubled sequentially, driven by the fact that unstructured data continues growing at an unprecedented rate. As with our SAN business, we are continuing to invest and innovate with our enterprise FAN offering. And again, you can refer to our press releases earlier this week for details of our most our most recent enhancements.

We continue to make excellent progress in our Services business. And I am pleased to report that in Q2, our Services business exceeded 10% of our total company revenues for the first time.

Before I turn the call over to Richard, I would like to provide some additional color on our announcement today regarding our expanded data center and server connectivity offerings. As we have discussed previously, we believe that the transformation to next-generation data centers involves greater level of connectivity, intelligence and simplification.

Server connectivity is an important part of this equation. Today, fewer than 20% of servers are attached to shared storage. This number is expected to grow significantly as customers increasingly strive for the benefits of consolidation, server virtualization, Bladed servers and management simplifications.

With a complete family of server connectivity offerings, we believe that we will be in a unique position to provide more end-to-end value, innovate across a broader platform, and provide increased levels of service and support to our customers.

We have mentioned in the past our enterprise SAN products connect to eight to ten servers for every port of storage they connect to. So we are very familiar with the need of this product category.

As part of our announcement today, we are introducing a family of high-performance Host Bus Adapters that support multiple data center protocols, and a specified roadmap to next generation Intelligent Server Adapters.

Specifically we announced, first, a Brocade iSCSI HBA that is immediately available to our channel partners and customers. This product, the Brocade 2110, is the first product from our Silverback acquisition earlier this year. It delivers higher performance at a lower cost than competitive products in the market today.

Secondly, we announced a family of high-performance, 4-Gig Fibre Channel HBA that will be in the market this summer. These products support multiple operating systems across a wide range of enterprise servers, and meet our expensive testing and reliability standards. Initial feedback from our OEMs and channel partners has been very positive.

And thirdly, we announced our plans for a family of next-generation Intelligent Server Adapters that will be available to our partners and customers in 2008. These products will utilize 8-Gig Fibre Channel and 10-Gig Ethernet technologies, and will extend today's HBA functionality with innovations that will help to further consolidate and simplify data center environments.

Longer-term, Intelligent Server Adapters will be an increasingly important element of next-generation data center networks. And our announcement today signifies our logical intent to drive broader customer benefits as part of our ongoing growth and diversification strategy.

To close, I would like to once again thank our team, our partners, and our customers for the excellent progress in results in our first quarter of combined operation since the McDATA acquisition.

We will continue to execute on our strategy of growth and diversification. And we continue to be committed to delivering the exceptional results that all of our constituents expect.

We continue to reiterate our belief that shared storage will have an increasingly important role in driving next-generation efficiency across the enterprise, and that Brocade will be a leading supplier of these solutions.

Our Q2 results and new announcements today are further proof that we will continue to focus and execute on our strategy, and that our focused investments will further complement and strengthen our position across our business.

With that, I will turn it over to Richard for more detail on our Q2 results and expectations for Q3. And I will come back after Richard for some closing thoughts and Q&A.

Richard Deranleau

Thank you, Mike. Before I begin, I want to let you know that this will be the last earnings call where we will provide additional commentary on what was formerly McDATA. The company that was McDATA no longer exists, as we have rationalized our combined product lines and exited certain lines of business.

Now, let's review our Q2 results, beginning with the income statement. Q2 revenues were $345.3 million. This represented an increase of 54% sequentially from $224.2 million in Q1 '07, and 89% year-over-year from $182.7 million reported in the year ago quarter, reflecting a full quarter of McDATA revenue.

Q2 sell-through revenues were approximately $333 million. This represented an increase of 46% sequentially from sell-through of approximately $227 million in Q1 '07, and an increase of 86% year-over-year from sell-through of approximately $179 million in the year ago quarter.

The way to look at our performance this quarter is to compare our revenue on a combined company basis in Q2 versus Q1. Recall in Q1 Brocade's stand-alone revenue was $224 million, and McDATA stand-alone revenue was approximately $136 million. On a combined basis in Q1 revenue would have been approximately $360 million before any purchase accounting adjustments.

Our Q2 reported revenue includes a $5 million reduction in low-margin, non-strategic third-party products, and as previously discussed, a $7 million purchase accounting adjustment that reduced McDATA's deferred service revenue at the time of acquisition.

These two adjustments totaled $12 million. If you subtract the $12 million from Q1's combined revenue of $360 million, you would get an adjusted Q1 '07 combined revenue of approximately $348 million. So net-net, on a more apples-to-apples basis, we are relatively flat in a quarter that is historically down 5 to 8%.

Revenues for our combined core SAN business were down slightly quarter over quarter, reflecting strong performance in switches and embedded switches, offset by normal seasonality in directors. In addition, we were very pleased with the performance of our SAN extension and router business, which include the USDX product.

In FAN, revenues grew approximately 72% quarter over quarter, and greater than 2,000% year-over-year. Our actual number of FAN transactions continued to grow, and the average deal size increased by 25% sequentially.

Service revenue were greater than 10% of total sales for the first time this quarter. As stated earlier, McDATA's service revenue decreased by $7 million in Q2 due to the purchase accounting adjustment that reduced McDATA's deferred service revenue at the time of acquisition.

Our service bookings, which are a key indicator of our demand and progress, increased a healthy 259% quarter over quarter and 759% year-over-year.

As a percent of sales in Q2, OEM revenues were 85% of total, compared to 92% in Q1, and 93% in the year ago quarter, reflecting a more diversified revenue profile resulting from the McDATA transaction.

Our top three OEM partners, EMC, HP and IBM were approximately 67% of Q2 revenue, as opposed to 72% in Q1 and 70% in Q2, '06.

On a geographic basis as a percent of sales, domestic revenue was 65%, and international revenue was 35%. This compares to 59% and 41%, respectively in Q1, '07, and 63%, and 30 and 37%, respectively, in Q2, '06.

Core growth in Q2 grew 63% from Q1, reflecting the addition of McDATA product offering. This brings our total installed base to approximately $13.2 million cumulative ports shipped, and represents well over 80% of total installed SAN ports.

Q2, '07 non-GAAP diluted EPS was $0.11, $0.02 higher than consensus estimate of $0.09 per share. This compares to non-GAAP diluted EPS of $0.17 in Q1 '07, and non-GAAP diluted EPS of $0.10 in Q2 '06. This better-than-expected performance is the result of achieving expected cost synergies earlier than anticipated, as well as our continued expense management execution.

Reporting on a GAAP diluted basis, Q2, '07 EPS was breakeven, in line with our prior outlook. This compares to GAAP EPS of $0.12 in Q1 '07, and GAAP EPS of $0.05 in Q2 '06. The decrease quarter to quarter reflects the impact of the amortization of purchased intangibles and related income tax adjustments from the McDATA acquisition. And these aren't non-cash expenses.

Non-GAAP net income for Q2 excludes charges of approximately $7.6 million in expenses associated with the acquisition and integration planning activities with McDATA; $15.2 million in expenses related to the indemnification obligations related to various ongoing legal proceedings involving certain former employees and other related costs; $6.9 million for stock-based compensation; $19.3 million for amortization of acquired intangibles and related net income tax adjustments.

Our effective non-GAAP tax rate in Q2 was 30%, which was within our expected rate of 29 to 30%. In Q2, '07, net stock-based compensation expense was $8 million, of which $5.9 million is due to the impact of FAS 123R, and has been excluded from our non-GAAP results.

The difference between the total net stock-based compensation expense and the amount excluded from our non-GAAP results is primarily due to $1.1 million in charges related to restricted stock compensation.

Non-GAAP gross margin for Q2 '07 was 53.4%, within our outlook of 53 to 55%. This compares to non-GAAP gross margin of 63.7% in Q1 '07 and 58.6% in Q2 '06. Again, reflecting the impact from lower-margin products acquired from McDATA, as well as higher percentage of revenue from services.

In the quarter, sequential ASP decline were again in the low single digits.

Q2 '07 non-GAAP operating expenses, excluding the items referred to previously, were $126.6 million, significantly below our prior outlook of $135 million to $140 million. This compares to non-GAAP operating expenses of $84.3 million in Q1 '07 and $76.8 million in Q2 '06. This reflects significant over achievement in the delivery of the committed cost synergies from the McDATA transaction.

Non-GAAP operating margin for Q2, '07 was 16.8%, above the high end of our outlook of 13 to 15%, and within our long-term model of 15 to 20% of sales. This compares to non-GAAP operating margins of 26.1% in Q1, '07 and 16.6% in Q2, '06. I am very pleased to have achieved our financial model operating margin target in the first quarter of combined operations with McDATA.

Now, turning to our balance sheet, our cash and investment balance at the end of the quarter, net of convertible debt, was $674.5 million. This compares to cash and investments of $631.7 million at the end of Q1, '07, and cash and investments at the end of Q2, '06 of $502.1 million. This includes restricted short-term investments, and was net of the company's convertible debt.

In Q2, we paid off EMC's convertible debt of $122.4 million, and we assumed McDATA's convertible debt of $162 million. In Q2, '07, we repurchased $60 million, which represented 6.3 million shares of Brocade common stock. We have $192.9 million left under the outstanding stock buyback authorization.

Cash flow from operations in the quarter was a healthy $46.2 million compared to our expected range of $30 million to $40 million. This compares to cash flows from operations of $33.3 million in Q1, '07 and $55.7 million in Q2, '06.

Day’s sales outstanding in Q2, '07 was 40 days, and below guidance of 45 to 55 days, reflecting better than anticipated linearity in the McDATA business. This compares to 38 days in both Q1, '07 and in Q2, '06.

Our on hand inventory in Q2, '07 was $26.4 million, below our outlook for a range of $30 million to $40 million. This compares to $10.2 million in Q1, '07 and $8.2 million in Q2, '06.

As stated in last quarter's call, we expect on hand inventory to be higher than our historical level due to the absorption of the McDATA product inventory. We would expect inventory levels to decline to our historical inventory turns by the end of the year.

Just to be absolutely clear, the on hand inventory that we absorbed from McDATA is not OEM inventory, but it is Brocade-owned inventory, which is at our manufacturers and suppliers.

Capital expenditures in the quarter were $14.2 million. This was compared to $13.4 million in Q1, '07 and $7.3 million in Q2, '06. The increase in capital expenditures primarily reflects a previously disclosed planned major systems upgrade related to the integration of our IT system. Going forward, we would expect capital expenditures will grow in net dollars, but will return to historical levels as a percent of revenue.

Finally, deferred revenue was $126 million in Q2, '07. This compares to $69.2 million in Q1, '07 and $55.6 million in Q2, '06.

Now, for our expected Q3 outlook. First of all, we are very pleased with the integration of McDATA. But it is still early in our combined operational experience. As we mentioned last quarter, our visibility is not as clear as it was prior to the acquisition, so we expect it will improve over the next couple of quarters.

Now, regarding storage and server infrastructure market, we are cognizant of the cautious outlook for storage and server shipments in the near term, especially in North America, recently coming from a broad number of major IT vendors.

And while we believe that our business continues to benefit from positive trends in Blade servers, virtualization, and consolidation initiatives, we believe that seasonality may be more pronounced in Q3 than it has been over the last year.

Regarding competition, we believe that our competitive position remains strong, and we will continue to execute on our strategy and our business plans. Nevertheless, the market is extremely competitive, and our competitors have brought several new products to market.

Regarding pricing, the pricing environment for the past 18 months has been more favorable than historical levels. While we believe ASP decline will eventually return to the mid single digits per quarter as competitors ramp their new products, we are planning for a relatively benign pricing environment in Q3, with ASP declines once again in the low single digits.

Regarding seasonality, our fiscal Q3 is historically a seasonally slower quarter, with revenues flat to slightly down sequentially. Regarding McDATA's third-party revenue, in Q2 we've reduced third-party product revenues by $5 million.

And we will aggressively continue to reduce the resale of non-strategic, low-margin third-party product. These products are low margin, and do not fit within our product portfolio or our operating model. While this may impact top-line growth in the short-term, it is the right thing to do for the business.

When we take all of these factors into consideration, our outlook for Q3 is as follows. We expect our reported revenue in Q3 to be in a range of $330 million to $340 million. This includes further reduction of $5 million to $7 million in non-strategic, low-margin third-party party revenues. We expect to complete these reductions by the end of the third quarter.

We expect non-GAAP Q3 gross margin to be in the 53% to 55% range. For Q3 we expect total non-GAAP operating expenses to be in a range of $123 million to $126 million. For Q3, we expect other income, other expenses net, to be approximately $8 million to $8.5 million. We expect our Q3 non-GAAP effective tax rate to be approximately 27% to 28%.

We expect diluted shares outstanding to be in a range of 412 million to 417 million shares. We expect Q3 '07 non-GAAP EPS in a range of $0.10 to $0.12. We expect Q3 '07 GAAP EPS in a range of $0.03 to $0.05.

We expect the difference between non-GAAP and GAAP EPS in Q3 will consist of the same items as in Q2 '07, so we expect the acquisition and integration planning activities with McDATA to be lower and in the range of $2 million to $3 million.

And expenses related to the indemnification obligations related to various ongoing legal proceedings against certain former employees and other costs in a range of $9 million to $11 million.

We expect Q3 '07 non-GAAP operating margin range of 15% to 17%. We expect capital expenditures in Q3 to be in the $12 million to $15 million range. We expect DSOs in Q3 to be in a range of 40 to 45 days.

We expect on hand inventory in Q3 to be in a range of $30 million to $40 million. The increase reflects absorption of McDATA's product inventory. As stated previously, we expect on hand inventory to be higher than our historical levels, due to the absorption of McDATA's product inventory. We would expect inventory levels to decline to our historical inventory turns by the end of the year.

Q3 is historically a weaker cash flow quarter, and we expect to generate cash from operations in the quarter of approximately $25 million to $35 million. As a reminder, the Company has $192.9 million remaining under the previously announced stock repurchase program. We expect to be active in the market in Q3.

Now, I would like to give one last update to the McDATA acquisition milestone. First, let me reiterate that our commitment to our long-term financial model target -- our target model includes a gross margin range of 55% to 58%; non-GAAP operating expense range of 38% to 40%, and non-GAAP operating margin range of 15% to 20%.

In Q2, we achieved annualized synergies of $131 million, within the upward revised target range of $125 million to $150 million in annualized synergies. We achieved this milestone three full quarters earlier than our original commitment.

In Q2, the transaction was accretive to the acquisition model, as outlined at our analyst day meeting in September 2006. We achieved this milestone three full quarters earlier than our original commitment.

In Q2, we achieved our target operating margin model of 15% to 20%. We expect to reach our total gross margin target of 55% to 58% by the third quarter of combined operations, earlier than planned. Clearly, we have executed exceptionally well on our integration plan.

And with that, I would now like to turn the call back over to Mike.

Michael Klayko

Before we open up the call up for your questions, I’d like to share a couple of thoughts and recap the key takeaways from Q2. I am extremely pleased with our execution this quarter. We delivered very good results in our first quarter of combined operations, despite it being a seasonally soft quarter, and we are meeting or exceeding all of our integration milestones.

The fundamental drivers of our business remain intact. For our core business the reported secular trends of softer server and storage spending is being offset in large part by the trends of consolidation, server virtualization, and the ongoing challenge to more efficiently manage rapid data growth.

As a result of our continued, strong execution and results, we’re able to leverage a healthy business and shed products and revenue that are not core to our strategy or complementary to our financial model. We strongly believe this is the right thing to do, and we will continue to pursue this path.

And finally, we will continue to address new opportunities that will allow us to provide broader customer benefits, and deliver on our growth and diversification strategy. Our announcements today are another step forward in that strategy.

Thank you, and I look forward to updating you up on our next earnings call. Operator, please open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) And our first question comes from the line of Mark Moskowitz of J.P. Morgan. Please proceed.

Mark Moskowitz - J.P. Morgan

Yes. Good afternoon, thank you. Few questions, if I could. Richard, could you first talk a little more about the pricing environment and the competitive environment therein within switches?

Obviously, you’ve talked in the past about over time the ASP declines on a quarterly basis should revert back to the mid-to-high single digits, but you still see a pretty benign environment. So maybe you could just talk about what is going on there, in terms of your competitive positioning, or the lack of thrust from your competition and their new products?

Michael Klayko

Hi, Mark, this is Mike. I am going to have Richard do the first part on the pricing, and I will have Tom do a little bit about the competitive environment.

Mark Moskowitz - J.P. Morgan

Sure.

Richard Deranleau

So, Mark, the way that we are seeing it in our evaluation of the business is that we do expect, as you were saying, to see the pricing return to its more historical norms of mid single digits. But right now, we are seeing that we can still maintain our pricing.

It has been very benign. We have not been under any unusual pressures, and we would expect that really to continue until our competitors are fully in the market with their new products.

Tom Buiocchi

And, Mark, this is Tom. On a competitive front, we are continuing to be very confident there. We talked to thousands of customers this quarter, as you might expect given the new products roadmap and so forth. And they clearly have a choice with us. We continue to make sure they understand those choices, to extend their current investment.

Our win ratio versus the competition is very strong. It hasn't changed significantly over the last quarter and we increasingly see customers who have tried out the competition come back to Brocade after a year or two of trials. So we are quite confident, actually, in our competitive position.

Mark Moskowitz - J.P. Morgan

And then this is a follow-up, I guess, to the first question. Does price never need to get really get back to the historical norm? I mean, can it really just be maybe a reasonable duopoly going forward?

Obviously, you are going to cede some share to Cisco over time, just given the acquisition. But could we see a situation where the pricing dynamics that you are concerned about never really play out?

Michael Klayko

Well, I think at this stage that is a bit of an open question. Right now, we are planning. We are certainly running our business with the ability to react to the historical pricing norms. But, I think your point is fair at that. It is still an open question at this point.

Mark Moskowitz - J.P. Morgan

Okay, and then shifting gears to the revenue diversification strategy, could you, Mike or Tom, give us some more context around the HBA entry in terms of what were the drivers or the inspiration behind the entry? And what systems are you going to target first? Are they going to be high end, midrange or the whole spectrum?

Michael Klayko

Sure. As we have laid out in our strategy before that we have got a diversification strategy, and it gives us more touch points end-to-end and as we are building out this new data center fabric, there is a requirement to get deeper into the server and storage environment.

So, this is just a logical extension, not only in the protocols that we announced today on iSCSI and 4-Gig Fibre Channel, but all the future protocols we have. So, Tom?

Tom Buiocchi

Yes, I would think enterprise, Mark. And we say this every once in a while, but we are connected to way more servers than we are to storage ports. So, we understand that portion of the business. And remember also that only about 15 to 20% of all enterprise servers are attached to SANs today. So it is a big market potential there.

Here is what our customers have told us, and we reflect, tried to reflect it in our strategy going forward. For next generation data centers they want greater levels of connectivity, greater levels of intelligence, and greater levels of management simplification. We think by having to position in the SAN and on the server side, we can do all three of those things.

So that is kind of the focus. Think enterprise, think data center, and think greater connectivity, more intelligent and better management simplification for customers.

Mark Moskowitz - J.P. Morgan

And then how should we think about the margin profile just in terms of your touch on the silicon and firmware and the overall design? What is going to be internal versus external?

Michael Klayko

Richard?

Richard Deranleau

Right now, it is pretty early in the products we just announced. But from a business model point of view, we are not expecting our move into this market to be decretive to our business model.

Michael Klayko

Thanks Mark.

Mark Moskowitz - J.P. Morgan

Thanks you.

Operator

Thank you, very much sir. Ladies and gentlemen, your next question comes from the line of Tom Curlin of RBC Capital Markets. Please proceed.

Tom Curlin - RBC Capital Markets

Hi. Can you just delineate, I guess on the adapter side what you guys are doing versus LSI? What is the structure of the partnership? And also, is LSI, were they the foundry for Silverback? Is there a common denominator there on the foundry side?

Tom Buiocchi

Tom. Hi, this is Tom. So I will walk through the whole roadmap here. For the current iSCSI offering, the 2110, that is a Silverback product. That is not a LSI design. We are obviously doing that in-house as part of the acquisition. Our next generation 10-Gig Ethernet product based on that technology will be a Brocade internal design as well.

For our first 4-Gig Fibre Channel product, that is a technology partnership with LSI. And then for our 8-Gig Fibre Channel products, which will out in the first half of '08. That will be an internal Brocade design.

Tom Curlin - RBC Capital Markets

So you just use LSI for a foundry going forward?

Tom Buiocchi

Yes.

Michael Klayko

That's true.

Tom Buiocchi

And the design will be and technology we’ve done will be predominantly Brocade on the 8-Gig side, yes.

Tom Curlin - RBC Capital Markets

Okay, and then from a driver perspective, are you starting out with LSI drivers, or have you already developed your own drivers on top of the LSI chip?

Tom Buiocchi

Really good question, we are starting out, LSI is a great partner because they have experience in the market, great reliability of products, and an existing qual matrix and driver profile. So we are taking that as a basis. We are adding additional drivers to that, and we use that as kind of a launching pad to innovate on top of that.

Tom Curlin - RBC Capital Markets

Do you have and I mean what are the rights there? Have you licensed their driver code base, with the right to modify? Or how do you draw the line between what you own and don't own in that regard going forward, just given what is happening at the chip level?

Michael Klayko

Tom, the way I would characterize it is that really, this is going to be Brocade's intellectual property. And in terms of, as we migrate, it is the first stepping-stone. And then as we introduce on the 8-Gig, think about it being Brocade's internal owned IP.

Tom Curlin - RBC Capital Markets

All right, and then finally just on the, what is the latest in terms of timing for your intelligent switching Blade for the 48000? I think there is a standalone product called the 7500 or something like that. What is the timing for the integrated Blade for the 48000?

Tom Buiocchi

We have got a couple of different integrated Blades there, Tom. So we have routing Blades the 7500 is the pizza box. And we have a routing Blade similar to that for the 48K. Both are shipping today. And then…

Tom Curlin - RBC Capital Markets

Is there anything new that is coming on that front over the next quarter?

Tom Buiocchi

Yes, there are. We just announced just two days ago I guess. It is the 29th two new products. Again, one a pizza box, and one a Blade. The pizza box being the 7600, and then a Blade for the 48K as well that mirrors that, that will run the intelligent applications such as EMC and Vista and RecoverPoint in our data migration application.

Tom Curlin - RBC Capital Markets

Is that in shipping, or is that in qual with OEM?

Tom Buiocchi

That is in qual right now.

Tom Curlin - RBC Capital Markets

Okay. Thank you very much.

Tom Buiocchi

Sure Tom.

Operator

Thank you very much sir. Ladies and gentlemen your next question comes from the line of Laura Conigliaro, of Goldman Sachs. Please proceed.

Laura Conigliaro - Goldman Sachs

Yes, just a couple of things. You were able to drive out costs from the combined companies several quarters earlier than your previous commentary. Considering that you are at $131 million in synergies, and within the longer-term range how much more cost cutting can you, do you anticipate to take out?

Secondly, can you take us through the linearity of the quarter, given the fact that you yourselves bought up the topic of enterprise spending, so that we could have a better sense of what you actually saw?

And then finally, can you also give us a sense of who you previously have worked more closely with in the HBA market, QLogic or Emulex?

Richard Deranleau

Laura, this is Richard. I will cover the first two, and then Tom, can jump in on the second. In terms of the synergies, you are correct, we generated $131 million in the current quarter against the upward revised target of 125 to 150 on an annualized basis.

We are very confident that in the next two quarters, we will be able to get to the high end of that target. After that, the synergies become more long-term in nature, more structural, if you will. And as those synergies continue to come online, we will then be able to decide whether or not those synergies should be reinvested to try to further growth or further initiatives, say, for example, our initiatives in HBA to drive topline growth, or whether or not those should be incremental to the business model.

Michael Klayko

And HBA, Tom?

Richard Deranleau

Well, one last point I almost forgot the linearity thing. From Q2 actuals we were relatively linear. And which are a little bit too early in the quarter for us for Q3 to tell you if we are expecting that to change, or if we are experiencing change. But when you look at Q2, it was still relatively linear, and you can see that in our DSOs.

Michael Klayko

Tom?

Tom Buiocchi

Yes, Laura, on the HBA front, we work with both of those, QLogic and Emulex, on that qualification side, obviously internally and at the OEMs. From a marketing perspective, we were probably more active with Emulex in the past. And we expect to continue to partner with them in certain segments as well going forward.

Laura Conigliaro - Goldman Sachs

Thank you.

Tom Buiocchi

Thanks, Laura.

Operator

Thank you very much Ma'am. Ladies and gentlemen your next question comes from the line of Aaron Rakers, of A.G. Edwards. Please proceed.

Aaron Rakers - A.G. Edwards

Yes, thanks guys. I first want to touch again on the cost cutting side. Looking at the guidance with regard to OpEx in this next quarter, and the notion that you guys believe you can get to the high end of that range over the next two quarters.

You know, to me it looks like the guidance of $123 million to $126 million in OpEx this next quarter isn’t really baking in a lot of assumptions of incremental synergies. Just help me understand that there?

And if you can, in addition to that, kind of build on where we are at in terms of right now headcount reductions, as well as contract manufacturing consolidation?

Richard Deranleau

Okay, let me see if I can help you out there a little bit, Aaron. So if you look at the guidance we have given you on our expenses, if you grab a midpoint, say it is $3 million incremental in this next quarter, our Q3, should I give you another $12 million on an annualized basis.

And then we are saying we think we are pretty comfortable that we can, or pretty confidant that we can get to the upper range of the $125 million to $150 million. So as you exit our, look at our guidance and exit our run rate out of Q3, I think you would see that we don't have that much more to do in Q4.

When you, from a headcount point of view, I believe we exited the quarter with 2,440 employees. I would not be expecting to see a huge amount of reductions from this point forward. There are still a few people who are in transitioning roles. That will wrap up, but it is not going to be a big driver beyond what I just told you as anticipated in our guidance.

And then from a COGS point of view, we are currently working with three contract manufacturers. Foxconn continues on the Brocade side, as well as Selectron and SCI-Sanmina from the legacy McDATA.

We are still going to have that profile, really I think until the next generation. There are clearly some things we are doing within the product structure, but again, think about that being more longer-term or structural, and that is really not contemplated in our guidance.

Aaron Rakers - A.G. Edwards

And real quick follow-up, if I can. Can you talk a little bit about gross margin structure? One, what the gross margin structure looks like on services, as well as any quantification you can provide with regard to the impact that the third-party revenue, existing revenue had on your gross margin this last quarter?

Richard Deranleau

Sure, that's a good question. From a service perspective, I think if you look at our disclosure in our press release, you can see that the gross margin for services was at below or at the low-end of our targeted model for services.

If you remember, our target model for service is 35 to 45%. There is a little bit of anomaly on that because of the purchase accounting, the $7 million haircut we had to take. And if you, under the way you do purchase accounting that’s 100% gross margin.

So if you add that $7 million back in, just to see what the real business is doing, you kind of get back into that 35% to 45%, which is I think the right place for us to be. Obviously, we would like to be closer to the midpoint than, in the mid low 40%. And I think we can get there.

From a third party, one of the reasons we are focusing and putting a lot of visibility around this third-party is really a couple of things. We are really not trying to chase top-line revenue when it’s really not within our business model.

So that third-party product that we talked about was extremely low margin, and put downward pressure on our gross margins. And you can see some of that in Q2. So as we have continue to reduce the non-strategic aspects of that revenue, you are going to see a small benefit to our margins.

Aaron Rakers - A.G. Edwards

Okay. Thank you very much.

Shirley Stacy

Thank you. Our next question?

Operator

Thank you very much, Aaron (Operator Instructions). We now have question from the line of Shebly Seyrafi, Caris & Company. Please proceed.

Shebly Seyrafi - Caris & Co.

Yes. Thank you very much. So I am still trying to understand this statement that fiscal Q3 is typically down. I have looked at both the legacy Brocade and McDATA models, and actually typically, it has been up.

So is your caution, if that is the word, for your sequential growth in the July quarter, is that partially driven by increased competition from Cisco, which grew 20% sequentially in your business, and they have momentum now?

Is it U.S. enterprise spending? Maybe some additional color on why you expect it to be down, when I think typically, it has been up?

Richard Deranleau

Yes, thanks Shebly this is Richard. You might actually want to go back and check your historical facts and, if you exclude last year, last year we where pretty clear that linearity patterns were shifting. Now, we had up quarters Q1 to Q2 and Q3.

But I am pretty confident, if you go back and you look at your historical record, you are going to see definitely that Q2 is sequentially down from Q1. And what you will see again is that Q3 is going to be either flat to slightly down.

So, and then also, from a, I think Tom has been already said, we don't believe that we are losing ground to Cisco at all. We are extremely confident in our ability to compete. So, the one point you did make is and we’ve acknowledged in our prepared remarks, throughout the IT industry a lot of the vendors are coming out with cautionary forward-looking guidance.

Now, we have, we understand that. We think there are some upsides that we have potentially regarding virtualization and consolidation, but we have to be cognizant of what the industry is, what guidance in the industry has been.

So I would look at that color as the way that we are representing our forecast.

Shebly Seyrafi - Caris & Co.

Just a final clarification for me, typically, in my experience covering Brocade, the April quarter has been the more challenging one. And often, I think you have been weaker in April, may be down.

Should we, as we model going forward, think about April and July potentially been down sequentially and very strong growth in October? And additionally, can you comment if you will on what the October growth rate could be, not will be, but could be, after we get through this seasonally weaker July quarter?

Richard Deranleau

Sure, let me see if I can help. So the way I represented it at analyst day, starting out really with Q1. Q1 is our seasonally strongest quarter. And remember that we are in October year, and so that is November, December, January. That’s our strongest quarter.

Then, what happens as you see anywhere from a 5% to 8% seasonal decrease in Q2. In Q3, you look at anything from flat to, say, 3% to 4% sequentially down. And then ramping back into a strong Q4, which I don't have the numbers exactly in front of me, but they would be at least 5% to 8% up on a sequential basis.

I can get back to you later with some specifics. But historically, I think that’s what you would see. And so that’s the way our year looked. And I'm sorry, what was your second question?

Shebly Seyrafi - Caris & Co.

No, that was it. Thank you very much. I appreciate it.

Shirley Stacy

Thanks Shebly. Next question.

Operator

Thank you very much. Next question comes from the line of Samuel Wilson of JMP Securities. Please proceed. Mr. Wilson your line is open. Please check your mute feature.

Shirley Stacy

Bill, we can come back to Sam’s line. Why don’t we go the next question please?

Operator

Okay. Next question comes from the line of Glenn Hanus, Needham & Company. Please proceed.

Glenn Hanus - Needham & Co.

Good afternoon. Could you talk a little bit more about your go to market strategy on the Fibre Channel HBA side? It has sort of been a comfortable duopoly, except for certain places at IBM, it’s mostly dual sourced now.

Are you going to kind of go after the channel a little bit more initially, or are you going to sort of do some aggressive pricing with the OEMs, or what are you thinking there?

Tom Buiocchi

Yes. Good question, Glenn. This is Tom. So customers buy HBAs in a variety of different ways. So we have already, as you might expect, briefed our major OEM partners. And they are very excited about it.

So they will each maintain their own schedule and plans and quall cycles for those HBAs. And they will obviously comment on their particular timing. But, uniformly, a strong level of interest there. Secondly, we are selling more and more products through distribution channels, independent channels. So we'll offer those products through those channels as well.

And then thirdly, there are customers who will buy HBAs direct from vendors. So we will offer them through our online web site. Probably not high-volume offerings there, but the occasional HBA is bought online as well. So think of it as a multichannel strategy, with OEMs clearly a major part of it.

Glenn Hanus - Needham & Co.

Can you comment on what has surpassed your expectations on the integration? What’s kind of happened that has allowed you to be ahead of plan, or were you just giving conservative guidance?

Michael Klayko

Actually, there’s been a couple of really good surprises in this whole process. One of them has been in the logistics extension, and the product line is very robust. We continue to add enhancements. The market there is very strong also, so that has been a very pleasant surprise.

And the ability also which has been a great surprise for this whole process is how well the teams have executed together. And that we have actually exceeded the milestones that we said, which we thought were very aggressive internally, and we were actually able to exceed those.

Richard Deranleau

So, and I might jump in just on that, this is Richard, that I think what it also reflects our ability to execute is we took advantage of the time we had during HSR review. And we spent quite a bit of time and effort during that period to prep for it, to get a day one plan that we could go into execution on. And you know we did spend a reasonable amount of money in advance as well.

But I think you’d seen that pay off, because with that day one execution plan, rather than thinking about what we do next, we were all in the execution mode, and that allowed us to move so much more quickly than perhaps we had anticipated and this being our first very large transaction.

Glenn Hanus - Needham & Co.

And just looking back at my notes, didn't you give a fiscal year outlook fiscal '07 revenue outlook last quarter on a combined basis?

Richard Deranleau

Yes, I believe we gave some color last quarter on the second half side, right?

Glenn Hanus - Needham & Co.

A full-year target, $1.26 billion to $1.279 billion, or so, I wrote down here. Can you confirm sort of the year guidance that you previously gave for the fiscal year?

Richard Deranleau

I think with where we are in the market, I think I am going to have to beg off, and just say that we are trying to get back to our one quarter's worth of outlook, particularly in this type of a market.

Shirley Stacy

Thanks, Glenn.

Glenn Hanus - Needham & Co.

Thank you.

Shirley Stacy

Operator, we will take one more question, please.

Operator

Surely ma’am our last question comes from the line of Joel Inman of Baird. Please proceed.

Joel Inman - Robert W. Baird

Hi, thanks. Can you talk about your indemnification charges a little bit? I think the past couple of quarters it has been in the $5 million range, and now it’s $15 million, expected to be $9 million to $11 million next quarter?

What is kind of going on there, and what should we expect from a timing standpoint as we go out for the rest of the year?

Richard Deranleau

Yes. So, the genesis of this is that the company has an obligation to indemnify our former officers and employees, as well as current officers and employees. And we are honoring that obligation.

The spending itself is being driven by the actual expenditures of various, like you think about law firms or other ones that are in the process of executing that indemnification obligation. So the timing is directly related to when the services are occurred.

Not a lot of control over that from our perspective. The numbers that we show are net of any recovery we might have from insurance. We tried to give you our best view on where we think it’s going to be going forward, and that is really about the best we can do.

Joel Inman - Robert W. Baird

Okay, but there is no timing as to when it might be resolved, because it’s kind of open-ended? Right?

Richard Deranleau

Yes, that is really not under the company's control.

Joel Inman - Robert W. Baird

Okay. Thank you.

Shirley Stacy

Thanks, Joel and thank you, everyone. That concludes our earnings conference call today. We look forward to seeing you at our net financial conference, which is the Citigroup conference in New York in September, as well as our fall analyst meeting, which is tentatively scheduled for September in Boston.

Thank you, and have a great day.

Operator

Thank you very much, ma'am. Thank you, ladies and gentlemen, for your participation in today's conference call. This concludes your presentation, and you may now disconnect. Have a good day.

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Source: Brocade Communications Systems F2Q07 (Qtr End 4/28/07) Earnings Call Transcript
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