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Brocade Communications Systems (NASDAQ:BRCD)

Q1 2012 Earnings Call

February 21, 2012 5:30 pm ET

Executives

Robert Eggers -

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

Daniel W. Fairfax - Chief Financial Officer, Principal Accounting Officer and Vice President of Finance

Ian Whiting - Senior Vice President of Worldwide Sales and Marketing

Jason Nolet -

John P. McHugh - Chief Marketing Officer and Vice President

Dave Stevens - Former Chief Technology Officer

Analysts

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

Mark Sue - RBC Capital Markets, LLC, Research Division

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

Jack Monti - UBS Investment Bank, Research Division

Nikos Theodosopoulos - UBS Investment Bank, Research Division

Brian T. Modoff - Deutsche Bank AG, Research Division

Kent Schofield - Goldman Sachs Group Inc., Research Division

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

Andrew J. Nowinski - Piper Jaffray Companies, Research Division

Rohit N. Chopra - Wedbush Securities Inc., Research Division

Rajesh Ghai - ThinkEquity LLC, Research Division

Scott Schmitz - Morgan Stanley, Research Division

Erik Suppiger - JMP Securities LLC, Research Division

Jung Pak

Joanna Makris - Mizuho Securities USA Inc., Research Division

Stephen Patel - ISI Group Inc., Research Division

Operator

Good day, ladies and gentlemen. Thank you for standing by, and welcome to Brocade's First Quarter 2012 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. And I would now like to turn the program over to our speaker, Rob Eggers, Vice President of Investor Relations of Brocade. Sir, please go ahead.

Robert Eggers

Thank you, Jamie. Good afternoon, and welcome to Brocade's Q1 Earnings Call. By now, you should have seen our press release and prepared comments, which are available on our website, brcd.com. The press release is also distributed by MarketWire and furnished to the SEC. Before we take your questions, investors should note our comments today may include forward-looking statements regarding Brocade's financial results, plans, market opportunities and business outlooks, 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 on our Form 10-K for the fiscal year ended October 29, 2011.

These forward-looking statements reflect beliefs, assumptions, outlooks, 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 Q1 2012 press release, which has been furnished to the SEC on Form 8-K and in our slide presentation and prepared comments on our website, brcd.com.

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

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

Michael Klayko

Thanks, Rob. Before we start taking questions, I'd like to take a few minutes to provide some color on Q1. Dan will follow me with some comments of his own, including the assumptions that we are basing our Q2 outlook on.

Q1 was a record-setting quarter for Brocade across several key areas, continuing to build on good Q4 results. We continue to see strong momentum across many areas of our business, which resulted in Q1 revenues of $561 million, an all-time high for Brocade. We significantly increased profits with $0.20 of earnings per share on a non-GAAP basis and $0.12 on a GAAP basis. We improved both gross margin and operating margin in the quarter, exceeding our outlook for both measures, which resulted in strong operating cash flow.

In terms of business performance, Storage was clearly a highlight this quarter as we exceeded our expectations. The Storage business revenue, which includes products and services, ended at $406 million, which was up 12% quarter-over-quarter. In terms of storage product revenue, we were up 17% sequentially, generating nearly $353 million.

We also saw the fast ramp of our next-generation 16-gig Fibre Channel products continue in Q1. In fact, 16-gig products accounted for 27% of our total director sales in the quarter. There's no doubt that our decision to transition the SAN industry to 16 gig was well timed and is validated by strong customer demand due to major IT imperatives such as managing server virtualization, cloud computing, digital data growth and more applications becoming mission critical.

Another highlight in the quarter was the performance of our Service Provider business, which generated more than $64 million in revenue, another company record. Many of these customers are now upgrading their network infrastructure to enable the delivery of new services and capabilities such as cloud computing. This trend helped increase sales of key products that are optimized for the service provider market, including the Brocade MLX and MLXe family of routers, which saw revenue growth of 17% year-over-year and the Brocade ADX application delivery switches with 13% growth in revenue year-over-year.

The continued market adoption of our Ethernet fabric products was our third highlight. Sales of our VDX switches and VCS software were up 33% sequentially. We now have an installed base of more than 400 customers in many high-performing, data-intensive industries such as financial services, research networks and media and entertainment. Keep in mind that our Ethernet Fabric technology strategy is designed to allow our customers to scale over time, unlike the all or nothing designs of some of our competitors. Therefore, we expect many of our current customers to continue to build out their Ethernet Fabrics to keep pace with the growing demands of their data center networks.

The strength we enjoyed in our Storage, Service Provider and Ethernet Fabrics businesses helped offset some expected softnesses in other areas of our Ethernet business. We saw lower Ethernet revenue and our seasonally slower Q1 -- and our Federal revenue, I should say, in our seasonally lower, slower Q1.

We also saw a decline in our Enterprise Ethernet revenue in the quarter as we transition to a whole new portfolio of products that are engineered to be the most innovative enterprise campus solutions that the industry has seen in more than a decade. These products are part of the strategy and technologies behind the Effortless Network, which we believe will inject some much-needed game-changing innovations into the current Campus LAN environment. I encourage you to join us for our virtual launch on March 6 by registering for the event on brocade.com.

In early May, Brocade will also host our Annual Technology Summit, where we will outline more innovations for both the data center and service provider environments. This will include updates to our data center, fabric strategy as well as solutions for software-defined networking and Big Data opportunities.

The message is quite simple. The success we enjoyed in Q1 is a direct result of the investments we made in R&D over the last few years in key technology segments. We're very excited about the next phase of our innovation roadmap and we believe -- that we believe will fuel our future growth and drive long-term shareholder value.

Now I'd like to turn over to Dan for his comments.

Daniel W. Fairfax

Thanks, Mike. As you've already seen in our prepared remarks, we had a very good Q1, with our Storage product revenue leading the way with 17% growth quarter-over-quarter. I'm pleased with the overall gross margin expansion in the quarter and the resulting non-GAAP operating margin of 21.5%.

We generated strong cash flow from operations of $127 million and we reduced the term loan by $70 million during the quarter.

Now looking forward, we are seeing good growth, typically in our Storage business. And under current conditions, we anticipate that we'll see the market grow this year near the high end of the range of 2% to 5% that we provided at Analyst Day in September.

While the Q1 Ethernet business was relatively flat year-over-year, we believe that we can continue to grow faster than the market this year with the continued rollout of our new product offerings that will come to market over the balance of this year.

As a reminder, our Ethernet revenues are seasonally lower in Q1 and Q2, while our Storage business is seasonally lower in Q2 and Q3. Therefore, we anticipate lower gross margins and operating margins for the second quarter. However, based on our strong Q1 results, we now expect to be near the high end of the operating margin range of 16% to 18% for the full fiscal year '12.

With the strong cash flow that we generated in Q1 and the benefit of improvements in our working capital, we now anticipate that our operating cash flow will be in the range of $400 million to $425 million for fiscal year '12 as compared to the range of $350 million to $375 million we've modeled for you at Analyst Day.

Finally, with the continued reduction of the term loan, which is now at $120 million, we expect to continue to be active in terms of stock repurchases going forward. As a reminder, we have $178 million remaining in the board authorized share repurchase plan.

In summary, Q1 was a great way to start the year. And for Q2, we are expecting revenue between $530 million and $545 million, and non-GAAP EPS of $0.11 to $0.12.

With that quick summary, I will turn the call back over to Jamie to begin the question-and-answer session.

Question-and-Answer Session

Operator

[Operator Instructions] And we'll take our first question from Jess Lubert with Wells Fargo Securities.

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

I've got a couple of questions on the nonfederal non-Service Provider Ethernet business, which appears to decline about 36% sequentially according to my model, the lowest level since the foundry days, while most of your competitors reported much better sequential trends in their respective businesses. So can you help us understand what gives you confidence this weakness is transitory and due to some delays in channel build, and not a sign of material share loss in this area?

Ian Whiting

Yes, let me answer. This is Ian Whiting. So there’s a couple things. First of all, I mean it's important to point out that as Dan said, we are expecting to grow faster than the market again this year. We grew the Ethernet revenue 13% last year, and we're expecting to continue to outpace the market through this year as well. There are a few things that are affecting our revenue in that space. One is our continued move to more of a channel indirect model, which obviously takes time, and there is an impact on revenue and gross margin when you transition from a more direct sales model to a channel model. That's been a work in progress that's going to continue through this year. And that will undoubtedly result in more leverage and more growth for us in the long term. The second thing that we were feeling a little bit in Q1 was the product transition, as was alluded to earlier on. We are in the middle of a transition to a whole new, very exciting range of Campus LAN products, and there may well have been some pause in the market as we transition to those products. And lastly, as part of our continued focus on winning larger accounts, as some of those deals are longer sales cycles and we are sitting in the middle of some very competitive deals right now that in some cases moved out, and we'll continue to see those as we focus more effort, upscale and larger enterprise accounts. But overall, we're feeling that we will continue on the same trajectory as we have through last year, which is to outpace the market in Ethernet across the board.

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

Can you quantify the amount of Ethernet business that slipped from Q1 and your confidence in your ability to close that business? And perhaps remind us of how fast do you think the Ethernet business is going to grow this year?

Ian Whiting

Well I would -- I mean deals slip every quarter. And so to some extent that's a phenomenon we experience every quarter. We are very comfortable with the ranges that we've provided in terms of Ethernet close of share. As we said, we fully expect to outpace the market in terms of year-over-year growth this year, and we're on that trajectory as we enter into Q2.

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

And then my last question’s also on the Ethernet side of the business. Can you talk directionally about the margins you saw this quarter and to what degree the pricing environment changed over the last 90 days? And how do you expect Ethernet pricing and gross margins to progress going forward?

Daniel W. Fairfax

Yes. So Jess, this is Dan. In terms of the margins, we saw some pricing, as Ian talked about, the larger opportunities, which we're actually competing more and more often and tend to be aggressive in terms of initial wins. What we see as we win that business is longer term, we are able to expand the margin and there's a customer account. As time progresses, we add additional products in there. So we did see some impact in the quarter from pricing impacts. The other impact we saw on the quarter as the volumes dropped was the overhead load didn't drop and so the overhead absorption was negative for us. Ian, maybe you want to add some comments on?

Ian Whiting

Yes. I would just say that it's consistent with the strategy we laid out, which is for us, this is all about new account acquisition. We added 2,800 net new accounts over the last 2 years. We stayed on that trajectory in Q1 and we fully intend to continue to be aggressive, and obviously pricing and discounting is one element of that. The arrival of a really exciting new product line in Campus will help further accelerate growth there. But overall, I would say pricing and discounting is consistent with our cluster in the marketplace. And we'll continue to be aggressive and win new business.

Operator

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

Mark Sue - RBC Capital Markets, LLC, Research Division

What sort of price-performance magnitude should we consider on your new Campus Ethernet products? And should we think about an impact to gross margins as you see the initial ramp of the new products?

Jason Nolet

So Mark, this is Jason Nolet. Let me try that one. So we're not quite ready to disclose the announcements that we're going to make on March 6. We encourage you to attend the virtual launch and hear that story firsthand, if you would. But we do expect that the new Campus products will have improved margin relative to the existing portfolio, so that is an opportunity for us.

Mark Sue - RBC Capital Markets, LLC, Research Division

Got it. That's helpful. And then on VDX, recognizing it's small in revenues, but what's the indication, because I know that the growth is pretty healthy, in terms of wins against competitors and also the pull-through of other Brocade switches? And how big are some of the intended Ethernet Fabrics that some of your customers are discussing?

Ian Whiting

I'll take a first shot maybe. This is Ian. So we've continued very nicely with new account acquisition. I think you heard earlier on, we're now up to over 400 accounts that meet the Ethernet Fabric classification, and each one of those is now expanding. So that's exactly and consistent with our strategy. The deal sizes haven't changed significantly. I would say that certainly VDX and VCS is viewed as part of a larger Ethernet acquisition only. So you will see more products other than just VDX and VCS in those deals. But what we're really focusing on is expanding the Ethernet Fabric footprint. And I think probably when we get to Tech Day, we'll talk more about some of the applications specifically and where we’re starting to see some patents emerge in terms of the use cases. But we're very happy and very pleased with the overall progress in Ethernet Fabrics. And it has continued momentum through Q1, coming out of a very strong first year for us.

Operator

And we'll go next to Jayson Noland with Robert W. Baird.

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

I wanted to ask about gross margins on each side of the business. I didn't see the numbers in the press release, but I believe you said mid 70s in SAN and mid 40s in Ethernet?

Daniel W. Fairfax

That's correct. That's what we disclosed in the prepared remarks.

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

So is the 16-gig portfolio lifting gross margins in the SAN business? And then if you could address the decline in Ethernet gross margins.

Daniel W. Fairfax

Sure. In terms of the mix on the SAN side, so as we discussed the -- Mike pointed out again and the comments he just made, we're seeing in the 16 gig side, 27% of the business is now shifting over to 16 gig. That's giving us some uplift in terms of margins versus products that are priced higher. Plus, we are seeing the attach rates of some accessory items that come with those systems at a higher rate than we would have seen with 8 gig. So overall, we're seeing good gross margin expansion on the Storage side. As I -- I made a comment I think just a minute ago on the Ethernet side of the business, in the quarter with the volume being down, with the gross margins were negatively impacted by overhead absorption. And then about half of this shift quarter-over-quarter was due to that. The other half was due to pricing impacts.

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

Just on a go-forward quarters, Dan, should we expect to see SAN trend above the recent norm and the Ethernet trend a bit below the recent norm?

Daniel W. Fairfax

In terms of -- the reason are being the Q1 results?

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

Last, last few quarters, SAN’s been around 72% and Ethernet’s been around 49%, 50%.

Daniel W. Fairfax

Yes. So what I guess I'd say is the SAN side, I think, we'd expect to see it in the same range based on the mix. Now our 16-gig switches, we continue to roll out through this year and to early next year. And so again, we would expect that would help us improve the Storage margin picture a little bit. On the Ethernet side, it's really going to depend quarter-to-quarter. Again, seasonally we're a little bit lower on the Ethernet product, down in revenues in the first half of the year and stronger in the back half of the year. And it’s always going to be mix dependent. So if we're seeing more MLXs in the mix versus the Campus products, it's also going to be favorable to gross margins. But I would -- I don't think we're going to tell you right now that change in model dramatically.

Operator

And we'll go next to Nikos Theodosopoulos with UBS.

Jack Monti - UBS Investment Bank, Research Division

This is, Jack Monti, in for Nikos. Just a question on -- I'm thinking of growth next quarter from a quarter-over-quarter perspective. Is it fair to say that most of the decrease in the revenues for next quarter is going to stem on the Storage side of the business? Any color would be helpful.

Daniel W. Fairfax

Yes. So in terms of seasonality within our business, the second and third quarter or the second and third fiscal quarters, you tend to see our SAN business drop down a little bit and then recover in Q4 and in Q1. And then if we look at the recent past, record level with SAN business in Q4, a record level and even higher in Q1. And so we would expect the same seasonality on the Storage side.

Jack Monti - UBS Investment Bank, Research Division

Okay, great. And just one follow-up. I guess on the OEM inventory situation, it sounds like it was a little more than one week in the quarter. Can you comment on whether that was a tailwind in 1Q?

Daniel W. Fairfax

So I think -- let me make sure I get the question. OEM inventory dropped just a few days at the end of Q4 through the end of Q1. We would normally project OEMs would carry some place within a week, in 2 weeks with a little bit over 1 week in inventory with the OEMs right now.

Nikos Theodosopoulos - UBS Investment Bank, Research Division

Okay. So to be clear, that was kind of a slight negative in 1Q?

Daniel W. Fairfax

The inventory has dropped slightly in 1Q, yes.

Operator

And we'll go next to Brian Modoff with Deutsche Bank.

Brian T. Modoff - Deutsche Bank AG, Research Division

Guys, question around the cam [ph] with 16-gig Fibre Channel switching market. Where do you guys see that as potential opportunity? And the question, why are you seeing weakness in Ethernet switching? We saw Cisco was up 100% Nexus sales and 8% year-on-year overall in switching. What do you think’s going on with that?

Jason Nolet

So I missed the back half of your question. Can you say the second half again?

Brian T. Modoff - Deutsche Bank AG, Research Division

Yes, I'm sorry. Just you're switching business was pretty weak in the quarter. Cisco on the other hand saw strong growth in Nexus and 8% overall growth in switching. Is this just share losses? What's your view on that?

Ian Whiting

So I'll address the second part and maybe Jason can cover the SAN piece. I think as I referred to earlier, outside of the seasonality that Dan has already spoken to, there's a couple phenomenons happening in our business. One is we are consciously and aggressively moving more of our business to the channel. In fact, Q1 saw more revenue flow through the channel than we've ever seen before. So that comes at a price, because you afford those a certain amount of revenue and margin, when moving business through to distribution. But it's a conscious effort on our part, part of our overall channel engagement and enablement and strategy. The second thing as we've touched on, we are going through a product transition. And despite the fact that some of the new, efficient networks products announcement hasn't been fully communicated yet, there is awareness, I think, in the market and the channel that those products are coming, and you get a natural pause that will occur in some parts of the market. And thirdly, as I said, we do see this every quarter, where deals do cross the line between one quarter and the next. We have seen that in the past. I would characterize Q1 as being a little bit more -- being a few more of those happening than we've seen in recent quarters. So a combination of factors, but I think it's important that we restate the fact that we're expecting to get at least 2x market growth this year in Ethernet, and we saw 3x or 4x last year. So our model hasn't changed in terms of overall Ethernet growth. Q1 was what it was, and we're expecting to get back to growth in Q2 and beyond.

Jason Nolet

And Brian, on your -- this is Jason. On your question around 16-gig TAM, maybe 2 points to make there. One is per Dan's comments, we are expecting SAN, TAM growth to be at the high end of the range that we have provided. And that's largely a function of the success we are seeing on 16 gig in the adoption. And then just as a proof point of that, we are actually seeing a transition from 8 gig to 16 gig that's actually outpacing the same transition that occurred from 4 gig to 8 gig over the same timeframe. So very robust growth in the 16-gig portfolio, both in the end-user sense and also excitement within the OEM route to market for us.

Operator

And we'll go next to Kent Schofield with Goldman Sachs.

Kent Schofield - Goldman Sachs Group Inc., Research Division

A little bit of a follow-up on the last question. Can you talk about -- for the Ethernet channel, can you talk about the trade-off between pushing revenue towards them and then also what exactly you need to do to invest in that channel over the next year to get them ready to be able to handle that?

John P. McHugh

It's John McHugh here. So in general, we feel like we're on pretty good course and speed with our strategy around the channel. This is, as we said, this is a business, which does have variability from quarter-to-quarter. But we believe that in fact, a lot of stuff we're doing in terms of building a robust and long-term channel model is ultimately going to prevail and continue to produce great results. So if we look at the kind of stuff we did in innovative marketing and sales activities -- let me give you an example around Ethernet Fabric, for example. We've seen our total awareness in the market go from 33% to 48% in one-year timeframe. And so what we believe we're doing is foundationally for the channel is we're building compelling solutions, very channel-centric sort of strategies and products and offers. And then finally, as we go forward, we're continuing to invest and continuing to drive that. As was mentioned here, the Effortless Network is a program we're going to be running out shortly, to introduce in a very channel-centric manner instead of solutions for Enterprise LAN, which in fact have been designed from the ground up to be extremely effective for channel selling, very competitive from a cost of ownership. And so what you're getting from me is we don't believe that at the end of the day, this is a pricing-oriented strategy, or needs to be or should be, but instead that there's still opportunities for various solution or [indiscernible] there's still opportunities for a lot of value add through the channel. And that's really where our strategy is headed. And we continue to invest there.

Kent Schofield - Goldman Sachs Group Inc., Research Division

Great. And then looking at the strength in the Service Provider space, can you provide us a little bit more color as to what's driving that strength?

Dave Stevens

This is Dave. I'll make a couple of comments on there, Kent. And then maybe Jason can also pipe in on that. I think the demands in the service provider space are well-known and well-documented, the increase in bandwidth and the amount of applications running over the network to continue buildout of cloud environments and hosting centers. And I think when you look across the product portfolio, we've just done a good job on the router and application delivery front of tuning those products to the right sets of price performance and power and density, so that they provide tremendous value into those customers. And I think that value resonates to those guys, and so we win a disproportionately large number of those deals. And that's continuing this quarter, and we expect it will continue going forward.

Jason Nolet

The one specific I might add to that would be the adoption of 100 gig, which we continue to see strength in. You may recall we were first to market with the dual 400-gig adapter, and we're seeing great adoption of that, especially in the larger service providers looking to wrestle with bandwidth versus cost problem to the ground.

Operator

And we'll take our next question from Matt Robison with Wunderlich.

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

So it sounds like you're expecting a little bit of a rebound for Ethernet in the current quarter. Do you think we'll get that back to the kind of growth rates you've been talking about this quarter? Or do you think it's going to take into the third quarter before we see that?

Michael Klayko

Matt, this is Mike. I actually -- in one of the ways we've been trying to communicate this, last year, we put together a fairly robust strategy in terms of funneling product and innovation and channel. We actually retooled the sales force to focus after very specific vertical markets. And then we went out and executed, and we grew much faster than the market in Ethernet. We're continuing down that same strategy at this point in time. The expected softness that we've seen in Ethernet in Q1 was expected. And it was expected because of the trend lines, the product transitions, as well as we look at some of the strength we have in the other areas of our data center product set. On balance as a company, it's a very good position, because you become immune to either a geography or a specific industry and so forth. And as we look out through the whole year, we continue to execute on the strategy we laid out, and we're going to go ahead and we believe grow faster than the marketplace as we did last year. And so I think that's on a yearly basis, not just a quarterly basis. So we expect it to be up in our Storage revenue and we were, and we expect it to be a little soft. And that's the advantage I think of having a diversified portfolio that we have and the different markets we service with the service provider, the data center and the enterprise campus marketplace is it does give us opportunities to pile on in some areas, as well as expect softness in others. But on balance, I think we'll continue to grow in that space and not only with the current products but with some of the new exciting innovative products that we have coming out next month and then throughout the year.

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

So the foundry heritage is much more Campus than data center with the fabric products, clearly that's more of a data center type product. And now that's big enough to be meaningful revenue, it looks like. How was the growth -- how would you characterize the growth in data center Ethernet in the quarter? And can you comment on that a bit?

Michael Klayko

Well I think the – I don’t know if we’re going to break it out specifically in terms of revenue, but from a product set and where we're participating, the customers that -- we're in the data center and the largest, most conflict data centers along with our SAN products, and we're getting invited in with not only our IP products with this whole new category of Ethernet Fabric products, and you'll see continued innovation along that line. Again, we're on our second generation of product in that space. And we are participating in a larger footprint in these customers because they see the advantage in these large data centers. And so it comes out of our core strength and our heritage, and so we'll continue to add products in that space going forward.

Dave Stevens

One of the comments -- this is Dave, that I would just make in a broad technology sense to support kind of what Mike was saying is the -- there is and continues to be a very broad transformation happening in data centers today from this like deep hierarchal networks that we've been in over the last 20 years to these flat, fast fabric architectures. And that transition is happening across the board. The speeds are increasing to 10 gig and 40 gig and 100 gig in support of virtualization and more of the mission-critical applications that are being deployed and the buildout of these large enterprise and cloud data centers. And that's where we're selling the Fabric technology into there. So that product set continues to resonate with customers. We continue to -- as Mike said, we're rolling up the second wave of technology in there. We'll talk more about that at Technology Day this year. We're continuing to develop in that space. We're very happy with the progress that we're making. And as Ian said, we’re up over 400 production fabric customers today. So we're seeing nice growth in that space and good resonance among the customers.

Operator

And we'll take our next question from Andrew Nowinski with Piper Jaffray.

Andrew J. Nowinski - Piper Jaffray Companies, Research Division

So I just want to touch -- kind of dig into the Storage revenue a bit. You just drastically exceeded normal seasonality for Storage in Q1 with, what, 16.5% sequential growth. I guess where there some large deals in the quarter that bumped that up? And then I just have one follow-up.

Ian Whiting

This is Ian. Yes, we've been seeing, actually consistently now for 3 or 4 quarters, very large data center buildouts, it's all tied to virtualization, cloud computing trends that continue to fuel the growth in Fibre Channel. And customers have been boasting for Fibre Channel as the key technology for anything that's mission-critical, that's data center class. And I think what you've seen in Q1 was a continuation of that theme. There's been some additional, obviously some additional impetus to that, as Jason was saying, with a much more rapid transition to 16 gig, which has enabled us to win more accounts. In fact, go back and win back a number of accounts from our only other competitor in that space. So there's a lot of trends that are our friend right now in terms of the Fibre Channel business, the technology leadership. I think there's just a general acceptance in the marketplace today that Fibre Channel is the technology for data center and cloud deployments, driven by virtualization. And long may that continue. And we feel we're in a very strong position there to capitalize on that and to, as you heard early on, to be at the high end of the growth expectations that we’ve set for the year.

Andrew J. Nowinski - Piper Jaffray Companies, Research Division

Right, okay. Then my follow-up is do you expect it to be at the high end of the 2% to 5% range for FY '12? I would suggest a pretty draconian outlook for Storage revenue over the next 3 quarters. It's by a mile, the low end of your normal seasonality for April and July, you have to be basically flat in October. And given the strong ramp in adoption of 16 gig, why should we assume a worst-than-normal seasonality going forward?

Michael Klayko

We do our modeling once a year. And right now, we're saying that we have confidence that it will be at the high end of the range. But we typically, during the course of the year, don't change the models until we get to our Analyst Days. And so for that reason, we'll say we feel comfortable we can be at the high end of the range.

Operator

And we'll go next to Rohit Chopra with Wedbush Morgan.

Rohit N. Chopra - Wedbush Securities Inc., Research Division

Good, just a couple of questions. One on the geos. Can you just talk to us a little bit about what was working in Europe that seemed to be very good according to what you've indicated in the slides? And what wasn't working in Asia? And then the last question would be towards Dan. You referenced the Analyst Day, so I thought maybe I'd reference it too. I want to talk about Ethernet gross margins. But if we assume that you're going to have new products, you're going to invest in the channel and going to go aggressively after some deals, what's the difference between last September and now, other than volumes when you look at Ethernet gross margins and targets that you laid out in September?

Daniel W. Fairfax

So this is Dan. Let me address the gross margin issue, the gross margin question first. In terms of the business, from what we had expected in September when we gave guidance for the full year, I think we're pleased with the fact that we're competing in many, many more large opportunities. I made a couple of comments earlier around those opportunities tend to be more aggressive in terms of pricing and the competition that's bidding for that business. And clearly we're in an aggressive market right now. So that's -- I think that's one difference than what we saw in September. And beyond that, I think it's a little bit too early for us to tell if there's going to be a significant mix shift. We've got some interesting products coming to market throughout this year and then the margin structure of our VDX product line, which I think we've talked about in the past being much more favorable versus the merchant silicon-based products. That mix is -- we continue to plan into the business. So that stays the same. We had expected as our volume increases, we'll get better overhead absorption. And so maybe the only difference really to talk to is the larger deals that, again, we're quite pleased that we're competing for that business because back in the foundry days, you wouldn't have seen us being asked into those competitions.

Ian Whiting

Yes. I think on the geos, there was, I mean, nothing specifically underlining those numbers. I think what you saw in the year, we just have a much bigger base of business in EMEA. Just historically our installed base is that much bigger. And therefore, when you get more customers buying, you just see a bigger pop. But overall, I think all geos through the course of this year are forecasting, as you've heard earlier on, strong growth in FAN and we expect to see large data center buildouts in Asia as we see in the United States and in the Europe. So there's nothing underlying the specific performance in Q1 by geo that I would call out. I think it was just deal driven, and we expect all geos to be performing well this year across the board in FAN.

Operator

And we'll go next to Rajesh Ghai with ThinkEquity.

Rajesh Ghai - ThinkEquity LLC, Research Division

The last time you moved to indirect model from a direct model in the LAN business did not go down too well. I'm just wondering what are you doing different this time? Or what are the leading indicators that you see that gives you confidence that the move to the channel, the model and the LAN side is going to be successful?

Ian Whiting

Well I think you're probably referring to the move to the OEM model -- or not move to it, but adding an OEM route to market, which we looked at early on post foundry. That didn't play out as we or anyone else had expected. I think it's fundamentally different. The channel is a very well-oiled machine. It's how the business, the 20 years has been done. It takes time to build loyalty relationships and run rates in the channels. It starts with making a quick commitment to the channel, which we've done by moving a significant percentage of the former foundry directors and its customer base, as well as all these new customers we've been winning to a single to a distribution model. It comes as a result of a lot of the work that John McHugh’s team is doing in terms of building infrastructure, systems and tools, making us easier to do business with. And having the kind of incentives in place that make it worthwhile for channel partners to invest in your product line. All of that work has -- a lot of that work, I should say, has been done. And we're starting to see the benefits of that, but it is a process and it takes time. Our competitions have been doing this a lot longer than we have. But there is a general sense that the channel is much more able and certainly in many places, willing to participate and cooperate with Brocade, because they see Ethernet Fabrics and other innovation that we're bringing to the market as a way for them to differentiate and build their own business. So I think the OEM and channel models are fundamentally different. And I think that what we're doing right now is a tried and tested formula for success. So we have to let it play out, and we're not going to de-commit it from that course.

Rajesh Ghai - ThinkEquity LLC, Research Division

And on the VDX, VCS ramp of 7,000,400 customers total, a couple of questions on that. How many of those customers are using VDX in a production data center environment? And B, how many of your customers are at cloud hosting, up on the cloud hosting vertical?

Ian Whiting

So our definition of a VDX or VCS customer is that they are in production in some form or fashion. So you should see in that, if not all, and certainly 90%-plus of those customers are using Ethernet Fabrics in a production environment. I don't have the breakdown by customer segment in front of me, but I would say that certainly a key marketplace for us, or the target marketplace for us, is cloud and hosted service providers because the fundamental value proposition of Ethernet Fabrics is that it simplifies the entire network design and enables people to deliver services in a much more efficient, high-performance way. But we can certainly get that number to you. I just don't have it to hand right now.

Operator

And we'll go next to Scott Schmitz with Morgan Stanley.

Scott Schmitz - Morgan Stanley, Research Division

Just a follow-up on that. Can you talk about the order patterns of VDX for your existing customers versus the new customers? And when do you expect to see larger deployments?

Michael Klayko

Again, this is Mike. We actually started out down the path of making sure we can get to as many possible new customers in the VDX space, and that's still the strategy that we're on. We've got defined verticals, as well as blueprints with very refined customers that we're going after. So it's programmatic and it's very prescriptive. At that point in time, when they go through these initial installs, as we roll out additional products in the space and offerings in the space, we will continue to see them buy more. But today, it is -- customer acquisition is actually more critical because we see these customers when they use our technology in their enterprises really become customers for life. And we have a significant lead in technology over anybody else in the market. So for us, it's much more important to get as many of these customers, because I think once we get them and they see the value of this product set, they will stay with us for a very, very long period of time.

Scott Schmitz - Morgan Stanley, Research Division

Okay, that's fair. And then just, can you give us an update on your diversification efforts within the public sector as you try to move outside some of the DoD and intelligence agencies?

Ian Whiting

Yes, this is Ian. So very consistent with what we said last time. We definitely see a massive opportunity for us to expand our footprint in the federal government space. We have made some very key strategic hires in that space recently. So we have a new leader of our Civilian Agency business. And we're also now actively involved in pursuing a lot of new program business. Whereas in the past, certainly the former foundry was highly concentrated in a very few very profitable high-growth areas within the federal government. Our strategy has always been to expand the base. And we are certainly well down that path now. It starts with having the right leadership in place. And with some of these new products, we are getting invited to a lot more interesting conversations today. And you can expect us to continue to update you on these calls every quarter on growth and expansion in that area.

Operator

And we'll take our next question from Erik Suppiger with JMP Securities.

Erik Suppiger - JMP Securities LLC, Research Division

Two questions. On the SAN front, your channel inventory has been coming down for the last few quarters. What are you expecting that to do in the Q2? And when is that trend going to start -- when are you going to start benefiting from at least stabilizing channel inventory or increasing channel inventory?

Daniel W. Fairfax

Eric, this is Dan. Right now, we think that the OEMs will probably manage the inventory across that set of -- our channel partners there to about a week to 2 weeks, probably close [ph] depending on their own seasonality. And we seem to come down, but we're now near the bottom end of that range. So I wouldn't expect it go much lower than this.

Erik Suppiger - JMP Securities LLC, Research Division

And then the second question on the LAN front. I just want to be clear. When you talked about expecting growth of 2x in the market, you're talking about your fiscal year LAN business versus the fiscal 2011, is that correct?

Daniel W. Fairfax

I think what we actually are reflecting that against is for the markets we serve with our products, which is very broad. We would expect our growth rate for our particular business to be at about twice the market rate, not making a specific comment about last year.

Erik Suppiger - JMP Securities LLC, Research Division

Well can you just give us a flavor, modeling that out and gives us a sense for whether you expect the non-Federal Enterprise business to be growing? And what kind of rate that would be? Would it be up or down year-on-year? And would you expect the Federal to be up or down, because clearly, the Service Provider is, but the other one is not clear?

Daniel W. Fairfax

So I think generally right now, with the way our sales go-to market is, we would expect it to be above last year in each of the segments that we talked about serving. Ian, I don't know if you want to make any...

Ian Whiting

Yes. I think -- so The Enterprise landmark, also referred to as the Campus landmark place, is where that channel place is going to be critical to us. And I think we’ve set the course for a long-term strategy there because it's going to take time to win over channel partners and start to get that real leverage in that marketplace. Where I think we are expecting to see healthy growth in addition to service provider is in the data center, where I think we have some really great technology differentiation that ties into all the major trends that we're hearing today around virtualization and cloud. So we don't break it down into that level of granular detail. But certainly in terms of the activity levels, the number of deals we're getting involved in that are material for the business, it's service provider, it's data center IP. And we are optimistic that the Federal business this year will be strong for us. But I think there's a lot of other factors that play into that, that we're all dealing with.

Operator

We'll take our next question from Keith Bachman with BMO Capital Markets.

Jung Pak

It's Jung Pak for Keith Bachman. I want to follow up on the Ethernet side. Can you say what you expect the Federal business would do for the April quarter?

Daniel W. Fairfax

Yes. So we tend to not to give that level of granular detail in terms of our forecasting. But what we would point analysts, investors to look at is a kind of classic seasonality is at the first half of our fiscal year, Ethernet revenue with our Federal customers is lower than the back half, quite significantly. So I think you get plenty of guidance if you look at the historical patterns there.

Jung Pak

Okay, fair enough. And then switching on the Service Provider side. Many of your customers have indicated some weakness on the service provider side, whereas you guys have outperformed. Can you just tell us what the difference between as for Brocade versus your competitors where you guys are winning things?

Dave Stevens

This is Dave again. What I would say is that we are targeting -- I can't really speak to the weakness that other folks are seeing in the Service Provider business. I can really just talk to what we see out of our Service Provider customers. And as I said before, we're seeing continued buildout of cloud and hosting centers, where MLXe and the ADXs and the VDX family played very, very well. And the continued buildout of backbone bandwidth with the MLXes and the 10-gig density and the 100-gig density in that platform, again, are very well tuned to the performance requirements in the power and density that the carriers are looking for in those particular environments. So we just continue to try and take the products and optimize them for the needs of those particular customers, and they continue to resonate with the customers.

Ian Whiting

We're also seeing some success with the application delivery control of product line, the ADX product line, which is giving us a great opportunity to penetrate some of the Tier 1 network operators and hosting providers as well. So that's an asset that we’ve started to use more and more to build bridges into similarly larger telcos.

Jung Pak

Was the strength in Q1 driven primarily by U.S. or in North America?

Ian Whiting

In Service Provider?

Jung Pak

Yes.

Ian Whiting

It was pretty much across the board. We saw some strength in parts of Asia for the reasons that Dave just mentioned, and also the strength of the ADX product line. But I wouldn't characterize it as being geo-specific. It was -- we saw some really good signs of growth and some key account wins in all theaters.

Operator

And we'll go next to Joanna Makris with Mizuho Securities.

Joanna Makris - Mizuho Securities USA Inc., Research Division

Wondering if you could comment with respect to the Service Provider business traction and on the -- your data points related to the network subscription service and how that's working out with Max Space [ph] and others.

Michael Klayko

Well the Brocade Network Subscription model is being used very prudently at many of these, not just service provider accounts as they built, although there's a larger traction there because of the fact their building out cloud-based computing models. And this pricing model aligns hand in glove with how you would implement cloud-based implementation. So there is a lot of interest in that space, a lot of discussion. But it's also in a much broader spectrum around many accounts that are looking to make sure that they can have the latest technology in place and give them some flexibility. So I wouldn't highlight to say it's just in that marketplace that we've seen growth. But I will tell you that there's interest there, as well as other -- in enterprise. And so I can't give any more comments on our BNS offering because I think it's just performing as we had expected it to perform at this point in time.

Operator

And our final question comes from Brian Marshall with ISI Group.

Stephen Patel - ISI Group Inc., Research Division

This is Stephen Patel calling for Brian Marshall. Looks like 16-gig Fibre Channel is ramping rapidly. Has that happened? Can you shed some light on what's happening with the 4 gig and 8 gig sales and how much of a headwind to growth that is? Given that we're seem to hitting the sweet spot of the upgrade cycle, do you view guidance for 4% to 5% growth as conservative?

Michael Klayko

Well as we mentioned earlier on the call and unfortunately, Stephen, it's always sad to go last when you're -- as all same questions come up. But it is -- 4 gig, there's not any adoption of 4 gig anymore. It's been really an 8 gig or 16 gig question. And as new data centers are built out and new customers bring in applications, what you're finding is if you already have the existing products in place, you may buy existing blades to fill out and populate the directors, and those could be 8 gig. But if you have a brand-new application or new data center, you're going to put in a new product, which is 16 gig. And we've seen that. And as virtualization, as you've heard before, gets more and more pervasive in throughout enterprises as well as cloud-based computing, and just the fact that the whole world has moved to mission-critical, every application becomes mission-critical. They're very robust architecture. And so it's moving very rapidly to 16 gig. It's actually exceeding our internal tracks. All the way from when we went -- from 1 to 2, 2 to 4, 4 to 8 and 8 to 16. This is the fastest adoption of this new technology. And it's not just, as we've mentioned in previous calls, it's not just the speed bump. It's all the enhanced features that come along with it, the manageability and how you use this and how easy it is to deploy and all the enhancements. You put all that together, it's a great value proposition that customers are actually pulling us into. And in fact, many of them are going to be going through upgrade cycles, I think, in a more rapid fashion than they've had in the past.

Stephen Patel - ISI Group Inc., Research Division

And then a follow-up on the switching side. You're one of the first vendors to support OpenFlow, and we've seen most other vendors follow with announcements. How do you view the long-term opportunity there? Is that just going to be a future checkbox for vendors? Or is there a market share or revenue opportunity you think you can take advantage of?

Dave Stevens

No. I think that -- this is Dave. Steve, as you I think noted that we've been very open and very aggressive in our development around OpenFlow and other software deployment networking technologies. We continue to see very good opportunities especially in the carrier markets and large data center and cloud environments for the adoption of that technology. It's very early in the adoption of it. We see it more in the service provider space than in the enterprise space, but we continue to participate very actively there and participate in the development of organizations and be a key contributor to driving the technology forward.

Michael Klayko

Okay. I want to thank everybody for their time this afternoon for participating in the conference call. We look forward to speaking to you. Hopefully you can join us on March 6 at the Effortless Network event that we have planned, as well as various investor conferences that we will be attending during the quarter.

So with that, operator, I'd like to conclude the call.

Operator

Thank you, sir. That does conclude today's conference. We do appreciate everyone's participation.

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